Global Economics EXPANSION CONTINUES, BUT NEW CAUTION SIGNS EMERGE

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1 PRICE POINT June 2017 Timely intelligence and analysis for our clients. Global Economics EXPANSION CONTINUES, BUT NEW CAUTION SIGNS EMERGE KEY POINTS A modest and synchronized global expansion continues, but new risks have emerged. Alan Levenson Chief U.S. Economist Growth in Europe is likely to remain moderate despite continuing uncertainties surrounding Brexit. China s stimulus-led rebound has had widespread benefits but has made the risks from a tightening in credit in the country a global concern. Struggles over health care reform and other legislative delays mean fiscal stimulus in the U.S. is unlikely to arrive before Nikolaj Schmidt Chief International Economist After picking up sharply in the second half of 2016, global growth shows signs of moderating. Growing tensions on the Korean peninsula and in Syria have the potential to act as headwinds to capital expenditures, which could be dampened further by conflicts in the South China Sea. Fiscal policy is also being tightened on a global basis for the first time in three years, according to the International Monetary Fund, which could limit growth in the coming months. Finally, China s sharpened focus on financial regulation bears watching, although authorities are moving slowly in order to avoid a credit squeeze. EUROPE DOING BETTER, BUT RATE HIKES ARE STILL SOME TIME AWAY In terms of the regional outlook, growth in Europe is likely to remain moderate, even as recent purchasing managers index (PMI) readings point to a solid expansion. The victory of pro-european Union (EU) forces in the French elections has bolstered prospects for the eurozone. But it may have simultaneously deepened the perils of Brexit for the UK economy by strengthening the resolve of EU leaders to make the British government pay a steep price for leaving as a warning to others. While the French election seems to have provoked little change in the euro, the stabilization in the currency since the start of the year has weakened a tailwind to exports. FOR INVESTMENT PROFESSIONAL S ONLY. NOT FOR FURTHER DISTRIBUTION.

2 Although the improvement in the European labor market has been consistent, wage growth has been anemic. We believe headline inflation peaked in the first quarter, as we expect oil prices to soften in the second half while food price pressure should remain benign. Meanwhile, core inflation (excluding volatile food and energy prices) is likely to continue rising gradually, but at a rate well below the European Central Bank s (ECB) target. Overall, we do not believe the ECB will be in a position to hike interest rates for a couple of years, but we do expect ECB officials to announce this fall that they will begin tapering their asset purchases in early Importantly for asset markets, the ECB s rhetoric in the coming months is likely to become slightly more hawkish, with the removal of current references to the likelihood that lower rates will persist until the end of the bank s asset purchase program. CHINA STIMULUS HAS HAD MANY BENEFICIARIES In our view, the stimulus measures undertaken by China in early 2016 continue to have an underappreciated effect on growth not only in that country, but globally, given that Chinese demand is an important driver of economies as diverse as Malaysia, Saudi Arabia, and Chile. The upcoming Communist Party Congress provides a political incentive for the government to foster steady economic growth throughout the remainder of the year. Figure 1: Trade with China has recently boosted growth in developed markets Trade With China, Contribution to Growth (Four-Quarter Average), March 2007 to March Contribution to GDP 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% U.S. Japan Euro Area -1.0% Sources: T. Rowe Price and Haver Analytics. Ongoing monetary tightening in China should eventually weigh on growth somewhat. Authorities have increased their focus on financial stability and funding conditions in the shadow banking system. The new head of the China Banking Regulatory Commission has launched an investigation into risky assets held by banks, with a particular emphasis on tamping down the creation of bundled wealth management products that are not included on banks balance sheets. Chinese officials are moving slowly, however, trying to push the cost of borrowing higher without resulting in a liquidity squeeze. We are currently seeing some signs of stress in China s interbank markets, but to date, they have had little impact on the overall economy, and controls on outflows appear to be keeping currency volatility to a minimum. For now, the housing sector is also holding up, boosted by reduced inventory, although it will probably slow eventually. A POSITIVE WILD CARD: CHINA TRADE TENSIONS HAVE EASED SOMEWHAT President Donald Trump s harsh campaign rhetoric regarding China s trade policies has yet to result in a change in U.S. policy. While it is premature to assess what actions, if any, the administration will take, an initial meeting in April between Trump and Chinese President Xi Jinping seems to have cooled tensions and established a stronger PR IC E POINT 2 2 2

