That Donald J. Trump’s election to be the 45th U.S. president upended the political world does not imply that it radically transformed the economic outlook. Reviewing our projections for important economies over the next few years provides an opportunity to catch our breath. Yes, the victory was a surprise to virtually all commentators, even though the vote-share margin was within sampling error in most major polls and a one-in-three outcome in predictions markets (as was the case the week before the election) should be expected to occur, wait for the higher math to follow, one in three times. Elections matter, but so too does the momentum of fundamentals in place before the election. A single-party government can engineer meaningful changes in public policy and national attitudes but most of that takes time to get traction, especially legislative initiatives about personal taxes and financial regulation. As for the former, the code is complicated and vested interests entrenched. As for the latter, legislation may change quickly, but regulators and the regulations they wrote roll off the books gradually.
In our forecast, economic momentum propels itself by Newton’s First Law that a body in motion stays in motion. Incoming data mostly make us more confident that the global economy is expanding, albeit at a slow pace. As shown in the chart, reports on activity in the U.S. and euro area have yielded few surprises, on net, relative to economists’ expectations over the past few months. As a result, we have only made minor adjustments to our forecasts for growth and inflation in the G-3 economies, other than marking up real GDP growth in Japan in light of more favorable outcomes of late. In the UK, the vote to leave the European Union has yet to weigh on national output, much to our and everyone else’s surprise. Still, because we think that there is a four-in-five chance that Article 50 to kick-start the UK’s long goodbye will be invoked by spring 2017, we remain pessimistic about the UK’s longer-run growth prospects. This performance in advanced economies, along with China anchoring the expansion of other emerging market economies, supports commodity prices. We expect oil prices to trade in a relatively narrow range.
Extending the forecast to 2018 adds little drama to the story, in part because we remain suspicious that potential output is poised to accelerate across advanced economies. Potential output moves along a shallow incline over time, determined by the demographic trend of an aging population in advanced economies and disappointingly slow productivity growth. On that score, we have the company of the staff of the International Monetary Fund. As shown in the chart on the next page, the latest World Economic Outlook (WEO) is built around the premise that potential output growth across 39 advanced economies stepped down in 2008 and has not recovered much since. Indeed, the spread of outcomes around the median forecast of long-term growth has narrowed (seen as the drawing together of the 25th and 75th percentiles, the dashed lines, toward the median, the solid line), suggesting that “growth miracles” will be few and far between.
With aggregate supply growing at a tepid pace since at least as far back as the financial crisis, resource slack is disappearing, and inflation is on the way up. Indeed, U.S. consumer price gains are poised to overshoot the Federal Reserve’s (the Fed’s) 2% goal. Global inflation remains in an even higher range because that average is pulled up by more aberrant high rates in a subset of countries. Significantly, membership in the club of monetary regimes behaving badly is on the rise. The chart below establishes both points from the vantage point of the WEO forecast. First, the solid lines plot the average and median inflation outturns from 1980 to 2016. The average is pulling slightly away from the median as a result of a few high readings (note the scale). Second, the bars plot the share of economies losing their grip on the change in consumer prices — where inflation is either negative or above 40% per year. Presumably, some economies are having difficulty coping with the widespread depreciation of their currencies over the prior few years or are resorting to monetary finance to plug fiscal gaps opened by earlier weak commodity prices. For whatever reason, the world is not back to the 1980s, yet, but it is closer to that experience than has been the case for some time.
U.S. inflation moving above 2% induces a reluctant and divided policy-making committee to tighten once this year and to quicken the pace of action in 2017 and 2018. The Fed getting into a firming frame of mind against the backdrop of global growth and a revival in inflation gives the other G-3 central banks some breathing room on increasing their own accommodation. The Bank of Japan’s yield cap has already put an automatic mechanism in place to support a pickup in inflation, should it come. The European Central Bank (ECB) will do enough to keep its asset purchase program on track, but not as much, with less heart in it, than we anticipated in our September outlook. This probably means that doubts about their resolve will dominate the discussion in markets through the remainder of the year. The November election, no doubt, thickens the usual fog surrounding the economic outlook. Regardless of the electoral outcome, we expect more fiscal impetus and a backpedaling on trade relationships in 2017. The extent and composition of both depend on the vote count, of course, and we suspect that the changes will be more extreme if one party sweeps into control of both the White House and Capitol Hill.
