NN IP: Taking stock of the global growth outlook
Next few quarters should be plain sailing for the global economy
Until about a year ago, we talked a lot about growth momentum on these pages for the simple reason that it was a major theme driving markets. Just to recap quickly: In H1’14 the consensus opinion was that the global growth recovery, which started in late 2012, would continue and eventually settle at a robust, somewhat above-potential pace. The implicit assumption here was that the digestion of developed market (DM) imbalances would allow for robust and clearly above-potential growth in that part of the world which, in turn, would allow emerging markets (EM) to digest its imbalances while maintaining a decent, albeit somewhat below potential, growth momentum. This period clearly serves as the most recent, but also as a general textbook example that the economic system cannot be captured in a set of fixed equations that describe its immutable structure. Rather the structure evolves endogenously over time in unpredictable ways. In H2’14 we started to see a complicated interaction between a positive commodity supply shock and a large divergence in G3 monetary policy cycles, which produced tectonic shifts in the oil price and the dollar effective exchange rate. This had repercussions beyond the sectors and regions directly impacted by these shifts in asset prices, both in the financial and real spheres. As a result, the world was faced with a substantial disinflationary shock, the effects of which were muted considerably by a dovish shift in the G3 central bank reaction function.
Around the summer of 2016, the ripple effects of this shock more or less died out. The world economy embarked on a strong acceleration phase, driven by a simultaneous and interrelated recovery in corporate profits and confidence which spilled over into a notable improvement in investment spending and continued solid levels of employment growth. As a result, during the past two quarters global growth has been hovering a bit above the ceiling seen since 2011 and this performance may well be continued in the current quarter. Having said that, the underlying composition of growth is changing. The relative importance of consumer spending has been declining somewhat while investment spending has become a bigger driver of growth. We view this as a positive development, because the implied increase in the capital stock should have positive implications for productivity growth. Still, it is important to remark that we are certainly not forecasting a substantial slowdown in consumer spending growth. After all, labour markets remain strong, consumer confidence is high and DM consumer balance sheets look pretty healthy.
All this begs the question to what extent the current global growth momentum can continue into 2018 and possibly 2019. The short answer to this is that we are somewhat more optimistic that it will be maintained until well into next year. In the near term, the risks could even be tilted somewhat to the upside. These risks reside in a larger-than-expected US private sector spending response to the combination of fiscal easing, deregulation in some sectors and high levels of business and consumer confidence. In Euroland, the positive feedback loop between consumer and business income and spending is well established by now and could well get some additional fuel from a combination of a decrease in the private sector financial balance (which is still firmly positive), the release of pent-up demand for durable goods and construction and an improvement in the credit pulse. Furthermore, in Japan the policy mix remains extremely favourable to a continuation of the “high pressure economy”, in which the output gap is closed according to many measures, but growth continues to substantially exceed most estimates of potential. The answer to this apparent conundrum is that the high pressure economy is eliciting a positive supply side response by raising the participation rate and encouraging investment in labour-saving technology. Even taking this into account, the economy will run into hard supply side constraints at some point, in which case wage and price inflation should visibly accelerate. However, this is precisely the whole point of the Abenomics program.
Synchronised recovery joined by emerging markets
It is important to remark that EM space is also participating in the global synchronised recovery, even though there are some laggards such as South Africa and, to a lesser extent, Brazil and Russia. The key story here over the past year has been that the external environment has become a lot more benign. This is clearly the case for international trade flows, which have accelerated both because of higher trade growth between DM and EM but also because of an acceleration in intra-EM trade growth, which betrays an improvement in EM domestic demand. Meanwhile, despite some jitters in recent weeks, EM financial conditions have eased substantially on balance from the moderate tightening seen immediately after the election of Trump. The main driver has been an improvement in EM capital flows, which have become a lot less sensitive to Fed policy expectations compared to 2015/16. In fact, the trade-weighted dollar depreciated on balance over the course of the year and this depreciation also took place against the EM currency basket. One reason could well be that the dollar tends to depreciate in a risk-on environment because US safe and liquid assets perform the function of global money. Another reason is probably that marginal change in growth momentum has been in favour of the world-ex-US. Finally, as far as policy and political risks are concerned, there has arguably been a marginal relative shift to the detriment of the US. Still, the events of recent weeks make it clear that a repricing of Fed expectations can still trigger somewhat of a deterioration in EM external financing conditions. Despite this, our base case of solid US and non-US growth, coupled with moderate US inflation pressures, should continue to act as a tailwind for EM.