3 line of communication between the two leaders. Indeed, President Trump has acknowledged needing China s assistance to curb North Korea s nuclear ambitions. Talk of upending the U.S. One China policy also seems to have dissipated, and Trump has backed away from his campaign promise to designate China as a currency manipulator. U.S. ECONOMY MAY RESUM E MODERAT E LONGER-T ERM GROWT H TREND Repeating a recent pattern, the U.S. economy slowed in the first quarter of However, most evidence suggests that residual seasonality in the data and other temporary factors were to blame. Recent data support our assumption that the recovery in capital expenditures that began even before the November elections is continuing, and rising capital goods shipments suggest a broad-based recovery in demand for business equipment. If, as we expect, the rebound in corporate profitability that began in mid-2016 is sustained, nominal capital equipment outlays may grow at more than double the 1.4% rate seen over the past four years. Meanwhile, solid gains in average hourly earnings may support an increase in consumer spending of 2.25% 2.50% in real terms. We expect that solid demand underpinnings may help U.S. gross domestic product growth revert to its 2% expansion trend over 2017 as a whole. Figure 2: Global PMIs: Expansion slows in U.S. and China; Europe is the outlier Purchasing Managers Indexes, April 2012 to April Reading Over 50 Indicates Expansion. 70 U.S. Markit PMI: Composite Output Euro Area PMI: Composite Output China PMI: Composite Output Composite PMI Copyright 2017, Markit Economics Limited. All rights reserved and all intellectual property rights retained by Markit Economics Limited. On the other hand, we see little evidence that a Trump reflation will boost growth out of its post-financial crisis lassitude, at least over the coming year. The failure of the initial Republican effort to replace the Obama-era Affordable Care Act dealt a setback to the broader Republican legislative agenda, and while the House managed to pass a repeal and replacement bill on its second attempt, the ongoing debate in the Senate has delayed progress on tax reform. The investigation into the Trump campaign s ties to Russia also has cast an obvious shadow over the administration. FED POLICY SUGGEST S TRUMP STIMULUS UNLIKEL Y TO ARRIVE UNTIL 2018 With tax and infrastructure measures unlikely to be addressed before late 2017, we doubt that actual fiscal policy stimulus will arrive until 2018 at the earliest. To be sure, the new administration s plans for deregulation and tax cuts have awakened animal spirits, as evident in stronger business and consumer confidence gauges, but these improvements have yet to translate into an acceleration in real demand. Federal Reserve policy currently reflects no expectation for a meaningful change in the fiscal environment, with officials signaling that the pace of rate hikes will remain moderate and the overall stance of monetary policy will stay accommodative. The Fed s March meeting dispelled the fears of some observers that the Federal Open PR IC E POINT 3 3 3

4 Market Committee (FOMC) would accelerate its expected path of hikes for 2017 and While the Fed delivered the rate hike expected in March, it struck a marginally dovish tone in its monetary policy statement. It is also notable that a small change in the statement s interest rate guidance referring to the Fed s inflation goal as symmetric made it explicit that the Fed s target of 2% inflation in personal consumption expenditures is a midpoint, not a ceiling. This suggests that the FOMC is willing to tolerate inflation modestly above 2% in order to ensure that its target is achieved on more than just a transitory basis. In other words, delivering 2% inflation over the medium term will all but require the Fed to accept spells of slightly above-target inflation. FED BALANCE SHEET LIKELY TO BECOM E A FOCUS LATE IN THE YEAR Given the greater clarity around interest rates, attention has recently shifted to the Fed s balance sheet. Minutes from recent policy meetings indicate policymakers expectations that a change in the Fed s current program of reinvesting its portfolio holdings as they mature can be expected at some point in Indeed, we expect that the Fed may announce a change in its reinvestment policy in September, with implementation as soon as October. Accordingly, we expect that balance sheet adjustment may become a preoccupation for financial markets in the coming months. PR IC E POINT 4 4 4

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