DEVELOPED MARKETS: UNITED STATES
Adding a year to the outlook gives us more scope to express our dim view on the longer-run picture of the U.S. economy. To be sure, our assessment that potential output is expanding at just 1.50% seems vulnerable — to the downside. The flow of entrants to the labor market seems poised to slow, and output per hour was unchanged in the past four quarters. Without extra hours worked and more output added with that effort, U.S. potential output growth may be headed toward that of some of its more sclerotic advanced-economy peers. We are not ready to throw in the towel on a revival of productivity just yet and are keeping our assessment of potential output growth.
The slow pace of longer-term growth centers the path of an economic forecast. Outcomes relative to that track depend importantly on the tailwinds or headwinds set by policy. This year and next, those winds are decidedly blowing on our back. Monetary policy is now and will remain accommodative through 2018, in that the real policy rate will be below zero over that entire period. With the election behind us, fiscal policy gets back into the game next year, as infrastructure spending kicks in. Tax changes, however, which are slower to work through the legislative process, limit that stimulus in 2018.
With the rest of the world offering a stable, albeit subdued, backdrop, we think real GDP expands around 1.75% over the next 27 months. This late in the year, the first part of the forecast is mostly arithmetic, with the ongoing quarter matching the average pace of the first three quarters. This is not exactly climbing out on a limb, in that real GDP growth averaged 1.75% over the recovery and expansion begun at the end of 2008. With aggregate demand expanding a touch faster than aggregate supply, resource slack turns into excess demand next year and beyond. As the unemployment rate heads toward 4.50% and commodity prices move sideways, upward pressure on costs shows through to headline inflation. Quarter-point increases in consumer price inflation each year sneak up on monetary policymakers, hitting 2.25% in 2017 and 2.50% in 2018.
Writing down a baseline path for Federal Reserve policy is easier than predicting how smoothly Janet Yellen and Company pull off that path. We believe that Chair Yellen leads from behind, agreeing to act only when the preponderance of her colleagues yearns to act. Because enough now do so, we expect a 25-basis-point hike in the fed funds rate target at the December meeting, essentially as Yellen would otherwise run out of room to deliver on her reassurances that tightening was appropriate this year. As inflation overshoots modestly (remembering that the Fed’s preferred personal consumption expenditures-based inflation measure will track a bit, but less than the past few years, below CPI inflation), policymakers pick up the pace of action, with two quarter-point increases each in 2017 and 2018.
The problem with leading from behind is that the pack can pull away. Look for a bit of divisiveness creeping into Fed communications, not so much as to imperil the project, but enough to make reading the signals from the institution even more difficult than usual.
DEVELOPED MARKETS: EURO AREA
The European economy surprised to the upside recently, as near-term Brexit spillover risks abate. We see this in the strong performance of survey indicators such as the Markit Purchasing Managers’ Surveys and the German Ifo business confidence index. As such, we have moderately upgraded our forecast for inflation and GDP growth in 2017 to 1.1% and 1.3%, respectively. We suspect that the underlying economic push is stemming from Chinese stimulus set in place earlier this year; so as long as the Chinese growth engine remains, we are increasingly positive on the near-term outlook for core countries, such as Germany specifically. Looking forward, strong yet uneven growth across the euro area will likely lead to a growing divide on the Governing Council, with those strong economies preventing the ECB from adding stimulus to the degree that Standish’s forecast suggests they should. In short, President Draghi no longer has sufficient support to maintain a dovish bias and we believe that the likelihood of a policy mistake is increasing. Nevertheless, in the near term we expect that Draghi can garner the support of the Council to extend the asset purchase program another 3-6 months.
