Feature Stories | Dec 19 2016
This story was originally published on 6th December 2016. It has now been re-published to make it available to a wider audience.
Equity strategists and economists provide their views and forecasts for the global economy in 2017.
– Stronger global growth
– Trump offers hope, and risk
– Europe offers political risk
– Emerging markets to outperform
By Greg Peel
Strategists agree on at least one thing in their outlooks for 2017 – it will be a potentially more volatile year than 2016. That’s not particularly comforting for investors given the volatility experienced throughout the year now coming to a close.
2016 began with a collapse in commodity prices, particularly oil, and a collapse in global bank shares, given concerns over the potential bankruptcy of major European banking houses. The counter was a rush to the bottom among central banks in terms of policy easing, compounded by the Fed holding off, and holding off, and holding off again with a rate hike. Yield stock valuations soared globally.
In the middle of the year we had Brexit. No one saw that coming. Commodity prices managed to rebound somewhat on supply-side constraints, before surging ahead once more on Chinese government production restrictions and the anticipation of, and eventual delivery of, OPEC production cuts (effective from January).
Expectations for a Fed rate rise grew and grew thus when the whole Brexit scare proved (so far) to be misguided, we soon saw a violent shift in investor allocation as previously oversold commodity stocks rebounded strongly and previously overbought yield stocks were dumped.
Then along came Trump. No one saw that coming.
As had been the case with regard Brexit, the worst was feared and all and sundry were proved wrong. Trump would of course be great for America. Or at least Wall Street. Presumably.
And strategists are suggesting 2017 is going to be even more volatile?
The buzzwords for 2017 are “political risk”. Not that we haven’t experienced political risk in recent times. We recall that the word that gave us “Brexit” was “Grexit”. We recall that not so long ago, the US government shut down. But 2016 gave us Brexit, and Trump, and possibly a developed market-wide seismic shift in voter perception and power. The workers are revolting, against globalisation, the GFC and what has transpired in the eight years hence.
2016 was the year of Farage, Hanson and Trump, and the Orange by-election. 2017 could be the year of Marine Le Pen and a possible Frexit, another Far Righter in the Netherlands and a possible Nexit, and an Italian comedian offering a possible Italeave. Germany, too, goes to the polls next year.
But before we get to the potential collapse of the EU, we have Trump.
Trump won the US election on policies of building a wall on the Mexican border, locking up Hillary Clinton, tearing up the TPP, NAFTA and the NATO and Pacific alliances, declaring Beijing a “currency manipulator” and whacking a 45% tariff on Chinese imports, while cutting the US corporate tax rate from 35% to 15%.
“Lock her up” went out the window as early as Trump’s victory speech. The Wall will partly be a fence. The Japanese prime minister left New York happy he could work with a Trump presidency. To date, many of Trump’s campaign “promises” appear to have been watered down and the man does not even take office until late January.
Few believe a full 45% tariff on Chinese exports is even remotely likely. A 15% tax is a very long way down from 35%. There is much faith being placed in Trump’s infrastructure intentions, but even if they do ring true, Rome wasn’t built in a day.
In other words, despite a full sweep of houses for the Republicans – upper lower and White – no one is really sure just what a Trump presidency might bring.
Markets do not like uncertainty.
The Global Economy
Morgan Stanley believes the global recovery is likely to gain more momentum in 2017, driven by faster US growth, stable developed market growth and rebounding emerging market momentum. But the strategists warn that while global growth may become more balanced, material risks emanate from fiscal stimulus, faster Fed rate hikes and a wider globalisation backlash.
The good news is global GDP growth should push back towards its historical average, Morgan Stanley suggests, with faster growth in the US and Japan offsetting a slower Europe, and a rebound for commodity-exporting emerging economies offsetting a gradual slowdown for China.
The bad news is the 2017 outlook is subject to material uncertainty, thanks to a new US administration taking office, key ballots in Europe and the formal start of Brexit.
Commonwealth Bank’s economists agree with Morgan Stanley that the global growth rate should move towards its historical average, rising 3.3% in 2017 and 3.5% in 2018 on their forecasts. This is still short of the average of 3.7%, but well above the 2.7% assumed for 2016.
CBA suggests global economic policies, particularly fiscal policies, will spill over into financial markets next year. Already the UK government has announced a large fiscal stimulus package intended to ward off the negativities implied by Brexit. Meanwhile, Donald Trump is expected to “unleash a very large fiscal stimulus” in the US, CBA notes.
The economists also expect Europe to be the centre of political risk.
Citi’s global strategists note “easier” fiscal policy (stimulus) and a shift away from super-accommodative monetary policy was already underway ahead of the US election but Trump has “potentially supercharged” this theme for 2017-18.
To gauge some idea of what might transpire, Citi is not alone in making the comparison to the last Washington outsider candidate who pledged to “make America great again”, Republican pin-up boy Ronald Reagan. While the period 1980-85 is not, by Citi’s admission, perfectly comparable, that experience suggests bond yields rise and the US dollar rallies well before fiscal deficits actually begin to widen (spending kicks in).
