Disruption Pays Dividends in Global Growth

2018 GLOBAL ECONOMIC OUTLOOK Disruption Pays Dividends in Global Growth In 2018, we expect a manufacturing-based business investment rebound to begin, which will send a powerful stimulus along the global manufacturing supply chain. The resynchronization of global growth should improve fundamentals sufficiently to support the ongoing risk-on rally in financial markets through 2018. Author: Markus Schomer, CFA Chief Economist Quantitative easing will continue to expand and support markets until 2019, when central banks will begin to withdraw liquidity for the first time since the financial crisis. The great financial crisis ended the last sustained period of synchronized global growth. In 2018, the global economy will finally experience it once more. It s been a long time coming. In the 10 years since the crisis, markets have been shocked time and time again. Recoveries, meanwhile, have fallen short, predominantly driven by falling unemployment, which boosted household income and consumer spending. Much of that money went to domestic services, so it did little to stimulate global growth. What s changed is that we have finally seen a disruption to the sluggish recovery that markets have been stuck in since the crisis. What do we mean by disruption? Of course, we ve seen plenty of traditional market disruptions, in the sense that a certain event shocked the market and sent investors scrambling. In another way, quantitative easing (QE) from central banks has disrupted financial markets, which many analysts would argue no longer function the way they once did. But quantitative easing fell short of changing the path of economic growth as central banks hoped they would. This disruption, at least for the global economy, is bigger: the start of a manufacturing-based business investment rebound. Stronger investment spending sends a powerful stimulus along the global manufacturing supply chain with two important effects. First, it boosts export performance among capital goods producers, which benefits economies in Europe and Asia. Second, it raises demand and prices for industrial commodities, improving growth prospects for producers in emerging markets. The result: global economic growth above the long-term average for the first time in five years. In its October World Economic Outlook, the International Monetary Fund (IMF) upgraded its forecasts for both 2017 and 2018. After that, central banks will have the next shot at disrupting the global economy by ending quantitative easing. For businesses, it s time to put money to work In 2017, we saw a critical inflection point for the world economy: a transition from a world of excess supply, which was deflationary and depressed business investment, to one where supply and demand are more in balance, encouraging business investment. The best evidence of the gradual absorption of excess capacity in the past few years is closing output gaps, the difference between an

economy s long-term growth potential and its actual growth rate. The IMF forecasts only a minimally negative output gap for the advanced world economies in 2017 and a slightly positive one for 2018. Drivers of the Business Investment Rebound US Output Gap Is Closing US Productivity Trend Growth Is at a New Record Low, Showing the First Signs of Improvement 2 5 Output Gap, in % of GDP 0-2 -4-6 US Output Gap 5 Year Change, in % 4 3 2 1 Output per Hour -8 1980 1985 1990 1995 Long-Term Average 2000 2005 2010 2015 2017 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 23 October 2017. The low rate of productivity growth also encourages business investment. In the 25 years between 1980 and 2005, the longer term growth trend in productivity as reported by the Organisation for Economic Co-operation and Development (OECD) was a fairly stable 1.9% per year. Since the financial market crisis, that trend slowed to just 0.75%, highlighting the erosion of global growth potential. On the company level, lower productivity growth diminishes the underlying profitability potential. With basic cost cutting very much exhausted, companies must increase expenditure on productivity-enhancing technology to maintain the rate of profit growth. That is especially true in economies that are approaching full employment. Despite the nascent beginning of a global rate hike cycle, the cost of capital remains historically low and companies still carry record amounts of cash on their balance sheets to finance such investment. Global economies sync up, with some potential for surprises The US is already seeing a rebound in investment spending, and we expect to see the most significant growth acceleration there. Strong cyclical improvements in employment and the global boost in demand for capital goods have significantly improved the growth outlook in Europe. Japan lacks the cyclical growth drivers, but looser fiscal policy and stronger export demand should contribute to a modest growth improvement, albeit one that will likely lag behind the US 2 PINEBRIDGE INVESTMENTS

