Originally published by IFM Investors
We entered 2017 full of trepidation. Geopolitical risks were taking precedence over economic ones, and a dreaded “Black Swan” event was seemingly a very real prospect.
As it turned out, these concerns were in part misplaced or at least over-stated. Elections in Europe did not follow the populist script of Brexit and the US election; the new
US administration has not made any significant missteps on policy; rising protectionism did not bring global trade crashing down; China’s corporate debt problem did not
cause a banking crisis and Brexit has not pushed the UK economy into recession.
Circumstances in the world’s major economies also improved in a synchronised upswing that has emboldened markets as we found ourselves in a good growth, low-
inflation sweet spot. Indeed the IMF World Economic Outlook upgraded its forecasts for global economic growth for 2017 twice in each of its updates this year – something
it has done only once before, after downgrading growth in eight out of the previous nine forecast revisions. This came despite the IMF’s October update expectations for
US economic growth softening – somewhat surprisingly forecast upgrades for Europe, Japan and China more than made up for the shortfall. The expectation now is for
3.6% real GDP growth in 2017 and higher frequency data suggests there is little reason to doubt, at this stage, that this will be achieved. For 2018, the IMF expect a slight
acceleration of this growth rate to 3.7%.
Though growth rates are not overly spectacular from a historical perspective they do, in the main, represent economies that are operating at, or are slightly above, potential growth rates – particularly in advanced economies. This has been reflected in labour market outcomes that have been very good, pushing unemployment rates lower – in many cases towards full employment.
However, to the surprise of many this tightening in global labour markets has not been accompanied by any significant outbreak of wages growth. This has been a theme in many advanced economies in particular, and a multitude of common and country specific reasons have been floated to explain it. These include scarring from the global financial crisis, rapid advances technology & automation, lack of productivity, age composition of labour markets, different measures of spare capacity, industry composition, lower inflation expectations, migration of labour and so on. This has led many to question accepted economic doctrine on the Phillips Curve - that it is now
flatter, or indeed flat, and that wages and inflation are now much less sensitive to labour market conditions and the output gap. Central banks have been much less quick to come to this conclusion, and most have faith tighter labour markets will prompt a sustained acceleration of inflation. It may just be that levels of full employment – or the NAIRU (non-accelerating inflation rate of unemployment) – are lower this cycle and wage growth is only a matter of time. However, they need to believe otherwise inflation
targets, and their anchoring of expectations, become less meaningful and less manageable.
As it stands, a more sustained period in which global inflation accelerates is needed to encourage the further and broader reduction in monetary policy accommodation
– and central banks believe this will occur as a more normal Phillips Curve relationship emerges. But headwinds to inflation will likely not go away and perhaps in the case,
for example, of technology only intensify. If inflation does not make a convincing return over the medium term then debate may shift to how central banks view their targets,
and will they tacitly need to bring them lower. While lowering targets, the banks may also have to decide what levels of growth and unemployment warrant the removal of
policy accommodation in the absence of either a stronger inflationary pulse nor any threat of disinflation. This would be not to combat inflation, but to manage financial stability.
Our base case is that we will see the gradual emergence of a stronger inflationary pulse over 2018 and this will be key in many economies. We say this as the implications
and policy responses will guide market direction in 2018, particularly after 2017 proved to be a year of solid gains.
It was ‘risk on’ for markets as geopolitical concerns dissipated and better growth outcomes prevailed. Even better, this growth was accompanied by little acceleration of price or wage inflation – and was all underpinned by still extraordinarily accommodative monetary policy and easy fiscal policy. Such an environment supported valuations of financial assets and, in many cases, physical assets alike. Global equity markets, and particularly technology stocks have been pushed to fresh highs as government bonds have fallen out of favour. Similarly, investor demand for yield has seen investment grade and non-investment grade corporate bond yields plumb to new lows in the year. All the while financial market indicators of risk such as the VIX index remained very low. The concern for these markets into 2018 will be if investors are under-pricing the risks they face.
