2017 Midyear Global Economic Outlook

2017 Midyear Outlook: Great Expectations for Global Growth

Markus Schomer, CFA
Chief Economist
New York

13 June 2017

We expect continued movement toward more synchronized growth in developed economies and believe that more bullish growth expectations are likely to be realized in 2017.

Political risk has dissipated in Europe but is increasing in the US and Latin America. Still, strong underlying economic fundamentals are likely to drown out political noise.

China might well see its first full-year growth acceleration in seven years, but a meaningful advance in US growth will probably have to wait until 2018.

Almost halfway through the year, we have seen some surprises in global markets and economies. Political risk in Europe – what seemed to be the biggest threat to global growth – has largely been defanged. But political risk in the US and Latin America is gaining strength. Economies in China and Europe have also surprised on the upside, spurring expectations for more synchronized growth among developed economies.

Indeed, we have seen a transition from excess supply, which was deflationary and depressed business investment, to one where supply and demand are more in balance. This “regime change” among markets is the result of years of underinvestment and record numbers of capacity-reducing mergers and acquisitions. Over the past few years, this industry consolidation reduced the excess supply and diminished global output gaps. The resulting rebound in business spending is the main driver of our more optimistic forecast for stronger and more synchronized global growth.

Ours is not the only optimistic view in town. The International Monetary Fund in its spring World Economic Outlook upgraded its growth projections for the first time since April 2014. It seems 2017 will be the year when more bullish growth expectations will finally be validated.

Global trade rises while commodities send mixed messages

Donald Trump’s election prompted fears of more protectionism and reduced global trade. Instead, global export volumes are rising again, especially in Asia, driven by a rebound in business investment in the US, Europe, and China. The improvement in global trade flows is best illustrated by leading indicators such as the Container Throughput Index, which measures the number of shipping containers handled in 80 major ports around the world. It ended the first quarter increasing at the fastest rate in nearly six years.

So far it seems the underlying economic fundamentals are stronger than the political noise. Emerging market equities have significantly outperformed their developed market peers this year, highlighting the market’s nod to improving global growth conditions. It seems we are on track for stronger global trade to be one of 2017’s macro surprises.

Commodity markets, however, have shown a lot of nervousness in recent weeks – despite surprising resilience in Chinese GDP growth. Oil prices were still up modestly at the end of February, but expectations of strong output increases in the US pushed prices lower again at the start of the second quarter. The ups and downs in oil prices so far this year are more a reaction to changing supply expectations and less a reflection of global growth trends.

Stronger Global Growth is Boosting Commodities

Global Growth and Commodities

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 31 May 2017.

Industrial metals tend to be a better bellwether for global manufacturing. Prices for those commodities did rise strongly in the first quarter, lending more support for the resynchronization of global growth cycles. Yet, even here we have seen a loss of momentum at the start of the second quarter, questioning the rebound in global demand.

The Federal Reserve faces more macroeconomic volatility

Despite our great expectations for global growth, macro volatility remains a major issue in the US, evidenced by yet another sharp slowdown in first-quarter GDP growth. The paltry 0.7% growth rate was even slower than the 1% first- quarter average since the recovery began in 2010. In the past, GDP reaccelerated to a more robust 2.5% clip in the subsequent three quarters and we expect a similar, likely somewhat stronger trend for the rest of this year. However, it won’t be enough to cause a meaningful acceleration in growth for the year as a whole. We now expect 2017 US GDP growth to average 2.1%, which barely matches the current recovery average. Once again, our expectations for a meaningful US growth acceleration will have to wait until next year.

The Trump administration’s rough start also has not helped. Rather than starting with individual and corporate tax cuts that would have pleased the business community and Congressional Republicans, the administration chose health care reform, Washington’s most protracted policy issue. The selection of fiscal priorities is absorbing much political energy and has slowed the progress toward more stimulative tax cuts. Where the administration is making progress is in rolling back regulation, which won’t deliver a tangible “big bang,” but should boost business activity over the coming years.

The reduction in excess supply is driving the rebound in domestic inflation rates around the world. Since the US is leading in the current business cycle among the major developed world economies, the normalization in inflation rates is most advanced here. Not surprisingly, that has given the Federal Reserve more confidence to pursue its policy rate normalization strategy. The latest rate hike in March was the third in the past 15 months, so we are close to the three hikes a year the bank is forecasting for the next few years.

Yet the Fed will surely take the uneven US growth performance and the uncertain fiscal policy direction into account when calibrating the appropriate amount of monetary policy tightening in the second half of the year. Furthermore, the Fed is moving closer to ending its reinvestment policy and allowing its massive $4.5 trillion balance sheet to shrink, which will give the Fed a second tool to accomplish the desired stimulus withdrawal. As a result, we maintain our forecast of only two actual rate hikes in each of the next two years with some additional future tightening coming from balance sheet reduction.