Besides the external environment, the real story of 2017 for EM is that domestic demand is finally showing some signs of life. A key driver in this respect is the notion that the EM deleveraging cycle may well have entered a phase which is more benign to domestic demand growth. In particular between 2011 and 2016, the EM private sector actively sought to pay off debts to such an extent that its collective effort acted as a formidable drag on domestic demand growth. Adding insult to this injury was a low level of EM corporate profitability. The latter has clearly improved over the past year and the EM private debt-to-GDP ratio has peaked. The latter development means that EM can now de-lever further by allowing improved nominal growth to reduce the debt burden over time. Needless to say that the collective expectation that this will happen will create its own reality. In this respect, the most recent IIF survey of EM bank lending standards reveals that EM banks have stopped tightening lending standards, while the demand for credit has improved over the course of the year. This cocktail is only reinforced by improvements in EM business and consumer confidence where the latter receives support from robust rates of employment growth. Finally, China is and will remain a key driver of EM fortunes. The good news here is that targeted credit tightening has succeeded in stabilizing the debt-to-GDP ratio and that there have been positive reforms to make the state-owned enterprises sector more resilient. Within the composition of Chinese GDP, the sharp rise in the consumption share is certainly a positive development.
2019 growth outlook is surrounded by lots of uncertainty
All in all, 2018 could be a year of continued strong DM performance with some upside risks and a moderate improvement in EM performance. As long as DM central banks remain on a gradual course towards the exit this should make for a good environment for risky assets. Clearly, the inflation outlook is the key variable in this story and we will come back to that in the next few weeks. For now, let’s stick to the growth outlook under the assumption that inflation pressures will remain benign, i.e. rise only gradually in the US and very gradually in Europe, while inflation may perhaps accelerate a bit faster in Japan. This assumption seems reasonable for the next year or so.
Nevertheless, plain sailing for the growth outlook becomes somewhat less certain as we approach the end of 2018 and go into 2019. In particular, there are a number of key uncertainties which cause us to believe that growth momentum in DM space could moderate somewhat starting roughly a year from now. A key driver here is the state of the US economy which could well experience a “sugar high” of fiscal easing in H2’18/H1’19, with uncertain effects on the demand and supply side of the economy. The Fed will have to decide to what extent it will react to this sugar high without having full information on its ultimate effect on the output gap. This increases the risk of a policy error, which could arguably be on either side. The Fed may err on the side of caution, in which case inflation will accelerate more than expected. From the perspective of the real economy this could actually be a welcome development, because a period of above-target inflation would better cement inflation expectations and provide a buffer from when the next downturn hits. Still, if inflation all of a sudden wakes up, financial markets could well display a knee-jerk reaction and start to price a sharp acceleration in the pace of Fed hikes, in which case financial conditions would tighten fast and furious. Alternatively, the Fed may overestimate the inflationary impact of the tax cuts and tighten to such an extent that the economy slows too much.
Even if the Fed does not make a fiscal policy induced mistake, the economy could well move beyond the point of full employment as the unemployment rate may well end up in the 3.5-4% range in late 2018/early 2019. It is important to remark that this by no means certain. A strong supply side response driven primarily by a pick-up in productivity growth could still trigger a decline in the unemployment rate which is much less pronounced, while at the same time allowing for an acceleration in wage growth which is not inflationary. Clearly, this would represent a continuation of the Goldilocks scenario. Still, the important point is that the economy will enter overheating territory at some point, but in this positive scenario this may only happen in 2020. If and when this happens, growth momentum will tend to become more susceptible to shocks or policy mistakes which trigger a recession. If there is a large degree of slack, the policy prescription is pretty easy and predictable: As long as inflation expectations are well-anchored the central bank should err on the side of caution.
Nevertheless, if the economy is already overheating this is no longer the case. What’s more, prolonged overheating could well lead to the build-up of imbalances in asset prices and private sector balance sheets. The Fed is very well aware of all this, which is why the relative weight it puts on its full employment objective could well increase the bigger it deems the risk of sustained overheating to be. In other words, for any given expected path of inflation the Fed will become more determined to see growth decelerate towards potential the lower the unemployment rate falls. This does not necessarily imply an acceleration of the pace of Fed rate hikes. In fact, by late 2018 and going into 2019, we expect that the trajectory of the G3 central bank balance sheet will start to put more upward pressure on the term premium in government bonds. After all, Fed balance sheet roll-off will gradually accelerate throughout the year, while the ECB is expected to stop net purchases in December 2018 and the BoJ in unlikely to reach the JPY 80 trillion quantity target because it has a price target. This rise in the term premium, combined with a policy rate that is gradually brought to neutral, could well be sufficient to engineer an overall tightening of financial conditions that slows growth down towards potential.