DEVELOPED MARKETS: JAPAN
Economic growth should be maintained at an above-potential pace through 2017 on the back of accommodative financial conditions and the effects of the government’s fiscal stimulus measures, as well as a gradual improvement in global demand. CPI inflation should rise from around zero to a near 1% rate in 2017-18 on account of base effects (especially oil price changes), narrowing output gaps, tightening labor markets, and further traction in wage negotiations. However, the dominance of adaptive price expectations, given the long history of deflation, and a near-at Philips curve will restrain core (as well as headline) inflation from rising much above 1%. The current account surplus should peak this year at around 3.5% of GDP and begin falling back modestly next year, as domestic demand picks up. An improving macro outlook should remain underpinned by negative real yields and more comfort around the sustainability of the Bank of Japan monetary policy framework. In turn, these trends in the economy should limit foreign exchange hedging by domestic investors and thereby alleviate appreciation pressures on the yen, barring adverse external surprises such as a slump in China or Europe or slower-than-expected Fed normalization. Deeper negative rates are more likely only if adverse or unexpected shocks materialize; and any tapering of asset purchases by the central bank will be gradual — so as to limit market volatility. Prime Minister Abe remains highly popular and is likely to seek a renewal of his mandate by calling early elections in Q1 2017. A renewed political mandate should reinvigorate the implementation of structural reform which should prove useful in the face of a near-certain postponement of the Trans-Pacific Partnership (TPP) agreement, which was expected to help boost the growth potential of Japan and other member states. Mr. Abe is also likely to seek closer relations with Russia to hedge against the risk of a more prolonged inward turn in U.S. politics.
DEVELOPED MARKETS: UNITED KINGDOM
Three months after the UK voted to leave the EU, the UK economy has been more resilient than had been expected. However, we continue to expect a slowdown in growth prior to the triggering of the formal Article 50 in Q1 2017, as household consumption declines under falling real incomes and increased uncertainty about the future. Sterling’s 5% depreciation in October will put additional pressure on inflation to rise and initially overshoot the Bank of England’s (BoE’s) inflation target, although we do not expect this to persist beyond the next two to three years. We do not expect substantial fiscal expansion at the Autumn Statement on November 23, but instead a relaxation in the pursuit of budget deficit targets and an expansion in infrastructure spending. Following the BoE’s more neutral stance, we do not expect further monetary easing until May 2017.
DEVELOPED MARKETS: AUSTRALIA AND NEW ZEALAND
The Reserve Bank of Australia (RBA) had little reason to significantly shift its stance at its November meeting. Newly appointed Governor Lowe did not shed much new information in his second statement as governor, with his overall assessment of the economy arguably a bit more cautious and downbeat, particularly on the composition of employment growth and housing. Data has been mixed since the last meeting — weak domestic jobs, inflation stuck at low levels, better commodities, perhaps a more stable China in the second half of this year, and no Fed hike yet. While positive for Australian growth, higher commodity prices could debatably be viewed as a risk to the RBA since they would drive unwanted Australian dollar strength and therefore disinflationary pressure. The recent lift in commodity prices is not nearly enough to spur a significant rebound in mining investment.
We continue to think that Australia will lag the global reflationary cycle as it faces structural headwinds to inflation as it transitions away from the mining boom. However, having already eased policy twice this year, if further easing were to be delivered by the RBA, it is a mid- 2017 story and requires further evidence of slowing underlying inflation, which we expect to materialize.
New Zealand’s economy has been experiencing robust growth in domestic demand, and the labor market is doing very well; the unemployment rate continues to fall despite strong labor supply growth.
As a result of high population growth, supply dynamics, and low lending costs, home prices have been growing rapidly, most acutely in Auckland. Tighter loan-to-value regulations have been introduced to control home price growth, but prices are still growing at a 14% annual rate. While we feel that home price growth has reached its peak, it should continue at a robust pace.