and Europe. Emerging markets were less connected to the global growth re-synchronization in 2017, but that is set to change. The wild cards for our global outlook are politics and fiscal policy. At the start of 2017 we faced a long list of potentially disruptive elections. So far, none has had a sustained market impact. Yet a number of political events could still result in major policy changes in the next nine to 18 months and affect market performance. This is especially true in Europe. We also see growing potential for looser fiscal policy, which can have both positive and negative effects. Fiscal stimulus packages are already being used to sustain growth in a number of Asian economies, such as China, Japan, and South Korea. Now, governments in Europe and the US show increasing willingness to loosen purse strings after years of austerity. It is possible that fiscal policy may amplify the growth acceleration that is already underway. However, it could equally amplify the negative feedback from the rising debt service cost of a sharply higher overall global debt burden relative to global GDP, a debt burden that was mainly fueled by rising government and corporate debt. The US economic engine The US has been a leader in the global recovery due to the more aggressive initial monetary policy response and the powerful cyclical stimulus from rising employment. The recovery was interrupted by the collapse in commodity prices in 2015, which pushed the business sector back into recession. The subsequent rebound in investment spending is a key driver of the growth acceleration we are forecasting for 2018. After a tepid 1.5% in 2016, US GDP growth is on track to accelerate to 2.3% in 2017 and should reach 2.7% in 2018. Tracking the Improving Manufacturing Momentum Developed Markets PMI Manufacturing Indexes Manufacturing PMI 60 56 52 48 Eurozone US UK Japan 44 2012 2013 2014 2015 2016 2017 Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 23 October 2017. GLOBAL ECONOMIC OUTLOOK 2018 3

Looser fiscal policy could amplify the pickup. Yet the Trump administration s tax reform will have less impact on consumer behavior given the offsetting elimination of deductions to finance the reduction in tax rates. Lowering corporate taxes should benefit US businesses and could amplify the investment rebound on the margin. Regardless of tax reform, robust consumer spending should continue to provide a solid base for growth fueled by further declining unemployment. Europe s growth surprise should continue Europe was the real growth surprise in 2017, especially the eurozone, which is in the midst of a strong cyclical labor market recovery. Eurozone-wide unemployment peaked in 2013, but it took until 2015 when French labor markets finally started to improve for economic conditions to brighten more meaningfully. The eurozone is now at a point in the cycle where the US was in 2013/2014: in an accelerating recovery fueled by falling unemployment but amplified by surging exports and strong domestic investment spending. Similar to the US, the prospect of looser fiscal policy could amplify the expected rate of growth next year. We expect the catalyst for a change in the European Union s (EU) long-running austerity stance could be an eventual, more-business friendly new governing coalition in Germany. It will likely still be led by long-time incumbent Chancellor Angela Merkel, and would likely prioritize lower taxes and increased infrastructure spending, something Germany can afford after running budget surpluses for the past four years. Other countries are likely to use the extra revenue from the better-than-expected growth to increase government Political risk still threatens the European recovery Stronger economic prospects and broadening employment gains have not calmed Europe s political atmosphere. Three potential risks stand out. 1The Brexit negotiations aren t going well. It is still obvious, as it was right after the referendum, that it is in the interest of both sides to conclude talks as quickly as possible. Yet negotiators have not been able to demonstrate an ability or willingness to compromise. Consequently, the risk of a no-deal Brexit has risen sharply, which is clearly in no one s interest. 4 PINEBRIDGE INVESTMENTS

spending as well. After averaging 1.7% in the three years through 2016, we expect eurozone GDP growth to accelerate to 2.4% in 2017 and 2.3% in 2018. Japan is benefiting from stronger global growth Japan s Prime Minister Shinzo Abe won a decisive new mandate in a snap election he called a year earlier than scheduled. Much of the government s newly won political capital is earmarked for changes to Japan s foreign and defense policies, signaling continuity in economic policy. The Japanese economy is feeling the stimulus from the increased global growth synchronization. Exports are rising and domestic business investment has picked up. However, Japan suffers from the same conundrum that has characterized this global business cycle: a lack of wage growth. The government remains committed to raise the consumption tax again in 2019 to address the country s fiscal woes. But, with stagnating purchasing power, such a move would risk triggering yet another recession as it did the first time around in 2014. In the meantime, after averaging just 0.8% in the three years ending in 2016, Japanese GDP should pick up in 2017 to 1.5% and fade only gradually to 1.4% in 2018 before facing probably another sharp downturn if the Abe government sticks with its tax hike plans. Emerging market fundamentals are improving The underlying fundamentals in most emerging market economies should continue to improve in 2018. Domestic growth drivers remain strong in countries such as India and Indonesia, where demographics have been driving consumer Separatist movements are not new to Europe, but Spain s constitutional crisis following Catalonia s independence declaration poses a new challenge for the EU that could undermine business confidence. The EU will have to find a way to discourage the dissolution of states while at the same time guaranteeing the geographical integrity of the union, which means accommodating new sovereign entities. 2 3 Anti-EU populists have not gained enough votes in Germany and France to force a change of policy in the EU s two leading nations. Yet those forces, which had already taken over Poland and Hungary, also won recent elections in the Czech Republic and Austria. The result is likely a widening of the rift between Eastern European member states and the rest of the union, which may accelerate the creation of a two-speed Europe with eurozone members moving more quickly toward greater integration while leaving the rest behind in a scaled-down free-trade zone. Europe s economics should continue to look good next year, but its politics remain a big source of worry. GLOBAL ECONOMIC OUTLOOK 2018 5

