Last year’s synchronised upswing in growth represented a rare patch of smooth sailing for the global economy, following years of turbulence in the wake of the financial crisis. Moving into 2018 the expectation was that growth would remain upbeat, despite a number of potential risks forming on the horizon. Halfway through the year and it seems fair to say that some of these feared headwinds have been picking up pace. For example, the US dollar has started to appreciate noticeably against a range of developed and emerging currencies since the middle of April, with this tightening dollar liquidity strong enough to generate stress in some of the more vulnerable emerging markets. Meanwhile, trade tensions have been clearly building between the US and its trade partners, as illustrated by the fraught G7 meetings over the weekend. Populist politics has not just been an issue in the US, with the Italian election delivering a government which threatens to violate the Eurozone fiscal compact, resuscitating fears over Italian and Eurozone institutional stability. Finally, oil prices, which increased amid improving demand last year, have tested new highs this year on concerns over supply disruptions.
The good news is that while these headwinds have all been building, they are not as yet strong enough to provide a serious dent in the global growth story. Indeed, even after taking into account some disruptions to activity at the start of the year, we have only nudged down our forecasts for headline growth over 2018. However, these developments have probably shifted the tone and composition around global growth a little more. In isolation, all of the risks highlighted have the potential to be much more disruptive and even bring the cycle to an end should they crystallise fully. Moreover, the combination of a rising dollar, higher oil prices, localised political uncertainty and trade spats are all likely to make growth more uneven across economies and sectors. This fading synchronisation would also imply increasing divergence on the monetary policy front. The upshot is that while the cycle is still chugging along, the outlook has become a good deal bumpier. This should underline the importance of differentiation between markets and asset classes.
Coming into 2018 we were expecting a strong year for the US economy. Growth was already running at 3% annualised over the second half of 2017, and a large programme of personal and corporate tax cuts was set to come into force, providing additional short-term impetus. However, this wasn’t to be the only fiscal giveaway delivered in 2018. In early February, Congress passed the Bipartisan Budget Agreement, which paved the way for increases in defence/non-defence spending and disaster relief funding. While much of this spending will not come into force until the second half of this year, a further loosening in fiscal policy has added to concerns around overheating. Certainly, data suggest that the economy continues to grow above trend. Following a now familiar slowdown during the first quarter, activity looks to have bounced back smartly in Q2, with improving trade data the latest sign of encouragement (see Chart 2). On a more cautious note; the higher oil prices seen over recent months will provide a modest drag on consumer spending, though this will be partly offset by improving activity in the shale sector. Taken together, developments so far this year suggest growth will run a little hotter than we had factored in just six months ago.
The rise in oil prices has also forced us to reconsider short-term inflation forecasts. Price growth for energy goods and services is up 8% over 2018 thus far in annualised terms, and is set to rise further in coming months. We have also seen an uptick in underlying inflation rates, with core CPI and PCE inflation growing 2.4% and 2% in 6-month annualised terms respectively. In part this likely reflects the fading effect of temporary drags seen in 2017 (such as falling telephony service prices), past dollar depreciation and seasonal forces. Indeed, we would not interpret this acceleration as a signal that US domestically generated inflationary pressures are rapidly breaking out. Indeed, looking at the labour market, the increase in wage pressures over recent months remains modest (see Chart 3), especially when we account for some improvements in productivity. This is consistent with the view that an overheating economy will translate into gradual rises in inflation, especially when we take into account monetary policy tightening.
On policy, additional fiscal stimulus earlier in the year caused us to revise up our expectations for the Fed to deliver four hikes this year and next. One increase was delivered in March and another looks set to come later this week. We will be watching the communication closely for signs that there is appetite to maintain this quarterly pace. Otherwise, the news around trade policy this year has been worse than feared. We have already seen tariff action on solar panels, washing machines, steel and aluminium while proposed levies on $50bn of Chinese imports would come into force this month. The scale of the measures announced to date is small, muting the economic impact on forecasts so far. However, the trajectory of discussions is alarming. Given the reciprocal harm done by a large scale trade conflict, we continue to factor in only small changes to policy amid the reckless rhetoric. But it is fair to say that the risks of a deeper trade war have increased this year.
Softer growth, inflation and Brexit
The UK economy has performed slightly worse than we expected at the start of the year. Activity in the first quarter was extremely weak, with quarter-on-quarter growth of just 0.1%. However, we think that much of this weakness was a weather-related phenomenon. We are therefore relatively optimistic about the prospects for second quarter growth, forecasting an increase in GDP of 0.5%, as pent-up demand is realised. The data so far has been broadly consistent with this bounce-back, with the various PMI surveys (see chart 4), retail sales, consumer confidence and credit data, all recovering nicely. However, the fall in industrial production in April was a disappointing start to the quarter (see chart 5), while the trade picture is also quite downbeat, with the trade deficit widening from £3.2bn in March to £5.3bn in April. Overall, we expect the economy to grow by 1.4% this year, followed by 1.5% next year and the year after.
