As far back as Homer (the blind Greek poet, not the portly Springfield resident), the dog days of summer, when the star Sirius tracks above the horizon in the Northern Hemisphere from early July to mid-August, were associated with catastrophe. That is how we felt two months ago when writing down our forecast for the global economy. A few weeks earlier, a slim majority of the citizens of the United Kingdom voted to leave the European Union but neglected to specify where they intended to arrive. First half real GDP growth in the United States was tracking below 1%. Oil prices might have settled in a trading range, but they might not have. Even more troubling, monetary policy in the euro area and Japan was evidently not in the right place, and policymakers there did not exude confidence that they knew where “right” was.
In any event, market economies proved resilient over the duration of Sirius’s arc, and incoming data were somewhat reassuring. The marked depreciation of the British pound and decline in gilt yields provided offset to the initial hit to confidence and activity, buoying economic data (but we suspect there is softening to come). Additional policy accommodation will likely be forthcoming from the Bank of England, the European Central Bank, and the Bank of Japan, although not as much or as quickly as market participants had suspected a few months ago. We have nudged up our projections for real GDP growth in the UK and Japan this year and the euro area next year.
Do not, however, take this as an uncharacteristic outbreak of optimism. The unpalatable reality is that potential output growth has slowed across advanced economies, and the expansion of aggregate demand in the most important emerging market, China, should slow to limit the already threatening build-up of excesses.
The growth of potential output sets the incline of the expected path of household income and business earnings. With both shallower, we are seeing more saving and less investment. The market outcome is a lower risk-free real rate and compressed spreads.
Potential output growth also marks the bull’s-eye centering economic growth forecasts. While we believe that center is low, in line with the better tone to incoming information, we have raised our outlook for the expansion of the global economy a tick. Risks this year still seem leaning to the downside, and next year is likely to be more of the same.
DEVELOPED MARKETS: UNITED STATES
Over the past three months, U.S. economic data surprises have netted to zero, consistent with the feeling that we have run around a big circle to wind up back where we were in early June. Now, as then, an accommodative Federal Reserve, supportive financial conditions, and steady-enough commodity prices serve as the foundation to center spending growth in a channel around 2% for the remainder of the year. At such a slow pace of expansion, random acts of nature and lumpy adjustments buffet quarterly real GDP growth within this channel, as witnessed by the first and second quarters scraping bottom and this quarter tracking 3%. The first half is bygones when it comes to calculating annual growth, which we think will be 1.7% on average this year, the same as in our prior forecast.
The slowing growth of our aging population, along with the inexplicable stalling of productivity, limits the annual rate of increase of potential output to 1.5%, which is also the current assessment of the Congressional Budget Office. This is at the low end of experience and implies resource slack has been virtually eliminated. This pushes inflation up to the Federal Reserve’s (Fed’s) goal of 2% by year-end and slightly over it next year. Core consumer price inflation, as well as the subset of the basket that tends to move more sluggishly, is already above 2%. Once the effects of earlier declines in oil prices have washed out, we should see a noticeable pop to headline inflation.
Our operative model of the Fed’s FOMC functioning is one of delay at the top of the pyramid. Tightening has to be extracted from the reluctant chair by the rest of her anxious committee. Chair Janet Yellen accedes, on occasion, because showing a willingness to tighten keeps her colleagues at bay. Delay, however, will keep the federal funds rate lower for longer. Right now, many Fed officials are getting restive about delay, but Chair Yellen might find a way to put them off for a time but not forever. We have penciled in one quarter-point hike in the federal funds rate in 2016, most likely in December.
The resulting firmer, but not firm, financial condition pulls the growth of aggregate demand in 2017 toward the pace of expansion of aggregate supply, but not quite. Expansion of real GDP at 1.7% further nibbles at available resources, leading the Fed to pick up the pace of tightening next year—to all of two quarter-point increases. This pulls the U.S. policy rate further above that of its advanced-economy peers stuck at the lower effective bound of rates, encouraging modest appreciation of the dollar.