While inflation surprised to the upside in Q3, CPI growth is still low and wages have yet to pick up significantly. Our central scenario is for the Reserve Bank of New Zealand (RBNZ) to ease policy only once more later this month. After that, base effects should help return headline inflation back to the RBNZ’s target band of 1% to 3% later this year, and higher levels of global inflation and oil prices should feed through to New Zealand’s small open economy. Dairy prices, a key export commodity for New Zealand, are up 60% from July lows, relieving some pressure on a dairy industry that has been experiencing negative cash flows for consecutive seasons.
A key risk to the RBNZ’s inflation forecasts is the high level of the New Zealand dollar, particularly on a trade-weighted basis. A stronger New Zealand dollar puts downward pressure on tradable inflation, and according to RBNZ forecasts, needs to depreciate ~6% from current levels on a trade-weighted basis in order for their inflation forecasts to be met. We feel that if the RBNZ were to cut again next year, it would likely be due to the strong currency.
EMERGING MARKETS: CHINA
China has been able to generate greater-than-expected cyclical momentum in the second half of this year by sustaining increases in infrastructure spending, and providing one-off incentives for boosting housing and auto sales. These efforts will not offset the structural drag on the economy from a rapid build-up in leverage, nor is it lowering the pace of the continuing pile-up in debt. But it is sustaining a “long landing” of the economy in line with the official target of 6.5% to 7% annual growth. We expect a further slowdown in 2017 and 2018 to test the authorities’ growth targets. However, fears of a hard landing remain distant.
This is because, firstly, China has been able to reflate the industrial sector through a mix of trade-weighted depreciation of its currency as well as capacity cuts in coal and steel sectors earlier in the year which have boosted industrial profits and ended producer price deflation; and secondly, fiscal spending by central and provincial governments — mainly on infrastructure — is likely to be maintained at fairly robust rates for at least another year or two. This trend is expected to remain backed by centrally sponsored debt swaps for the provincial governments and accommodative monetary policies by the central bank.
EMERGING MARKETS: SOUTH KOREA
Weak external demand, rising household debt and growing excess capacity will remain the bane of Korea’s gradually worsening macro outlook through 2017. Slowing Chinese demand for processing imports remains the main headwind for Korean exports. Recent setbacks at Samsung’s Galaxy-7 production, strikes at Hyundai Auto, and the president’s corruption scandal have weighed on production and exports and could weigh on growth through H12017. A cabinet reshuffle and recent rhetoric around a “micro tightening, but macro easing”— to limit housing and financial sector vulnerabilities while providing a boost to the economy — enable a cyclical stabilization in 2017. However, a growing risk is that ongoing investigations into the presidential scandal, and political dissonance in parliament, could slow the countercyclical response, and, in particular, thwart expansionary fiscal policy. These could raise further pressure on the central bank to restart the easing of policy by Q1 2017. In the interim, currency pressure on the won is likely to persist. Additionally, growing geopolitical tensions with North Korea alongside the prospect of a more prolonged inward turn in U.S. politics should add to the weakening bias in the currency.
EMERGING MARKETS: INDIA
India’s growth recovery has remained uneven and characterized by lackluster private investment, a slow pickup in bank credit, and disappointing exports. Private consumption and government investment — in infrastructure and social sectors — should remain the mainstay of domestic demand for the foreseeable future. Moreover, a better monsoon and an ongoing boost to incomes from the implementation of decennial public sector pay hikes should boost rural and public sector wages. Inflation should remain contained on account of an improving track record in managing food stocks, stable international oil prices, as well as reasonably prudent monetary and fiscal policies. Better-than-expected European activity, notwithstanding Brexit risks, is also limiting downside risks for now. Global excess capacity and a large overhang of bad loans at the public sector banks are curtailing a larger pickup in the corporate capital expenditure cycle. But domestic reforms are deepening, as evidenced by the recent passage of the goods and services tax, bankruptcy code, and ongoing liberalization of foreign direct investment norms. Recent border frictions with Pakistan are not expected to upend the overall priority of maintaining high growth backed by a deepening domestic reform program. Alongside stable domestic politics, supply-side improvements are continuing to attract more foreign direct investment and fueling a basic balance of surplus — which should keep the rupee fairly resilient against global risk events.