We have already seen substantial moves in both.
Goldman Sachs is another house assuming a pick-up in global growth next year. But Goldman does not believe stronger US growth will do much for asset classes beyond shift the narrative from “low-flation” and monetary accommodation towards reflation and rising rates. This will not change the fact that the trend growth rate of GDP appears to have fallen for both advanced and emerging economies during the post-GFC period.
Meanwhile, valuation levels for equities and especially bonds remain highly elevated by historical standards, Goldman notes, so expected returns appear to be low across most asset classes. In fixed income, yield is scarce, and in equities, growth is scarce.
Many of the fundamental drivers behind declining trends in developed market GDP growth are likely to remain weak for the foreseeable future, the investment bank believes. One of the sustained headwinds for economic growth in recent years has been the declining growth rate of the working age population. Productivity growth is also low, so has been no offset to the demographic drag.
Asset manager Blackrock is of a similar opinion.
Ageing societies, weak productivity growth and high levels of public debt will, in Blackrock’s view, limit the future pace of economic expansion and the ability for central banks to raise rates. The asset manager believes that from today’s depressed level, the average developed market ten-year bond yield will only rise by 50 basis points over the next five years.
On that basis, Blackrock does not see asset valuation multiples, elevated due to low interest rates, reverting to historical averages over the period. Equities should outperform fixed income over that time.
The United States
Morgan Stanley expects the US dollar to “break out” to the upside. Inflation will rise, and the Fed will be forced to tighten monetary policy more rapidly than assumed pre-Trump. While fiscal stimulus will help growth, it must not be forgotten that higher interest rates mean tighter financial conditions.
Current corporate debt levels are unprecedented outside a recession, Morgan Stanley points out. Stronger earnings will help but higher interest rates will not, and “the Fed could push us to the edge quicker”. To justify current Wall Street valuations, investors need to believe in modest growth, support from central banks and low defaults, and not just for the next year.
Markets anticipate defaults one year in advance, Morgan Stanley notes. Lower defaults in 2017 are “in the price”, rising defaults in 2018 are not.
The investment bank is presently tracking 2016 US growth at 1.6% year on year and has lifted its 2017 forecast to 2.0% and introduced an initial 2018 forecast of 2.0%. These numbers are consistent with Fed forecasting.
CBA had been forecasting 1.7% growth in 2017 but has now lifted that to 2.3% and has introduced a 2018 forecast of 2.6%, attributing the strength to “Trump’s fiscal pump-priming”. The economists expect promised cuts to personal and corporate taxes to be delivered in the first half of 2017, driving a pick-up in consumer spending and business investment.
There are nevertheless a couple of caveats.
Most of the value of the cuts to personal income tax will accrue to high income earners with high savings rates, CBA warns. And there is a risk in the form of the inevitable infrastructure time lag – large infrastructure projects are typically complex and take time to implement.
CBA, too, expects the fiscal boost to the US economy when it is already close to full employment will lead to higher inflation, a stronger US dollar and higher interest rates. The economists expect the Fed to lift its funds rate range by 50 basis points in 2017, to 1.00-1.25%, and another 50 in 2018, to 1.50-1.75%.
Goldman Sachs expects four Fed rate rises between now and end-2017.
These forecasts are in line with Morgan Stanley’s expectations of a “quicker” Fed. Prior to Trump’s election, and backed by constant talk from the Fed of “gradual” tightening and running the US economy “hot”, markets were pencilling in one 25 basis point hike in each of 2016, 2017 and 2018.
Morgan Stanley has retained its pre-Trump US stock market forecast, suggesting a base case 2300 for the S&P500 in twelve months (current level circa 2200). However the strategists now see more upside to their bull case than downside to their bear case. The same 2300 target is reached on a combination of a stronger earnings forecast and a lower PE multiple forecast, which the strategists see as “prudent”.
Morgan Stanley is the first to admit it had a bad year in 2016, following five consecutive years of portfolio outperformance. The strategists were caught out by “huge factor reversals, crowding and unwinds”, despite their overall market call a year ago proving to be quite accurate. Many an investor will have been caught in the same violently revolving door of rapid asset reallocation.
The strategists expect uncertainty and volatility will be a greater threat in 2017 given the Republican Sweep and impact this will clearly have on some policies. Big changes to interest rates, or moves in the US dollar or oil, and a different policy outlook will have a dramatic impact upon which market segments lead and lag the overall index. The strategists gut instinct is to “fade” current optimism about reflation and be prepared for a bit of legislative gridlock, despite the Republican Congressional majority, relative to current consensus banter.
“Fading” is trader-speak for incrementally selling into, or taking profits on, a rising market. Morgan Stanley’s best guess is to stay long the reflation trade until close to Trump’s inauguration and then fade it sometime after that.