This under-pricing of risk applies equally for bond markets. Despite the back up in yields in the wake of the US election, since then yields have traded in a relatively
narrow range – not responding materially to expected or actual Fed policy tightening or any acceleration of inflation. The risk of such a scenario would be if inflation and
wages growth gained traction and forced bond and equity markets alike to re-price. This is not our base case but something we are cognisant of as it is that stated goal of
central banks that would welcome such outcomes from an economic perspective. Another question worth pondering is how high yields can rise while quantitative easing is still underway in the Eurozone and Japan? It seems we are still some years away from fully extricating all advanced economies from this period of extraordinary monetary
accommodation. Although 2017 was likely the bottom of the cycle for global monetary accommodation, 2018 is unlikely to see central banks be in too much of a hurry to
remove stimulus programs.
US: recovery on track with upside risks
The US economy did particularly well in 2017. Real GDP growth has been tracking above potential, and as of the September quarter at 2.3%yoy. Additionally, the
unemployment rate appears as if it will end the year in the low-4% region – likely just below full employment. This is significantly better than where economists had
expected at the end of 2016, with 4 3/4% set as their median expectation, and also below the Federal Reserve’s (Fed) estimate of 4 1/2%. Economists and the Fed were more surprised this year that the complete closing of the output gap and significantly tighter labour market have not, as yet, brought about a marked acceleration of wage growth - and, more importantly for policy settings, inflation.
Inflation is an area where the US economy disappointed in 2017. While true that several ‘one-off’ factors weighed on inflation through the year, the underlying inflationary
pulse has remained relatively weak. Even despite this uncertainty the Fed has refused to become materially more dovish, delivering two rate hikes this year, and likely
to deliver a third in December – fulfilling its expectation at the start of the year. The Fed has also delivered on its promise to begin shrinking its US$4.5 trillion balance
sheet. Both steps have been undertaken without too much concern as unexpectedly financial conditions in the US had been getting easier, despite the Fed’s policy tightening. This includes the depreciation of the US dollar, which for much of the year until September was in a downtrend.
The question for 2018 will be whether a further decline in unemployment can continue to spur an acceleration in wage growth and subsequently inflation. And if so, will such a scenario give the Fed the confidence to keep raising rates another three times in 2018, as implied by its expectations? Conversely, the more sceptical reader
may ask what its reaction would be if inflation does not accelerate. Remembering that the Fed is only forecasting 2.3%yoy inflation for 2018. And this implies that its
preferred measure for policy, the core PCE deflator (Personal Consumption Expenditure) that historically tracks well under the headline and even core rates of
inflation, will likely track just below its 2%. Even if its headline forecast be met, let alone disappointed.
As of February this becomes incoming Fed Chair Jerome Powell’s problem, after Janet Yellen was not offered a second term by the Trump administration. The new chair’s
appointment was broadly expected and is not anticipated to materially alter the Fed’s currently stated stance on policy nor the course of projected rate hikes.
As was the case entering 2017 the other key unknown as we approach 2018 is US fiscal policy. It is once again the prospect of a pro-cyclical tax reform policy aimed at streamlining and reducing rates for households and businesses that remains the focus. The package is being deliberated currently by the US legislature and, if passed,
may come into effect in early 2018. Given the difficulty in passing legislation defined the US administration’s fortunes in 2017, markets are not completely convinced
the package will pass unscathed, particularly as it is expected to add US$1.5 trillion to the budget deficit in the decade following its implementation.
In a best case scenario the tax package is estimated to potentially add an estimated 0.4pp to economic growth in 2018 and 2019 – more modest alternative packages are in the vicinity of 0.2-0.3pp. Either way, this would present an upside risk for consensus forecasts that already anticipate 2 1/2% real growth. Consequently, the tax package clearly gives rise to upside risks for the Fed’s tightening cycle. It may also raise the neutral rate of interest which will be a key issue over coming years and likely complicate policy deliberations. It is notable the Fed has never been able to foster a soft landing for the economy at the end of a hiking cycle which gives some cause for concern in the years after 2018.
