Standard Bank Research*

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1 Standard Bank Research*

2 Global outlook 2018 Robust, but with risks Economic growth in the advanced economies should prove robust again in 2018 and, with inflation still modest, this has been christened the Goldilocks outlook. Financial markets have become exuberant at such a prospect; perhaps too exuberant. The three bears are lurking in the shape of monetary policy mistakes, trade wars, or even just plain investor flight. Looking like normal Advanced economies certainly have a more normal look to them right now after years struggling to escape the deflationary clutches of the 2008 financial crisis, or the debt crisis in the case of the euro zone. Japan has not had to escape a crisis as such but even its persistent deflationary pressure seems to have eased up modestly. Perhaps the only dark cloud hangs over the UK. For while the uncertainty unleashed by the vote to leave the EU in June 2016 has not hit growth as hard as feared, there has still been a significant economic cost. The UK economy might only grow by around 1.5% this year, and that could be up to one percentage point less than the US and perhaps the euro zone as well. In all, advanced countries are seen growing around 2.5% in 2018, which is tenth, or two, better than the likely outcome for This puts growth above potential which lies at around 1.5%-1.75% (Figure 1). Figure 1: Above potential Advanced countries GDP (%yr) Advanced countries potential GDP (%yr) Sources: IMF, OECD Although growth is above potential and labour markets are generally tightening, there s been no significant increase in inflation Although growth is above potential and labour markets are generally tightening, there s been no significant increase in inflation. For 2018, inflation in the advanced economies is likely to be close to the 2% level that many deem to be their inflation target. This said, there is no getting away from the fact that labour markets seem very tight in some countries such as Japan, the US and the UK. Policymakers in all these countries want wages to rise but they might have to be careful what they wish for. Germany s labour market is arguably not as tight as the others but the higher incidence of unionisation suggests that wage rises here could become dangerously robust. Faster wage growth will help push back against some of the distributional shortcomings of income growth in recent years; shortcomings that have contributed to some of the populist political upsurges that we have seen around the world. Our sense is that domestic political angst has receded somewhat as growth has improved, especially in the euro zone. 1

3 Nonetheless, international political angst has replaced domestic concerns, not least because of the more confrontational position taken by the US administration on trade and perceived security risks. International political strains represent one of the three main bear risks to the Goldilocks economy and financial markets: the others being a monetary policy mistake or a simple capitulation of risk appetite on the part of global investors. More monetary tightening Bond yields are likely to rise; we look for 10-year US yields to rise to the 3.25% region over the coming year The risk of a monetary policy mistake by major central banks is not negligible. The Federal Reserve would appear to be most at risk given that rate hikes to date have not tightened financial conditions (Figure 2). This is on account of factors such as the slide in the dollar, the steadiness of longer-term yields and the strength in riskier assets such as corporate credit. As Figure 2 shows the easing of financial conditions following the start of rate hikes in December 2015 puts the US in a very different situation to that we have seen during prior tightening cycles. In most of these cycles, financial conditions have tightened in line with higher policy rates. Things were a little different in the cycle as financial conditions remained stable for some years; a fact that many thought responsible for creating the financial excesses that finally revealed themselves in the 2008 global financial crisis. With this in mind, we might have some sympathy for the idea that if 2008 was a crisis, what we could see in the future is a catastrophe, not just because financial conditions are still easing but because the Fed and other advanced central banks will have only modest (or no) scope to lower policy rates if a catastrophe strikes. All of this makes us feel that the Fed will deliver four rate hikes in 2018; one more than the median forecast of FOMC members. This is also more than priced in by the financial market but we saw last year that the bond market dealt with underappreciating the Fed s tightening resolve. However, as time goes on and inflation risks rise, the short-end of the market is more likely to converge towards the Fed s forecasts and bond yields are likely to rise. We look for 10-year US yields to rise to the 3.25% region over the coming year. Figure 2: Financial conditions ease in spite of higher policy rates US National financial conditions index US Fed funds target (RHS) Sources: Chicago Fed, Reuters While the Fed might appear to be the central bank most at risk of having a monetary policy hiccup because of easing financial conditions, there are plenty of other problems elsewhere. The Bank of Japan seems flummoxed by the fact that the rising treasury/jgb spread is no longer lifting dollar/yen. We feel the BoJ specifically set a zero percent 10-year JGB yield target in order to engineer some back-door yen weakness, and so keep upward pressure on inflation. For a time, this policy worked well. But now the focus of the currency market seems to have shifted from yield spreads to trade, given the US administration s tough trade talk. If this continues the BoJ runs the risk of undershooting its 2% target for even longer than it currently envisages. 2