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: EURO AREA
The euro area is expected to grow 1.5% in 2016 and 1.2% in 2017. Over the month, we upgraded our economic forecast for 2017, given that Brexit uncertainty and fears have yet to pass through to the economy as seen in the relative resilience of the confidence surveys. We attribute this muted economic response to the fact that financial markets have largely priced in “status quo” on the UK-EU relationship after the UK exits the political and economic union. We put a 75% probability on the survival of the status quo that would allow the UK to maintain free labor mobility and bank passporting rights. Nevertheless, given the uncertainty associated with these negotiations and some evidence pointing to stress in confidence, such as the manufacturing PMIs, we maintain that growth will come in lower than the European Central Bank’s (ECB’s) current projections on real growth through 2018 and more significantly so on inflation. This will prompt new easing from the ECB next year. In the near term, we expect the ECB to extend its asset purchase program beyond its end date of March 2017 by modifying the terms of the program at the December meeting.
DEVELOPED MARKETS: JAPAN
The recent trend of waning inflation and a strengthening currency raised market concern about income and GDP growth. But underlying consumption has held steady and capital expenditures have been resilient against external shocks, as evidenced by the larger-than-expected second quarter GDP expansion (even after revision) to a 0.7% annualized rate. Further fiscal and monetary easing should boost Japan’s macro outlook through 2017.
The Cabinet Office announced a three-year, ¥28 trillion package comprised mostly of loan guarantees and interest subsidies to help small and medium enterprises tide over Brexit-related headwinds. The fiscal component of this package, of ¥13.5 trillion (comprising loans and direct spending), should provide a 50-70 basis-point boost to growth from Q4 2016 through the end of 2017. Additional support should come through monetary channels.
The Bank of Japan (BOJ) will complete the comprehensive review of its monetary policy framework on September 21, at which time we expect further monetary easing. As of this writing, we expect the BOJ to prioritize deeper negative rates and re-commit to larger asset purchases (possibly across a wider spectrum of risk assets). Continuing monetary accommodation of fiscal stimulus should help contain bond yields and, thereby, boost the potency of the fiscal measures. For these reasons, we are raising our growth forecast to 0.4% this year and see further upside scope in view of supportive policies helping out before the year is out. However, the balance of risks to the medium-term inflation outlook remains tilted lower, unless onshore inflation expectations firm up considerably.
The prospect of more extreme policy reactions continues to generate considerable market interest. But we doubt if the authorities will go down the route of “helicopter money” anytime soon or, for that matter, consider ending the BOJ’s unconventional policies altogether. The authorities’ ability to shore up policy credibility would also go some ways in alleviating risk aversion by domestic residents, thereby quelling some of the appreciation pressure on the Japanese yen.
DEVELOPED MARKETS: UNITED KINGDOM
The focus for the UK was the much-anticipated monetary easing package from the Bank of England (BoE) after the June 23 vote to leave the EU. The BoE’s self-described ‘smart stimulus’ exceeded market expectations (as shown by the rally in gilts and sell-off in sterling). The BoE was keen to roll out a stimulus package despite the lack of hard data confirming a hit to the economy from the vote. The package was considered ‘smart’ as it is multi-pronged, and includes both rate cuts and credit easing measures. Furthermore, the BoE provided forward guidance that they would continue to provide monetary easing as required.
- The package consisted of a 25bps cut in the bank rate to 0.25%, a new term funding scheme TFS (aka long-term re financing operation LTRO in the Euro area) which provides up to £100bn in cheap funding for the banks at 100bps discount to current funding levels, £60bn in gilt purchases for the next six months and up to £10bn in corporate non-financial investment-grade bond purchases over the next 18 months.
- In addition to the package, there was a clear commitment to lower the base rate to 5/10bps by year-end even if current forecasts are met. There was also a clear commitment to extend all elements of the package should data disappoint these optimistic forecasts.
- Quantitative easing will follow the existing structure, despite concerns regarding the impact of falling rates on the long end of the curve and the negative impact on pension deficits.
- Governor Mark Carney was clear that negative policy rates will not be implemented on his watch, with the lower bound considered to be 0.05/0.1%.
- The BoE knows it can’t fully offset the Brexit-related slowdown which is coming, but it will do as much as it can on the monetary easing side—even abandoning its inflation-targeting regime for the next couple of years. And the Chancellor of the Exchequer has committed to fiscal stimulus in the autumn—which will most likely be matched by further base-rate cuts.
DEVELOPED MARKETS: AUSTRALIA
As we expected, the Reserve Bank of Australia (RBA) eased policy a further 25 basis points in August to 1.50%. Policy easing continues to be in response to low inflation, which was underscored by a disappointing print for the second quarter. Growth continues to hold up, and the mining investment drag should wane. Yet, as we have seen, greater than potential growth is not necessarily accompanied by higher inflation, especially if that growth is concentrated in the external sector as opposed to domestic demand. While we think it is likely that the RBA will deliver more accommodative policy, it is not likely to arrive until 2017, barring a significant down side inflation surprise before then.