spending. What is needed is more economic reforms and infrastructure investment to strengthen the underlying growth potential in those countries. Rising commodity prices are transmitting the business-investment-driven stimulus from the developed world to countries where commodity exports play a large role, such as Malaysia, Chile, and much of Sub-Saharan Africa. A few key emerging market economies continue to face more idiosyncratic risks. While the recovery in Brazil should gather pace and allow Latin America s biggest economy to benefit from improved global growth conditions, Mexico is facing a possible disruptive election in the midst of growing risk that the US could withdraw from the North American Free Trade Association (NAFTA). Sanctions against Russia are unlikely to be lifted, and Turkey s move to a more autocratic future is starting to sever economic ties with the EU that could depress foreign direct investment. Overall, we expect emerging market growth to pick up to 4.5% in 2017 and 4.7% in 2018. The acceleration has the potential to carry further into 2019 as well. Slower growth is ahead in China While many economies will benefit from accelerating growth, China is looking at a further downshift in its growth trend. China is the world s second-largest economy, and it s still expanding faster than most other countries. Rising exports to China are also a key stimulus for the rest of the world. Yet China is also on a different growth cycle. The 19th Congress of the Communist Party just confirmed President Xi as the undisputed leader of the country. He is now likely to turn his attention to improving China s economic and financial stability. Part of those reforms will be a reduction in China s excessive debt burden. The risk of an imminent crisis is low, but reducing the growth of credit below nominal GDP growth will have a negative effect on fixed asset investment. Furthermore, China s dramatic environmental problems, a by-product of its fast growth strategy, will force the government to close down some of the worst polluting companies. All that suggests we should see a noticeable reduction in supply growth that will further dampen the already slowing trend in China s economy. The rise of the Chinese consumer will offset some of that. Households still save more than 30% of their income. There is room to raise consumption growth in the future with the right kind of economic policies, but that will take time. China is on track for a 6.9% annual increase in its GDP in 2017, significantly outperforming expectations just in time for the key party congress. However, we expect more restrictive credit provisions and supply restraints will slow China s growth rate to 6.4% in 2018 and further to 6.2% in 2019. Risks beyond 2018 A defining characteristic of this global recovery has been strong financial market performance in the face of only modest economic growth. One of 6 PINEBRIDGE INVESTMENTS

the main drivers of that performance has been the excessive liquidity central bank asset purchases created. That QE will continue in 2018 despite the start of balance sheet reduction in the US. The ECB and Bank of Japan will continue their programs and the three major banks combined will still increase global QE by around $700 billion in 2018. However, global QE will end in 2019 as central banks begin to withdraw liquidity for the first time since the financial crisis. We also expect the global rate hike cycle will broaden in the next few years. So far it s only the Federal Reserve and the Bank of Canada that have begun the process of normalizing monetary policy. In 2018 we expect central banks in a few other countries such as Australia and New Zealand to join. A more serious acceleration in global monetary policy tightening is in the cards in 2019, when the ECB and other European central banks begin to eliminate high, distortive negative interest rates and then gradually raise policy rates back toward neutral. The resynchronization of global growth should improve fundamentals sufficiently to support the risk-on rally that has dominated financial markets through 2018. The cycle has more room to run in emerging markets, where policymakers are further behind their developed world colleagues. Yet the policy reaction to the stronger global growth trend is already sowing the seeds for a renewed growth slowdown beyond our 2018 forecast horizon. Global Growth Forecasts Europe North America 2.4% 2.3% 2.3% 2.7% Asia Latin America 1.4% 2.1% 1.3% 2.4% Middle East /Africa 5.7% 5.6% Faster growth expected Neutral growth expected Slower growth expected Global GDP Growth: : 3.6% : 3.8% Source: IMF, Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 17 November 2017. GLOBAL ECONOMIC OUTLOOK 2018 7

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