4 The problem could be one of bond yields (and policy rates) being far too low for the stronger countries in the euro zone, particularly Germany In the euro zone, the issue is not necessarily one of misbehaving inflation at the aggregate level but, instead, country-wide divergence. For as the economy has improved and the memory of the debt crisis has fallen by the wayside, so the nature of the ECB s problems has changed. Some years ago, the ECB faced the problem that bond yields were too high for weaker euro zone countries, such as the likes of Greece, Portugal and Ireland that received bailouts during the debt crisis. These countries no longer had a currency that they could devalue, and hence the burden of the crisis fell full-square on the bond market. If we fast-forward to today, the situation runs the risk of going into reverse. What we mean by this is that the problem could be one of bond yields (and policy rates) being far too low for the stronger countries in the euro zone, particularly Germany. The German economy is running very hot at the moment and the tight labour market threatens to lift wage growth and inflation more rapidly than most anticipate. Of course this might only prove sufficient to help lift the euro zone inflation rate moderately towards the 2% target, given that many other countries do not have the same tightness in their labour market. But, for Germany, inflation could become a problem caused not just by the fact that it cannot lift the policy rates but it has no deutschemark that it can revalue. The consequence of having next-to-no jurisdiction over the level of policy rates and the level of the euro is that the burden of any adjustment to higher inflation is likely to come through rising bond yields. Indeed, we see a bigger proportionate rise in 10-year German yields this year than we do in treasuries, or any other major bond market for that matter. And while spreads between German bonds and other euro zone nations will likely close, it still seems likely that the general drift of bond yields across the region will be to higher levels. Higher euro zone yields and rising treasury yields are likely to inject a bias for higher yields elsewhere. But on top of this more central banks are likely to start raising interest rates this year. Norway and Sweden should see their first rate hikes in the tightening cycle, and both Australia and New Zealand could join in as well. Those that have started to lift rates, like the UK and Canada, should continue to push ahead, albeit very slowly. While the ECB is inching its way to tighter monetary policy, the first rate hike seems unlikely until the second half of 2019, even if some countries, such as Germany, start to generate more worrying price trends. The real laggards in this monetary tightening cycle will be Japan and Switzerland but these are two central banks that seem willing to hang back because they desire currency weakness. America first There are clear undertones of a weak dollar bias that has pushed the dollar into reverse over the past year We expect the euro/dollar rate to rise to at least 1.40 over the next two years The currency market itself should realise that the euro is in the firing line and push euro/dollar towards 1.40 over the next couple of years without any explicit prodding by the US The desirability of currency weakness in a low inflation, or deflationary, environment has been a contentious issue since the US Fed was criticised for starting a currency war with its quantitative easing. The normalisation of monetary policy by the Fed in recent years has caused the dollar to rise but, in the shape of the US administration and its America first policy, there are clear undertones of a weak dollar bias that has pushed the dollar into reverse over the past year. The prior focus on monetary policy and interest rate differentials as the key driver of currency levels has been replaced by trade concerns as the administration pushes back against globalisation and multilateralism in order to make the global trading system fairer to the US. While not admitting that this also means a bias for currency weakness, it is crystal clear that a lower dollar is consistent with the America first trade policy. What s more, the main target is likely to be the euro. This is one reason why we expect the euro/dollar rate to rise to at least 1.40 over the next two years. In terms of currency fairness, the US administration appears to be pointing to the euro as the main problem. The Treasury s semi-annual report on the FX policies of other nations uses IMF research on appropriate currency levels as its benchmark. While the IMF s work does not suggest that the euro s real effective exchange rate is materially undervalued across the region, there are large discrepancies between individual countries within the euro zone. For instance, Germany s huge current account surplus of around 8% of GDP means that the euro is undervalued by around 15% in real effective 3