The tax package is equally important politically as the US administration looks to leverage the passing of significant legislation heading into the mid-term elections late in
the year. Incumbent governments tend to lose seats in the mid-term elections, particularly in the House of Representatives, and any loss of control would see legislation become even more difficult to pass for the government than it has already been.
Europe and UK: diverging fortunes
The fortunes of continental Europe and the UK are likely to diverge further in 2018, despite both economies surprising on the upside with regard to growth in 2017. Downside risks in the UK will likely weigh on growth more than those in the Eurozone. Subsequently, further monetary policy divergence is likely to be limited in our view, and the Bank of England’s (BoE) recent tightening of policy proves to be a one-off. We say this as an extraordinary level of uncertainty around future growth persists. And are more assured that the European Central Bank (ECB) keeps policy almost as accommodative as ever – despite stronger and more broader growth across the region.
Eurozone growth is expected to be 2 1/4% in 2017, a solid uplift from the 1.8% recorded in 2016, and outperforming market expectations at the start of the year of a slowdown to just 1.4%. Strong external demand has been a key driver of growth, supported by a weaker euro and improved global growth. This has subsequently driven a recovery in business investment. This dynamic occurred particularly in Germany, but also more broadly across the Continent as business confidence rose in response to the worst outcomes from elections across the region failing to materialise.
Growth was also supported by robust household consumption as the unemployment rate continues to edge lower. There was also a boost to spending from the influx of
refugees into Germany, facilitated by government transfer payments, which added around 1/4pp to growth. Strong consumer confidence, and a rise in disposable income as oil prices fell, were also supportive. However, as with other advanced economies, wages growth has been modest and the pulse of inflation weak.
Next year is expected to bring much of the same economic narrative with growth decelerating slightly to 2.0% as some of tailwinds that were beneficial in 2017 being to
moderate. Yet such growth remains more than enough to erode spare capacity and bring the unemployment rate lower considering estimates of potential growth centre
around 1.0%. Accommodative fiscal policy is also expected to continue and further support growth. Of the big three Eurozone economies in 2018 Germany is expected to
perform best with around 21⁄2% GDP growth, followed by France with 2.0% and Italy still somewhat languishing with likely just over a 1% expansion.
Despite ongoing above-potential growth, inflation will remain hard to come by, remaining around 11⁄2%. This comes as wages growth, particularly in Germany, remains
subdued. The lack of inflation will allow the ECB to keep policy very accommodative. It intends to reduce the pace of quantitative easing from €60 billion to €30 billion by
January and continue at such a pace until September 2018. We note this is still a robust pace of balance sheet expansion so we are not yet at a turning point for policy. It
has also suggested that interest rates will “remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases”. For now, the risk is that the asset purchases plan will be extended and therefore rates hikes are not seriously considered until some point in 2019.
Downside risks to the Eurozone may emerge as concerns around country specific politics come to the fore again. Italy’s election is due between March and May next
year and a reformist government that could tackle its government debt problem and the fragile state of its banks would be ideal. However this is unlikely to be the case,
and at this stage a hung parliament is expected to be the outcome with the risk that the populist 5 Star Movement is strongly represented.
Risks also continue in Spain around Catalonian independence. In December the Catalonian parliamentary election will occur after the Spanish government dissolved
it amidst heavy protests. The outcome of the election could resolve this issue in a victory for the status quo or continue the uncertain path to independence. Catalonia accounts for 20% of the Spanish economy, 17% of employment and 25% of its exports. It is also hugely important for tourism. The economic stakes alone remain high, let alone implications for broader Europe.