EMERGING MARKETS: ASIA
Chinese authorities are in the early stages of a long overdue shift toward greater structural reform of state-owned enterprises. Meanwhile, they have also continued to push ahead with infrastructure spending and liquidity provision in the money markets to try to keep credit growth and real activity from slowing too much. Moreover, government officials have also begun taking measures to try to turn around the continuing downshift in private investment. For instance, they are allowing private companies to enter protected areas of activity, and are also trying to ease credit access for small to medium size enterprises that have been hit hard by the worldwide trade recession and that lack the benefits of implicit state support. At best, we think these measures could slow the downturn, with a lag, but not prevent it. Expectations for more monetary easing have risen as credit growth has slowed below officials’ targets. But, amid continuing capital outflow, monetary officials are likely to remain cautious. They will remain biased to actively using repo and term-lending facilities for at least a few more months, rather than opting for any outright reductions in benchmark rates or the banks’ required reserve ratio. They are also likely to continue to prioritize a weakening of the currency on a trade-weighted basis to ease monetary conditions and end producer price deflation. We think Chinese growth will ease to below 6.5% year over year in the second half of 2016 and that the USDCNY exchange rate will end the year around 6.8. However, insofar as the authorities avoid any serious policy errors, we don’t think softening trends in the country’s growth and foreign exchange rates will generate significant market volatility or policy pressure. This is underscored by reasonably stable onshore (and offshore) credit spreads, and a recent recovery of both the Caixin and official (National Bureau of Statistics) PMIs.
EMERGING MARKETS: SOUTH KOREA
Weak external demand and growing excess capacity remain the bane of Korea’s gradually worsening macro outlook. Slowing Chinese demand for processing imports remains the main headwind for Korean exports. Some respite comes from the recent strengthening of the Japanese yen and a pick-up in infrastructure investment by the Chinese authorities. But these remain insufficient for altering the overall macro outlook for Korea through 2017. This is because the extent of overcapacity and the inventory overhang will take more time to wind down. To their credit, the authorities have lowered financial vulnerabilities by proactively restructuring corporate debt in hard-hit sectors such as shipping and shipbuilding. They have also launched a small supplementary fiscal budget and recapitalized the policy banks so as to strengthen financial safety nets within a slowing economy. But these measures seem inadequate for narrowing Korea’s widening output gaps, and, as such, further easing by the Bank of Korea seems inevitable to keep growth and inflation from softening further.
EMERGING MARKETS: INDIA
India’s growth recovery has remained patchy and uneven, weighed down by lackluster private investment and disappointing exports. Private consumption and government investment in infrastructure and social sectors should remain the mainstay of domestic demand for the foreseeable future, with additional benefits from a better monsoon and a forthcoming boost to incomes from the implementation of decennial public-sector pay hikes. Inflation should remain contained on account of an improving track record in managing food stocks, as well as increasingly prudent monetary and fiscal policies which should also help contain core inflation expectations. The country could face headwinds from China’s slowdown and Brexit-related uncertainty. Global excess capacity and a large overhang of bad loans at the public-sector banks are curtailing a larger pick-up in the corporate capex cycle. But domestic reforms are deepening, as evidenced by the recent passage of a goods and services tax, bankruptcy code, and ongoing liberalization of foreign direct investment norms. These supply-side improvements should begin crowding in more foreign investment and tilt the balance of growth risks higher than what we currently project.
LATIN AMERICA: BRAZIL & MEXICO
The lowering by Standard and Poor’s of Mexico’s (A3 neg/BBB+ neg/Fitch stable) outlook, to BBB+ negative from stable, was not completely unexpected, given the worsening of economic fundamentals. There are strong chances that Moody’s may downgrade Mexico to Baa1 and Fitch cut its outlook before the end of the year as well. Mexico has limited fiscal flexibility, despite generally cautious policy management. The government insists the fiscal deficit would be contained at 3% of GDP this year thanks to revenue and spending adjustments but, in reality, the economy suffers from strong dependency on oil revenues for its (non-NAFTA) external trade and fiscal accounts. On top of that, PEMEX liquidity shortfalls have required cuts of oil production on the order of 5%, which, together with the decline in oil prices over the last two years, has put pressure on the government accounts. The government has been running a primary deficit since 2010; the government expects this will return to a surplus next year, a tall order, in our view.