LATIN AMERICA: BRAZIL & MEXICO
The big story of 2016 was the regime change in Argentina and the country’s re-entry to voluntary international financial markets. This was followed by some resolution of the political crisis in Brazil, with the impeachment of President Rousseff and the acting government of President Temer. In both cases, authorities are laboring to improve the fiscal accounts and bring inflation down over the next two years. Similar success against inflation is taking place in Colombia and Peru, where monetary policy is likely to become accommodating in 2017. Although questions remain about Colombia’s success in approving an important fiscal reform and avoiding a ratings downgrade before year-end, it appears that in the countries mentioned above growth will accelerate marginally in 2017 compared to the expected growth rates in 2016. The outlier in that group has been Mexico, where growth deceleration and marginal increase in inflation are accompanied by needed cuts in fiscal spending in order to arrest the deterioration of debt dynamics. Of the Latin American countries mentioned above, Mexico is the one where growth may continue to disappoint in 2017. One important consideration is the resolution to the adjustments in PEMEX, the Mexican oil company, which could produce positive surprises and additional investment flows into the energy sector. It appears that recession will be avoided in all the major economies, with the notable exception of Venezuela, where the economic deterioration is expected to continue, together with a large chance of suffering a credit event, given the dire liquidity situation of PDVSA, the national oil company and the government, in general. Firmer commodity prices are helping in this scenario, with expected marginal improvements in the current account. Overall, not including Venezuela, local currency debt should continue to perform well. The above outlook remains hostage in the short term to the uncertainties surrounding the U.S. presidential election and the direction of economic policy under the next administration. However, no major credit deterioration should take place, with the exception of Venezuela, and the possible realignment of the ratings of Colombia and Mexico within the investment grade group. On that basis, Chile and Peru should continue to trade at tighter levels than other high grade Latin American countries, while Mexico should underperform its peers in the same category.
POLAND, HUNGARY AND ROMANIA
Central and Eastern Europe (CEE) continues to remain resilient to the spill-overs following the Brexit vote, which is not unsurprising as the Eurozone data has also remained resilient. As we enter into the final quarter of the year, growth is set to weaken compared to a very strong H1 — although it will continue to be driven by domestic demand fueled by rising real household incomes and fiscal stimulus across the three major CEE economies. In line with the Eurozone, we expect inflation to rise in Q4 of this year and H1 2017 as base effects related to food and oil are phased out. Focus remains on the formulation of 2017 budgets across the region, and we assume that budget deficits will be limited to the European Commission’s max of 3% of GDP and do not expect to see the Excessive Debt Procedure triggered in any of the CEE economies. Elections in Romania in December do exhibit risks to fiscal finances, although we expect these to be contained whatever the election outcome.
RUSSIA, TURKEY, AND SOUTH AFRICA
Economic fundamentals remain resilient across the largest markets in the Central and Eastern Europe, Middle East and Africa region. Growth and inflation are relatively stable in Turkey and South Africa, while improving in Russia. Fiscal finances remain under stress across these markets, with monetary policy set to be the adjustment mechanism for the economic cycle. While we remain confident that Russia and South Africa will continue their pursuit of orthodox monetary policy, we are less certain that Turkey’s monetary policy simplification (movement to a single interest rate) will be successful and believe that it may indeed induce volatility. Focus will likely remain on the continuing political battles domestically in South Africa, particularly those concerning Finance Minister Gordhan and President Zuma. It remains our base case that S&P will downgrade South Africa to sub-investment grade status at their review on December 2. As we approach year-end, there will also be increased scrutiny of President’s Erdoğan’s pursuit of an executive presidency in Turkey — particularly given the risk of either a referendum or early elections in spring 2017.