Lastly, and perhaps unexpectedly, there is rising political uncertainty in Germany. Talks between parties in Chancellor Merkel’s “Jamaica” coalition have broken down, prompted by the Free Democratic Party (FDP) exiting talks to form a coalition government with the Union parties of CDU and CSU and the Greens. A coalition between the three remaining parties potentially leaves Chancellor Merkel 42 seats short of a majority (355 are seats needed), and she will either have to form an even smaller difficult minority government, persuade her former coalition partners in the SPD to once again join her, or face the unpalatable prospect of staging another election in 2018. This would threaten Merkel’s personal standing as Chancellor of Germany and the de facto leader of Europe. As well as encourage the rise of the far-right AfD party. Rising uncertainty may also risk strong German economic growth that is built on high levels of business and consumer confidence. It would also potentially hamper both internal talks on further integration within the EU and those with the UK on Brexit. However on the latter the ball is currently in the UK’s court and with no significant alteration of position or response being need from the Europeans for at least some time.
Indeed the only more threatening geopolitical risk in 2018 is not on the continent but in the UK with Brexit. Negotiations to date have been painfully slow and little significant headway has been made beyond high-level but essentially superficial platitudes. Nonetheless to date the UK economy has surprised all with its resilience and in particular its ability to generate employment. At the start of the year consensus expected UK GDP growth to falter to just 1.0%, it actually accelerated to 1.7% and will likely finish the year at 1 1/2%. The upside came primarily from better than expected business investment that was expected to slow dramatically amidst Brexit uncertainty. This offset the significant slowdown that occurred in household spending as the real income shock from weak wages growth but high inflation hit home. This high level of inflation seemingly has potential to further erode consumer confidence and undermine spending growth.
Yet despite weaker economic activity, the unemployment rate hit 42-year lows and remains in the low 4% range. It is only very late in the year are we now finally seeing the early stages of labour market weakness with employment growth slowing – a trend worth watching into 2018.
As noted above the UK economy has also generated its fair share of inflation, largely due to the weaker pound sterling. Nonetheless a seemingly hawkish BoE reacted by raising interest rates 25bp to 0.50% in November. Few seem to believe the BoE will be in any hurry to hike again given the significant uncertainty around the outlook for the economy. As such, it is expected to leave rates on hold for most, if not all, of 2018.
Expectations are for the UK economy to expand by just 1 1/4% in 2018, with significant downside risks. On Brexit little progress has been made today yet time continues to
ebb away, so uncertainty for the business sector is rising. The hope at this stage is that the UK and the Europeans can come to agreement on a transition deal that keeps the current terms of trade in place while negotiations extend beyond the March 2019 exit date. This is to give time for the exit from the EU single market and the customs union to be negotiated. We would anticipate failure to do so will likely trigger downside risks to the economy as businesses act on contingency plans. All the while negotiations are made more difficult by the political uncertainty within the UK government itself and now also in Europe.
Japan: tracking above (low) potential
The Japanese economy has performed well over the course of 2017 to date, recording six straight quarters of positive growth to mid-year. It looks on track to record 11⁄2% real GDP growth by year’s end. This marks a material lift in growth from the 1.0% rate that prevailed in 2016.
The economy benefitted from tailwinds from an uplift in global demand which has seen net exports add materially to growth, as well as a strong impulse from fiscal stimulus. However, this growth rate is expected to ease modestly in 2018 based on three factors: (1) an end to the recovery in business investment despite solid profit growth; (2) the end of the recovery in consumer durables spending (particularly if households start to save in preparation for the consumption tax hike scheduled for October 2019); and (3) government policy aimed at a reduction in inefficient work practices – so called “work-style” reforms. The latter is to introduce more work life balance at a national level with the hope that it will improve productivity and in time population growth.
Nonetheless 2018 growth is still expected to be around 1 1/4%, above the Bank of Japan’s (BoJ) estimate for potential growth that sits between 0.5-1.0%. The unemployment rate has already pushed under 3% - low even by Japanese standards – but wage growth and inflation still seem some way off. Inflation expectations of the market and business sector remain low further reinforcing a the current weakness of the price-wage spiral.