Political risk is dissipating

At the end of 2016, the new year looked like one full of potentially market-disrupting political risk. With the surprises of the UK’s Brexit vote and the election of Donald Trump, we looked with trepidation at the crowded 2017 European election calendar that threatened to bring new, untested governments to power in four of the five largest eurozone economies.

We are nearly halfway through the year and European voters have not been persuaded by populist parties who campaigned against globalization and the euro. Instead, centrist candidates won elections in the Netherlands and France, promising to keep those countries firmly committed to the EU and its future. Support for populist parties is also waning in Germany, which still faces elections in September. Angela Merkel’s re-election chances are rising again, and the 2017 European political calendar may very well turn out to be a positive inflection point toward a more stable and united EU – and not the feared catalyst for its demise.

Bullish Economic Recovery in Europe

Economic recovery in Europe

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 31 May 2017.

An unexpected entry on the political calendar was the snap election in the UK, called by Prime Minister Theresa May to provide her with a stronger mandate to lead her country into what looks increasingly like acrimonious Brexit negotiations with the EU. It didn’t seem much of a gamble judging from the 20-point lead her Conservative party enjoyed in April, yet political events once again proved unpredictable. The Conservatives lost their majority, creating more uncertainty around what kind of Brexit we will face a few years from now. Most of the divisive Brexit language from both sides is likely for domestic audiences as neither side wants to be seen as weak. Yet the way the negotiations start off this summer will be critical to gauging their overall success.

We still believe the differences are manageable. If negotiators can find a compromise over the untangling of the UK’s financial obligations to the EU, defining the new trading relationship could happen faster and in a more friendly climate than is expected right now. The other far less likely option is a so-called “hard Brexit” without an agreement, which would be highly damaging for both the UK and the EU.

A stronger China

Stronger growth in China so far this year has been a significant surprise. The economy held up better than expected in the first three months, posting the first pickup in the annual GDP growth trend since mid-2013. Part of the strong start to 2017 is still attributable to the housing boom of the past few years. Much of the government’s recent tightening measures specifically targeted that sector and both new construction and house prices have started to slow noticeably.

Yet the rebound in global business activity has boosted exports, helped by a yuan that is down more than 6% against the US dollar in the past 12 months. If the government is really trying to tighten financial conditions, it hasn’t materially slowed new credit supply, which has averaged a steady 24% of (nominal) GDP in the past year and a half. It’s still early, but another 2017 surprise could be the first full-year growth acceleration China has seen in seven years.

A slow turn in the global monetary policy cycle

So far the Fed is on its own to use the rebound in inflation and the decline in unemployment as justification to start withdrawing stimulus. While the Fed has taken the lead in normalizing monetary policy, other banks are starting to face similar macro fundamentals that are likely to prompt similar policy decisions over the next nine to 18 months.

The European Central Bank (ECB) has already started to taper its asset purchase program, but is still far away from raising policy rates. Australia and New Zealand are the most obvious candidates for such a move. Both economies have grown significantly faster than the developed world average over the past five years, have seen inflation rates move back to their respective banks’ target ranges, and face rising private sector leverage. All of that should be enough to prompt the first rate hikes probably as early as the end of this year.

Transition Toward Global Normalization

Economic recovery in Europe, investing in Europe

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 31 May 2017.

Despite further Fed tightening and improving global growth trends, fixed income markets have proven resilient. As we had expected, fixed income markets are on a slower performance trajectory this year following last year’s exceptional returns, especially in high yield and emerging market bonds. Global government bond returns are flat so far this year, while continued spread tightening generated solid gains for most corporate bond asset classes, albeit at a slower pace compared with 2016.

A more disorderly bond market unwind remains a risk, especially in light of the Fed’s expected move toward balance sheet reduction later this year. But the Fed’s transparent communication and the lack of an actual inflation problem should dampen the negative impact on longer term bond yields.

A new regime brings new opportunities

We went into the year with cautious optimism that we had reached an inflection point in the transition from the post-crisis world of excess supply that was deflationary, depressed business investment, and required significant policy support to one where animal spirits are again driving growth in private sector activity. The accumulating evidence of faster and more synchronized global growth has strengthened the case for a real regime change.

Interest rates have bottomed, central banks are starting to look at stimulus withdrawal, and fiscal policy easing is taking the baton as the preferred stimulus tool. The resulting increase in dispersion between regions, sectors, and asset classes is creating a healthy backdrop to create alpha from choosing the right beta. US financials should benefit from regulatory rollback and rising interest rates. Economic reforms in India and Indonesia present structural improvement opportunities there, while Brazil’s bond market rally is still a long way from over. Unless the world sees a lurch towards more protectionism, we believe these markets offer plenty of opportunities for asset allocators.

Global Growth Forecasts

Global Growth Forecasts as of 31 May 2017

Source: Thomson Reuters Datastream, Bloomberg, PineBridge Investments calculations as of 31 May 2017.