The inflation profile this year has also been a little softer than we had expected, falling more rapidly towards the Bank of England’s target. This largely reflects slightly less pass-through into domestic inflation from past sterling weakness. However, the recent increase in oil prices will put upward pressure on the energy component of the inflation basket. At a minimum, this will slow the current decline in inflation towards target, and may even see year-on-year inflation tick-up briefly over the summer. We expect inflation this year of 2.3%, down from 2.7% last year. The domestic inflation fundamentals in the UK appear to be firming slightly. Nominal wage growth is creeping higher as the labour market continues to tighten. After a jump in labour productivity growth in the second half of 2017, Q1 2018 saw productivity fall. While the underlying trend is not completely clear, we forecast trend growth of around 1.5%. As wage growth pushes further above this rate, unit labour costs will rise more quickly, generating greater domestic inflationary pressures. We expect the Bank of England to increase Bank rate just once this year, in August, slightly less than we had originally anticipated, reflecting the marginally weaker growth and inflation paths.
On Brexit, our expectations have shifted to a slightly ‘softer’ outcome. In our baseline forecast, the UK enters into a customs union with the EU. This reflects a subtle hardening of the EU’s negotiating position over the Irish border, and shifts in UK domestic politics. The EU has made clear that it does not believe any of the UK’s preferred customs arrangements (maximum facilitation or a customs partnership) can solve the crucial Irish border issues - at least for the foreseeable future. As such, the UK will probably need to commit to customs union membership (either by falling back on a supposed “backstop” or by explicit agreement) to reach an exit deal. Meanwhile, the Labour Party has committed to a customs union, which means there is probably now a cross-party coalition big enough to defeat the government in the Commons on exiting the customs union. The timeline for agreeing the final deal seems to have slipped slightly. Originally, the June EU submit was expected to deliver significant progress on solving various issues, before the final deal was then signed-off in October. It now appears that most of the work will now be postponed to the October summit at the earliest.
A few cylinders misfiring
At the start of this year, we described the Eurozone economy as “firing on all cylinders”. Almost six months into the year, it looks like a few cylinders have started to misfire. The first quarter GDP print came in at 0.4% quarter-on-quarter, down from a consistent 0.7% throughout the previous year. Domestic demand remained robust, with consumption and investment both posting solid increases. But net trade was a drag on overall GDP growth (see Chart 6), with both imports and exports declining – albeit the latter by more. Meanwhile, survey data relating to the second quarter have continued to come in soft, with both confidence indices and the PMIs losing further momentum. Temporary drags have played a role, but the Eurozone also faces some more fundamental headwinds that were less pressing at the start of the year, including the lagged impact of earlier euro appreciation, higher oil prices and rising capacity constraints in some member states. Overall, we’ve lowered our 2018 GDP forecast from 2.3% at the start of the year to 2.1% now. This reflects both the disappointment at the start of the year, but also some slight drags from these headwinds.
Meanwhile, the Italian general election loomed large on an otherwise light European electoral calendar at the start of the year. Fast forward to last month and the approval of the 5 Star Movement – League government, and investors’ worst nightmares appeared to be coming true. The longevity of the Italian government is highly uncertain, but that may increase the parties’ desire to pursue populist policies ahead of possible fresh elections. The government is planning to incorporate both parties’ pet economic policies by introducing universal basic income and cutting taxes, while rolling back pension reforms. If enacted fully, these are likely to cause the budget deficit to balloon, from 2.3% of GDP now to as high as 8%. The EU’s response to fiscal slippage and immigration policy changes will be key for markets, as a hard-line approach risks sparking more Europhobic tendencies in Italy.
On the inflation front, at the start of 2018 we were revising up our Eurozone inflation forecasts on the back of higher commodity prices. Those upward revisions have continued over the first half of the year, as the euro-denominated oil price has risen 10% since January (and at one point the rise was more than 20%). Headline HICP inflation hit a 14-month high of 1.9% in May, and is likely to breach 2.0% over the next few months as higher oil prices are passed through to consumers. We now see inflation averaging 1.7% over the course of this year as a whole, up from a forecast of 1.4% at the start of the year. But we haven’t observed the same strong upward pressure on core inflation measures (see Chart 7), which we expect to rise only very gradually as spare capacity continues to be eroded. The upshot is that ECB policy appears to be proceeding broadly as we had expected: we continue to anticipate a tapering down of net asset purchases over the course of Q4, which looks likely to be announced either this week or at the July meeting. And we see a first rate rise, hiking the deposit rate by 20 basis points, in September 2019.
Don’t look down
Japan has had a sobering 2018 so far, with both growth and inflation coming in below expectations. Is this likely to trigger a policy response, or should we expect more of the same? In terms of economic activity, the disappointment of a contraction in Q1 is threatening to turn into a (technical) recession, with our Nowcast framework pointing to another negative quarter in Q2. This is significantly below our judgemental forecast (see Chart 8). This reflects our views that production and sentiment data have been distorted by idiosyncratic factors in the semiconductor sector, rather than a broader downturn in the industrial cycle, and that consumer weakness is adverse weather related. If the downside risks do materialise, this will raise significant questions about the policy outlook. Most notably, pressure will increase on the government to recalibrate its fiscal policy. At present, the government has pencilled in a VAT hike in October 2019. However, even with the additional revenue from this levy, it has been forced into a five-year delay of its target for a primary budget surplus. A final decision on the VAT hike will be taken after the release of the Q3 GDP data – set for November 14th. If momentum does not recover sufficiently, an implementation delay may be on the cards, putting fiscal consolidation plans into turmoil – and potentially testing market lethargy on debt sustainability.