The BoJ itself continues to highlight these dynamics in its October outlook that while “upside and downside risks to economic activity are generally balance[d]” the “risks
to prices are skewed to the downside”. This represents a status quo outcome for 2018, with 2017 failing to bring any sustained inflationary pressure.
Consequently we would not expect any material change from the BoJ in terms of policy stance with yield curve control becoming entrenched. There is also a potential
change in leadership at the Bank with the five-year term of Governor Haruhiko Kuroda coming to an end in April. However Kuroda is broadly expected to be reappointed
and, if not, the government has given assurances that the settings and objectives of monetary policy will remain intact.
China: a managed deceleration
Chinese growth in 2017 surprised on the upside and the economy appears to be headed for at least a 6 3/4% expansion, around 1/4pp ahead of the government’s growth
target. This is arguably less surprising given a noticeable acceleration in growth heading into the Party Congress – with the authorities supporting growth heading into that
important event. Growth was also driven by the external sector, with stronger global demand increasing demand for exports, without the need for a depreciation of the
renminbi which remained relatively stable.
Investment was also an important driver led by infrastructure and property sectors. Indeed the property market was expected to cool materially in 2017. However, the government was able to tailor policy to extend the almost traditional three year property cycle by supporting activity and price growth in tier-two and tier-three cities rather than the overheated tier-one cities. And although this year marked a slowing in the transition to consumption led growth, the broader wealth effects of the property cycle should ensure this continues going forward, as will the steady acceleration of growth in consumer credit. These dynamics also are supportive of demand for services both domestic and foreign which bodes well for Australian inbound tourism.
The expectation for 2018 is that growth decelerates modestly to around 6 1/2% as the property market consolidates, ongoing financial market reforms are put in place and the government takes steps to reign in corporate borrowing. To achieve the latter, and perhaps even prompt deleveraging, the government is expected to clamp down
on credit issuance, particularly in the shadow banking sector, and also encourage corporate bond issuance. It will also balance this by fostering strong nominal GDP in order to grow out of the problem. This has already occurred to some extent with a stabilisation of the credit to GDP ratio in recent quarters – albeit at a very high level.
President Xi Jinping’s longer term vision at the Party Congress also feeds into this narrative as he looks to improve the ‘quality’ of Chinese growth. This likely entails
reducing financial support for inefficient, indebted and often high polluting state owned enterprises. A reduction in capital outflow has also allowed the People’s Bank of
China (PBOC) to tighten financial conditions more broadly which should also be beneficial to stabilise corporate credit growth.
Depending on the impact of these measures, the PBOC may seek to remove some monetary accommodation. This is particularly true if the spike in producer price inflation
through late 2016 and 2017 translates to materially higher consumer price inflation. The latter surprised on the downside in 2017 but will accelerate to some extent
in 2018. However at this stage it is not expected to elicit a monetary policy response.
Australia: will the RBA hike in 2018?
The most important question for 2018 in an Australian context will be whether the economy is strong enough for the Reserve Bank of Australia (RBA) to start removing
policy accommodation. That is to say, to have confidently begun a tightening cycle. This is the expectation of most market economists and indeed some continue to believe
this will occur in the first half of the year. At this stage this seems optimistic in our view and a second half hike seems more plausible. That said there seems to be little reward for the RBA to go early so we would be unsurprised if it only intimated a tightening cycle was imminent in late 2018 before acting in early 2019.
Important to timing of domestic policy tightening will be the pace of hikes in the US. This is because the RBA are still concerned about a materially higher Australian dollar.
Any undue appreciation at this stage would be unwelcome and crimp the growth narrative from services exports in particular that has been strong in 2017.
Perhaps the key question on growth outside the ongoing services expansion is whether the growth and jobs that have been driven by residential construction will be
transitioned to the infrastructure and non-residential building cycle. This is as the residential construction cycle inevitably weakens. We have already observed this
in New South Wales and Victoria to some extent – both states that were willing and able to take advantage of the Commonwealth government’s asset recycling program
to facilitate a strong public spending agenda. We expect this to support both growth and, importantly, jobs in these states. The latter is almost more important considering the sheer size of the labour force exposed to the construction cycle. In the absence of rate hikes the dwelling investment cycle, that already seems past its peak, should continue to trend lower. However a rate hike would likely accelerate this cycle and is a reason why we think that ongoing jobs strong growth is required to warrant a rate rise in the year.