In our view, the “need” for the US economy to slow down going into 2019 is thus the main reason to expect the global growth gear to shift a notch lower in 2019. Having said that, there is a lot of uncertainty here. First of all, the need for the US to slow may be less than currently anticipated if productivity growth surprises on the upside. Secondly, the rule of thumb that a downshift in US growth momentum will automatically lead to a slowdown in Europe too may well remain a lot less strong than it used to be. Over the past year or so, we have already seen that this rule of thumb did not really apply. EMU growth momentum over the past year has to a large extent been driven by domestic demand, even though it must be said that the latest push towards a 2.5% cruising altitude owes a lot to improved external demand. In this respect, a US slowdown should still impact Europe, unless it is compensated by stronger EM demand. The latter is of course a possibility, but we have to bear in mind that EM space will still be in the process of digesting leverage imbalances around a year from now, even though the drag this exerts has grown a lot less. The question is then whether or not EMU domestic demand can compensate for a mild US slowdown. Never say never, but this is not likely. EMU growth is already well above potential and to some extent supported by the release of pent-up demand. This pillar of support could well become less strong as we move into 2019. What’s more, Europe will not be able to entirely escape a tightening of financial conditions triggered by rising term premiums, even though the ECB’s lower-for-longer policy should be an important counterweight to this. Finally, an environment of gradually rising term premiums, an end to net asset purchases, and political risks suggests that the risks for peripheral spreads may change in the direction of some moderate widening at some point.
The final piece of the puzzle is then Japan. As we argued earlier, we see compelling reasons why the high pressure economy will continue to improve the supply side. On top of this, the BoJ can insulate Japanese financial conditions from rising global term premiums. In fact, the latter could act to drive the yen exchange rate lower. Still, Japan will feel the deceleration of US and EMU growth as well as a gradual slowdown in Chinese growth. On top of this, there is a limit to which the supply side can expand. Rising unit labour costs may at some point cause profit growth to slow down, which in turn may spill over into a mild deceleration of employment and capex growth. All this must be weighed against the potential stimulus effect from the 2020 Olympics and volatility induced by the H2’19 planned VAT hike. The latter is planned for October 2019 and could lead to a surge in Japanese growth in the middle of 2019, but also some payback in Q4’19.
Emerging markets: South Africa’s uncertainty
Last Friday, S&P decided to again downgrade South Africa’s local-currency and foreign-currency credit ratings. This was widely expected by the markets. More surprising was that Moody’s put its ratings on review for a possible downgrade. Moody’s ratings are still one level above junk, while S&P’s ratings are below investment grade now.
The problem is that South Africa’s growth performance continues to be weak, with big implications for fiscal revenues. The authorities remain unable to break the vicious circle the country has been in for years. Raising taxes is not a real option anymore. Unemployment, still at 30%, needs to be reduced and a positive confidence shock is required to get private investment growth at a structurally higher pace.
Meanwhile, the budget deficit remains at 4% of GDP and public debt is rising by some 4 percentage points on an annual basis. Only a few weeks before the important ANC conference, where the next party leader will be elected, political uncertainty is high. If Vice-President Cyril Ramaphosa is appointed, sound policies might look secured. But also from the moderate ANC wing, clear solutions to create jobs, achieve higher growth and reduce macro imbalances at the same time are not available. If Nkosazana Dlamini, President Zuma’s ex-wife, is appointed, confidence is likely to erode further. Populism, continuous corruption and unorthodox policy choices can potentially derail the fragile post-apartheid equilibrium.
In either scenario, an ANC win in the 2019 general elections looks far from certain, after years of rising corruption, numerous scandals and weak economic growth. Uncertainty is therefore likely to remain high, paralysing the economy and leading to more fiscal problems. More credit rating downgrades and capital outflows will then be difficult to avoid. The country needs at least 2.5% growth to stabilise public debt ratios; the current growth pace is only 1%.