5 terms when looked at from Germany s perspective, while countries with weaker trade positions, like France, face euro overvaluation of 11%, or 7.5% in the case of Spain. The US administration s focus is not on the likes of France and Spain, but Germany and hence it seems logical to think that the White House sees the euro as significantly undervalued. In fact, this undervaluation is much greater still when looked at from the US perspective because the same IMF analysis cited by the US Treasury suggests that the dollar is overvalued by some 15% in real effective terms. Of the five monitoring countries listed by the US as possibly manipulating their currencies, it is Germany that claims the biggest currency misalignment (Figure 3). The other countries are China, Japan, Switzerland and South Korea. Now while we don t expect the US administration to turn up the heat on the euro with explicit demands for currency strength, it should not need to, as the currency market itself should realise that the euro is in the firing line and push euro/dollar towards 1.40 over the next couple of years without any explicit prodding by the US. Figure 3: Germany in the firing line Japan Switzerland China Germany S. Korea US IMF calculation of FEER overvaluation (+), or undervaluation (-) Source: IMF, US Treasury The Republican down-cycle for the dollar will prove correct again The weakness that we expect for the dollar against the euro should be replicated by dollar weakness against other developed currencies. History shows that the dollar tends to move in long-run cycles against other major currencies, usually lasting between six and ten years. The last cycle lasted from 2011 to the start of 2017 when the greenback rose some 37% in trade-weighted terms. In coming years, we look for a slide of at least 20%. These cycles do not tend to follow monetary policy cycles but rather the political cycle with Democrat-led administrations tending to preside over dollar strength and Republicans over dollar weakness. This is often due to the different economic agendas and, in the shape of the tax cuts and protectionism from the current presidency it seems that the Republican down-cycle for the dollar will prove correct again. Investor exhaustion Even a reasonably rapid fall could tip financial asset prices over the edge as loosening financial conditions in the US could force the Fed to tighten faster and increase the speed at which treasury yields rise We spoke at the start about the Goldilocks global economy and how the three bears of policy mistakes, trade tensions or plain investor caution could undermine economies and cause financial asset prices such as stocks, bonds and corporate credit to tumble. Policy mistakes and trade wars are certainly possible but they do not form our base case. Hence, we think it most likely that advanced country growth will stay robust, with inflation mainly contained. But with asset prices at lofty levels, some sort of sharp correction cannot be ruled out, even if it is not spurred by policy mistakes or trade strains. For instance, while a global trade war might not be on the agenda, a slide in the 4

6 dollar seems likely, and, if this were to gain substantial momentum, could clearly start to weigh on financial market prices in a negative way. A dollar crisis does not seem to be on the cards but even a reasonably rapid fall could tip financial asset prices over the edge as loosening financial conditions in the US could force the Fed to tighten faster and increase the speed at which treasury yields rise. We remain reasonably optimistic that, while asset price correction may occur, it will not be as destabilising as in the past. The bears might lurk but the Goldilocks economy should remain alive and kicking In addition to this there are numerous other ways that we might envisage a rapid reversal of the positive momentum in asset prices. Geopolitical strains with North Korea, for instance, or new political tensions in the euro zone. Alternatively, of course, the pure weight of excessively expensive assets could create caution and a rapid reversal in prices. But of these risks we do think it is the possibility of a deeper and swifter slide in the dollar that bears watching the most. Another point to make concerns the ability of advanced economies to shrug off any reversal in asset prices and continue to grow strongly. This proved difficult during the 2008 financial crisis, not least because the banks were very weak. Today banks appear stronger, and that might mean that credit continues to flow even in the event of asset price capitulation. Of course there are other elements of the financial system that could reveal vulnerabilities that are not obvious at the moment. The fact that global debt has continued to rise since the financial crisis is suggests that there could still be pockets of vulnerability that only reveal themselves once asset prices slump. Nonetheless, we remain reasonably optimistic that, while asset price correction may occur, it will not be as destabilising as in the past. The bears might lurk but the Goldilocks economy should remain alive and kicking. 5

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