Thursday, November 12, 2015

Moderate global growth but ongoing European & US upswing

Please find below a short summary of some structural themes and the building blocks for my medium term/2016 outlook:

1.) Trend growth rates have fallen in a large number of economies amid worsening demographics as well as lower productivity growth. Still, US trend growth (of currently around 1 3/4%) should be able to increase moderately amid slightly more favorable demographics and moderately rising productivity growth. 

2.) The Great Moderation 2.0 – the notion that macro-economic volatility has become lower on a structural basis – remains in play. Macro-prudential policies are adding to the reasons for an environment of structurally low macro-economic volatility in developed market economies. In turn, upswings will be more muted but longer-lasting, downswings should be milder and shorter. The current long but mild upswing in the US economy is a case in point. (For more see Macro-prudential policies and the Great Moderation 2.0)

3.) The commodity super-cycle has gone into reverse and weighs on commodity producers. A large number of important Emerging Markets and commodity producers is going through the Third Wave of the global debt-deleveraging cycle. The first wave – the global financial crisis – started when dropping asset values lead to an evaporation of equity capital in the highly leveraged banking sector. During the second wave – the Eurozone debt crisis – the peripheral countries saw their deficits and debt ratios balloon while market access deteriorated, forcing sovereigns to dramatically tighten fiscal policy. Now, we are in the midst of the third wave, a debt-deflation spiral which is spreading amongst emerging market and commodity producing corporates where indebtedness has risen significantly over the past years. Given a reduction in asset prices – amid weaker growth and lower commodity prices – and higher debt values for those corporates with US-Dollar denominated debt, an increasing number of corporates is being forced to deleverage. In general the period of strong growth across emerging markets, rising commodity prices, strong capital inflows into EMs, the build-up of large FX reserves and a weak US-Dollar were all interconnected but have gone into reverse over the past two years. Now we have weak EM growth, sideways to falling commodity prices, capital flowing out of EM and commodity producers back into Europe and the US, a strong US-Dollar as well as a draw-down of FX reserves. (Further details here: The Third Wave: Debt-deflation spiral reaches the corporate sector)

4.) The economic backdrop will likely worsen further in a number of EM and commodity producing countries. However, China as the most important emerging market should not suffer from a hard landing. While Chinese growth finds itself on a structural downward trend, cyclically growth should be able to stabilise at lower levels amid the support provided by ongoing macro-economic easing steps, from both the fiscal and the monetary policy side.

5.) The outlook for Europe and the US is a favourable one:
  • Improved structural situation. Macro-economic imbalances have been reduced, especially in the Eurozone periphery, bank balance sheets have been significantly improved and structural budget deficits have been reduced materially.
    US & Eurozone current account and budget balances
    Source: Bloomberg

  • Growth friendly macro-economic policies: Despite the likely start of the rate hiking cycle in the US around the turn of the year and later on in the UK, monetary policy will stay accommodative. In the Eurozone, monetary policy will become even more accommodative amid further ECB action as well as a gradual restoration in the transmission mechanism (i.e. improved credit availability). Fiscal policy will not be restrictive anymore and can become even moderately accommodative (especially in the US and Germany). The Eurozone economy has moved from the blue square in the table below in 2009/10 via the red square in 2011-2013 to the grey one in 2014/15. In 2016 it might just shift into the green area. 
    Source: ResearchAhead

  • Rebounding inflation rates: Inflation rates will bottom during autumn and should rise noticeably into late winter amid strong base effects. Thereafter, it can slowly move slightly higher over the medium term. Current inflation rates are around 0% mainly amid the previous collapse in energy prices (as well as the strong USD in case of the US). These effects should weaken in the months ahead. As a result, the Fed’s “Window to wait” and the ECB’s “Window to act” will close early next year unless the economies cool materially. The chart below shows the development of US CPI inflation. In the first scenario, the seasonally adjusted CPI index is left unchanged, meaning that there are zero inflation pressures from now on. In the second scenario, the core CPI index continues to rise by the average rise increase far this year (i.e. core inflation pressures remain unchanged). In the first case, yoy CPI can rise to +1.2% in January, in the latter case even to +1.8%.
    US Inflation developments
    Source: Bloomberg, ResearchAhead

  • The strong USD, the subdued growth environment in EMs as well as commodity producers  hurt industrial companies while the low energy prices weigh on the oil & gas sector. On the other side, the recovering housing and labour markets as well as low energy prices support domestic consumers. The discrepancy between the global economy focused/export dependent manufacturing sectors on the one side and the more domestically/consumer oriented services sectors on the other can continue. However, manufacturing and mining account for only 14.5% of US GDP while the private service sectors account for 67.5% of GDP. In the Eurozone, the export environment should in general do ok as the Eurozone and UK economies are mostly dependent on each other as well as the US and depend less on Emerging Markets.
  • The Fed will start hiking rates soon, followed a few months later by the BoE. Rate hiking processes will be gradual and the upward pressure on the currencies should provide for part of the necessary tightening. The ECB on the other side will ease monetary policy somewhat further.
6.) Overall, therefore, the global economy should be growing at a moderate pace. However, given the recent significant downgrading in forecasts, it can surprise positively vs. expectations given developments in Europe and the US. Inflation pressures remain limited due to weak commodity prices and global excess capacity. Still, as described above actual inflation rates in Europe and especially the US will rise back closer towards the central banks’ targets.

7.) The multi-decade bond bull market in Europe and the US has ended. While easy monetary policy should keep bond yields below nominal GDP growth – especially in the Eurozone - improved real growth, moderately higher inflation rates and the start of the US rate hiking cycle should take bond yields higher in the years ahead even though this should be a gradual process. Given the very low yields, sovereign bonds do not provide a large enough cushion against such adverse market movements and negative total returns are likely.

10y German Bund yield vs. Eurozone nominal GDP growth
Source: Bloomberg