The other aspect of this residential cycle will also be important, that is the property market. Dwelling prices have been weaker in the resources states already and now
are softening in the previously strong non-resources states also. This includes the cities with the strongest growth this cycle – Sydney and Melbourne. This is in response
to only a modest tightening of conditions in the investor space. Should this price softness continue, or indeed be exacerbated by a rate rise, this will be a test for the
household sector. That is because Australian households have capitalised both structural declines and now cyclically low interest rates into dwelling prices over an
extended period. Even the partial reversal of this trend will see downward pressure exerted on prices.
A downtrend in prices may negatively impact households’ desire to spend - the ‘wealth effect’ has been touted as supporting consumption growth on the way up it may equally have a negative impact on the way down. Declining prices are also a problem for negatively geared investors, particularly newer ones. As it may become clearer if we are in for an extended period of flat or modestly declining prices, investor confidence may be shaken.
Further there is the direct income effect that higher rates will have on disposable income. Australian households are amongst the most highly indebted in the world with
a debt-to-GDP ratio nearing 125%. Consequently, even incremental rate rises will get significant traction and impact that sector’s ability to consume.
Therefore wages growth becomes as important in the Australian context for monetary policy as it is elsewhere – if not more important given the weight of debt on
household balance sheets. It will define not only future inflation but also growth – with Australians’ ability and appetite to run down their rate of savings increasingly questionable.
Yet it is likely to be the case in Australian that wages growth is even more elusive. Firstly, for the reasons cited previously in the global context, but also because of Australia’s unique lack of competitiveness that deteriorated markedly as wages rose strongly through the resources boom. The nominal exchange rate has not fallen enough to repair this. Consequently, an elongated period of soft wages growth may be required to become more competitive or indeed sustained improvement in
productivity that would lower unit labour costs.
And lastly, there is also Australia’s underemployment problem. We remain dubious that this can be addressed fully by accommodative monetary policy alone. Indeed, it is
the choice of individuals and perhaps more importantly the business sector that has and is driving the higher rate of part-time employment – that is employment that is likely to have significantly less wage bargaining power.
Therefore the labour market may need to be significantly tighter and the unemployment rate lower, well below 5%, to elicit consistent wage growth. This is because the natural rate of unemployment (or NAIRU) or the rate is again likely to be lower, as it is in other developed economies. As wage growth is delayed, inflation returning to the mid-point of the RBA’s target will require rates to be on hold for a longer period of time. Indeed the RBA itself does not have the rate of inflation returning to even the lower bound of its target until 2019. The concern has been for some time and will continue to be that running rates too low for too long is simply building imbalances elsewhere and household debt is already a risk to the economy. The RBA’s balancing act in this regard will continue.
Also important in the growth narrative will be whether the resources states of Western Australia and Queensland (and Northern Territory) can continue to stabilise and
shake off the worst of the reversal in the commodities down cycle. As this may give the RBA confidence to normalise policy.
What is also evident from recent communications is the expectation that productivity growth and innovation will play a part in future growth. We are in complete agreement,
we cannot and should not rely on ‘lazy’ growth reliant on expanding the population.
With regard to infrastructure investment we do think there is a productivity dividend. However we also need fiscal/government policy innovation and reform to generate
productivity and this may prove optimistic. The political process seems again to be mired in uncertainty with no strong narrative emerging. A continuation of this
may indeed undermine current high levels of business confidence to the detriment of the economy. Business tax cuts may be supportive if passed and the government
has also recently touted personal income tax cuts. This is to redress the bracket creep that has eroded household income growth for some years. But it also is a clear ploy to garner favour ahead of the coming Federal election that is to take place in 2019.