Turning to inflation, the disappointments in H1 have been no less distressing. Inflation has stalled again, with the April core CPI decelerating to 0.7% quarter-on-quarter (q/q), from 0.9% in March. More importantly, the Bank of Japan’s (BoJ) preferred core core measure was a miserly 0.4%q/q in April (see Chart 9). This dashes optimism on the inflation outlook, with the BoJ rumoured to be considering revising down its price outlook – prompting media speculation that it will launch a review at its June and July meetings of why inflation remains so weak. On our key measures of inflation fundamentals, we have observed some positive signs such as a closing of the output gap in 2018 and a sustained rise in core CPI – although this has largely been driven by energy prices. The big disappointment has come in wage setting behaviour, with the labour unions’ fourth estimate of the shunto outcome indicating a 0.53% rise. This is a long way from the 2-3% consistent with the BoJ’s target and only a marginal increase from the 0.48% year-on-year in 2017, versus the BoJ’s hopes for a step change. Further, survey-based measures of inflation expectations have weakened of late. The key question is whether the BoJ will respond. Its new leadership team has retreated from comments guiding markets toward exit of late. We think the BoJ has been late to recognise the trap it finds itself in. We believe this has two elements. Firstly, essential to any successful policy exit will be improving inflation fundamentals. However, the current Yield Curve Control framework does not provide the firepower to generate sufficient momentum for fundamentals to endure an exit. Secondly, debt sustainability rests increasingly on financial repression, with the government inaugurating a debt-to-GDP target to accompany its primary deficit target. This requires nominal interest rates to remain below nominal GDP for a very long time – meaning a normalisation of debt pricing remains impossible until the government has achieved a primary surplus. The stakes around the price and growth outlook are clearly rising. However, we think policy settings are sufficient for things to get back on track in H2. However, events so far this year have demonstrated Japan’s vulnerability to a downturn.
First half surprises
2018 has already seen its fair share of surprises. Nearly at the mid-point, we’ve seen a shift (even if temporarily) in US-North Korea relations that was deemed unbelievable just six months ago; the consensus around synchronised global growth has weakened; the US is moving towards protectionism; and the ZTE debacle crushed the myth of world-beating Chinese innovation. In emerging markets (EM), the optimism that started the year has largely faded in the face of rising rates, a stronger dollar, and higher oil prices leading to more volatility and less risk appetite. What is perhaps most surprising (though certainly receiving less attention) is the fact that the market stress and negative growth shocks in EM has occurred amid unexpected strength in China’s economy. This highlights two uncomfortable truths about EM: first, though intra-EM trade has grown and China’s economy exhibits a far larger influence over the EM cycle than it did ten years ago, EM has yet to ‘decouple’ from the developed market and dollar cycle; second; it is highly unlikely China can maintain current levels of activity, and will slow in the second half. Given that we have already seen negative growth surprises in Brazil, Russia, Indonesia, and South Africa, among others, alongside strong Chinese growth, the environment could get more difficult if the China factor also turns less supportive.
For most of 2018, China has been able to have its cake and eat it too. The government has emphasised de-risking the financial sector and cleaning up the environment, causing credit growth to slow substantially. Our measure of total credit (including hidden credit not captured in official statistics) slowed to 10.1% year-on-year (y/y) from a peak of 21.9% y/y in March 2016 (see Chart 10). But the government has not had to pay any price for these efforts as the economy has barely slowed: PMIs have held steady at five-year highs, manufacturing industrial production (according to official data) has held steady, and property sales have hovered near all-time highs (see Chart 11). Although pessimists have been proven wrong over their China forecasts this year, most factors are still pointing to slowing growth – borrowing costs are higher; trade tensions look to sap sentiment even in the event they are smoothly resolved (which we doubt); and industrial production volumes (our own measures that looks to more accurately measure production activity) slowed over the first quarter.
So what should investors look for as we moved into the second half of the year? The first would be production volumes, which tend to reflect two themes – trade tensions and environmental shutdowns. Production slowed sharply over 4Q17 and 1Q18 as environmental policies forced shutdowns and looming trade threats pushed businesses to run down inventories and slow current production. However, this figure bounced back in April to 6.6% y/y from 1.4%, reflecting an easing of environmental policies. The impact of on-again-off-again trade tensions with the US are as yet unclear and the negative sentiment impact could yet slow production. The housing market is the other key factor. Following an unexpected bounce in Q1, it’s unclear where we are in the current cycle. On the one hand the current edition is among the longest since housing has been deregulated, but on the other hand inventories are at multi-year lows. On balance, we expect a slowdown, which further dampens the outlook for broader EM.