We also expect that the Banco de Mexico will cut its growth forecast for 2016 to 1.7-2.5%, down from 2-3%, and to 2-3% from 2.3-3.3% for 2017. The finance ministry similarly cut its 2016 forecast, to 2-2.6%, following a quarter of negative growth in Q216, and expects 2017 growth to be between 2.6-3.6% (likely to be revised down in the budget to be presented
in September). Lack of growth in U.S. manufacturing and the resulting sluggishness in Mexican industrial exports are the two main reasons for the slowdown in the Mexican economy. Meanwhile, MXN is subject to volatility brought by market expectations regarding the U.S. Fed. Together with the increase in gasoline prices, these are factors which will influence overall inflation. Currently, headline inflation remains below the 3% central target (July: 2.65%), but core inflation has been just under that target for the last three months (July: 2.97%). It will be difficult for the central bank to act independently from the U.S. Fed, despite economic sluggishness.
In Brazil, the decision to impeach President Dilma Rousseff by 61 to 20 votes (54 votes needed) in the Senate, although widely expected, removes a major source of political uncertainty. The basis for impeachment was manipulation of the fiscal accounts in the last two years, but she was not accused of criminal charges. This seriously damages the standing of the erstwhile ruling PT, the left-of-center Labor Party. Furthermore, criminal investigations have increased against former president Lula, the figurehead of that party.
This means that the near-term political future in Brazil may be decided between the more centrist Brazilian Democratic Movement Party (PMDB) and the Brazilian Social Democracy Party (PSDB), while the role of the PT will diminish drastically. Now, interim president Michel Temer will end the mandate through 2018. Mr. Temer’s policy moves so far include the naming of a market-friendly economic cabinet which, in turn, has already proposed important fiscal adjustments to the legislature. These have not been fully approved yet and fall short of serious structural reforms, but it is conceivable that the political environment will give the Temer administration some space to advance a more ambitious agenda over the next couple of years.
In the meantime, the proposed 2017 budget incorporates a spending freeze in real terms in public spending, which has to be approved by the legislature. A return to fiscal prudence and reversal of negative debt dynamics are necessary to get the country out of recession. Given the fiscal challenges mentioned and the needed pro-cyclical fiscal policies, risks to growth in both Mexico and Brazil remain to the downside for next year.
POLAND, HUNGARY, AND ROMANIA
Poland continues to be the focus point in Central and Eastern Europe (CEE). As we had expected, political risk premium continues to be reduced as the PiS government provides more market-friendly versions of its major policy proposals. In August, an update was provided on the CHF loan conversion issue. Most significantly, the government avoided the nuclear option of forced conversions and instead focused on dealing with the ‘spread’ issue. In short, banks will be required to refund the FX spread mis-marking (as they are accused of mis-selling) rather than forcing the conversion of Swiss franc loans into Polish zloty ones. This amended proposal will still cost around PLN 5 billion—equivalent to 25% of annual banking sector’s profits but easily handled—and is still considerably less than the potential PLN 40/50 billion cost of forced conversions. In addition, the authorities maintained the right to force conversions in one year’s time if they see fit, if there were significant gains in PLN.
Looking toward the fourth quarter, the focus will continue to be on the impact of BREXIT on Eurozone and CEE growth—with the confidence channel likely to be the most significant. Inflation is likely to remain lower than expected, and allow local central banks to remain dovish. On the politics side, there were a referendum on migration in Hungary and elections in Romania looming.
RUSSIA, TURKEY, AND SOUTH AFRICA
Summer 2016 has been unexpectedly volatile in the three major local CEEMEA (Central and Eastern Europe, Middle East, Africa) markets, with significant escalation in political tensions. Firstly, there was an attempted coup led by the military in Turkey (which ultimately failed), an escalation in violence between Russia and Ukraine, and finally the near-removal of the much-respected finance minister of South Africa. This is likely to continue to weigh on investor confidence across CEEMEA going forward. In Turkey, we maintain our focus on President Erdoğan’s apparent desire for an executive presidency—and the actions he will take both at home and abroad to achieve this. In South Africa, the focus will be on whether Finance Minister Gordhan remains in his role—and his ability to continue fiscal consolidation, structural reforms and state-owned enterprise reform. And in Russia, the parliamentary elections in September are likely to be symbolic as well.