Trump’s 2016 election shocked the world. In 2017, a five-year change to China’s top leadership team will take place, followed by a five-yearly government reshuffle in 2018. While there is little doubt ultimate leader Xi Jinping will be granted another go-round, the make-up rest of the seven member leadership team is considerably uncertain.
These pending changes should keep Chinese policy-makers risk averse in the meantime, CBA suggests, given no one wants questions raised over his/her running of the world’s second largest economy.
CBA is forecasting 6.8% GDP growth for China in 2017, slightly better than 2016’s expected 6.7%, and above consensus of 6.4%. Growth is then expected to moderate to 6.6% in 2018 as China gradually converges towards slower structural growth rates.
Heading into 2017, the Chinese economy should be boosted by a lower exchange rate and a stronger US economy providing support to export growth, CBA suggests. Import growth should remain moderate due to a cooling housing market and easing consumer spending. A big spike in government expenditure in 2016 should be dialled back in 2017.
Of course there remains one small issue that leads the CBA economists to warn the risk to their 2017 forecasts lay clearly to the downside. If Trump does indeed follow through with threats to name China as a currency manipulator and imposes a 45% tariff on imports from China, it could reduce China’s GDP by a full percentage point in the first year.
But if there is a major disruption to global trade flows, CBA would expect the Chinese government to renew policy easing to support economic growth.
Morgan Stanley’s strategists have lifted their rating on China to Overweight from Underweight.
Europe and the UK
In the wake of Brexit, the European economy has proven to be resilient, Morgan Stanley notes. Morgan Stanley is forecasting 1.4% GDP growth for the eurozone in 2017 and 1.6% in 2018. Slower consumer spending and sluggish investment activity will be offset by stronger net exports, thanks to the weaker euro, and stronger global demand.
The combination of a higher oil price and weaker euro will push European headline inflation materially higher, Morgan Stanley suggests, while core (ex food & energy) inflation will rise more gradually. The ECB will likely extend its bond buying program (QE) for another six months to September 2017 while leaving its cash rate unchanged, before “tapering” purchases thereafter.
CBA’s economists agree the lower euro will provide for stronger European exports, as will a stronger US economy. Some 14% of European exports are destined for the US. But household spending will remain resilient and business investment will further improve, in CBA’s opinion, leading to faster GDP growth than the ECB’s forecasts of 1.6% in each of 2017-18.
Once again, all forecasts come with the caveat of political risk.
CBA does not believe the ECB will increase easing measures in 2017, rather the central bank will begin tapering in the September quarter.
CBA does believe the much lower pound will crimp household spending and business investment in the UK, while improving net exports. Brexit uncertainty will also contribute to restraint. The Bank of England is forecasting a slowing in UK economic growth to 1.4% in 2017 and 1.5% in 2018, but given the UK government’s recently announced fiscal stimulus package, CBA forecasts a more confident 1.6% in both years.
Morgan Stanley believes stronger global growth in 2017 will be led by the US and Japan, with the weaker yen against the stronger US dollar proving supportive for the latter. The Bank of Japan is forecasting 1.3% GDP growth in 2017 and 0.9% in 2018, which in Japan’s case can be considered “strong”.
CBA agrees the Japanese economy will see strength next year thanks to modest further cuts in the Bank of Japan’s cash rate and further fiscal stimulus from the government. The BoJ will nevertheless be wary of cutting its cash rate too much further into the negative given the effect on pension returns.
Which brings us back to the developed world problem of an ageing population. Nowhere is this as more pronounced than in Japan. CBA’s GDP forecasts for Japan are lower than those of the BoJ – 0.9% in 2017 and 0.6% in 2018 – given an economic recovery cannot be sustained without a larger lift in real wages.
And now for the good news.
Back in the noughties, when the commodity super-cycle prevailed, India was invariably mentioned in the same breath as China as the new frontiers of global growth. But in the meantime India has wavered China has completely stolen the spotlight, through economic boom to globally influential slowdown.
The Reserve Bank of India is forecasting 7.9% growth in fiscal year 2017-18, up from 7.6% in 2016-17, in line with the CBA economists’ forecasts. If accurate, India would be the fastest growing economy in the world.
Unlike the developed world, India does not suffer from an ageing population. Solid growth in wages is leading to robust consumer spending, CBA notes, and the introduction of a GST should boost business confidence and investment, albeit low capacity utilisation and funding constraints will provide headwinds.
Morgan Stanley’s strategists have India as their “largest Overweight”. They believe concerns over India’s de-monetisation have been overdone.
While the Indian government could not be accused of being smooth operators when it comes to the recent assault on India’s black market cash economy, the combination, via banknote reissuance and banking sector initiatives, of forcing billions of rupees into the real economy and providing banking facilities for poorer regional areas for the first time should provide a significant boost to the Indian economy, it is generally believed.
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