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Outlook Overview: Political Noise Drowns Out Growth Signals

By:  David Sloan Posted:  17 Mar 13:00
  • Global economic conditions continue to improve, particularly in Europe, where we have upgraded our growth forecasts. This momentum, which includes the strongest DM growth in years and a bottoming out of commodity producers, provides resilience to some shocks.
  • Our themes of returning inflationChinese macro volatility and an EM investment recovery look to be on track, while central banks (aside from the People’s Bank of China) seem less bound by market concerns and will move to end easing.
  • Despite his Russia troubles, President Trump seems to be taking action on many of his campaign promises. His focus on trade first and fiscal expansion later suggests a weaker growth outlook for 2017 than we had previously expected and less benefit to U.S. trading partners.
  • Globally, political uncertainty remains the key risk and pressures are building on the probability we have assigned to our downside scenario of trade protectionism occurring, at the expense of our upside and baseline scenarios. We will detail the implications of this in our forthcoming “Heatmap and Global Scenarios” publication.
  • The dollar’s “Trump Rally” is proving less buoyant than expected and most G10 FX trends seem relatively range-bound. We expect rates to grind higher and a bear market to persist in bonds. But fear seems absent in the equity market, which still looks vulnerable to a correction (we have cut our S&P 500 target to 2150 for year-end 2017). Within this negative outlook, we see relative opportunity for EM local bonds.

Figure 1: OECD Leading Indicators Pointing Up

Source: Roubini Global Economics, Haver Analytics

The global economy is looking fairly solid right now. Leading indicators of growth are picking up (Figure 1) and imbalances are manageable for now. The risk of disinflation has abated and price measures are trending higher in much of the world, reaching target levels. Policy and short-term interest rates are set to rise modestly in the U.S. and some EMs. Commodity producers like Russia and Brazil are bottoming out and expanding modestly and Latin America is set to experience its first year of growth in three years. Meanwhile, we see growth in China slowing down somewhat this year due to a tighter stance, but is slowing from a strong pace.

Amid this otherwise benign outlook, there is a growing risk that politicians will bring it all crashing down. In particular, we now see the U.S. policy mix skewed more toward earlier trade threats and later fiscal stimulus, which may delay or even limit its benefit to global growth—so we have modestly revised down our U.S. growth estimate for this year.

As inflation rises, DM central banks are coming to the end of easing and will soon be following the Fed’s lead in removing accommodation. Reducing monetary stimulus is perfectly consistent with solid economic performance, but comes at a time at which policy uncertainty around fiscal and trade policy is high. These trends coincide with equity markets in particular looking more expensively priced.

Inflation Returns, Leaving Few Obstacles to Tightening

The Return of Inflation, one of our key themes for 2017, seems to be on track. Prices have risen sharply, fueled by commodity prices and past reflationary policies, and are approaching target levels in much of the world. This trend suggests that monetary easing is ending and that tightening, led by the U.S., will be the order of the day. One consequence of this is that major central banks are beginning to consider shrinking their swollen balance sheets, a process that could be more complicated than is generally perceived.

This year, we do not expect any interest rate hikes in DMs (aside from the U.S.) and we predict rather modest hikes in the EM world.

Figure 2: Headline Inflation in the ‘Big Four’ (12-month change, %)

Source: MacroBond, Roubini Global Economics

Watch Chinese Tightening

There will be a notable shift to a tighter stance in China, where the People’s Bank of China is allowing rates to drift upward even as local regulations reduce funding for the property sector. We expect Chinese growth, after accelerating sharply from past stimulus, to slow in 2017 as higher inflation restrains consumer purchasing power, the property boom slows and fiscal policy becomes less supportive.

The focus on political stability ahead of this year’s National People’s Congress suggests the slowdown will be moderate—another round of stimulus is possible when it overshoots, as it inevitably will. The authorities’ concerns about excessive debt levels will likely come to naught, with credit growth still outpacing GDP in 2017 and limited steps being taken to reduce excess capacity.

Threatening a Bear Market in Bonds

One consequence of rising inflation and less accommodative monetary policy is rising bond yields. A key question is whether this is just a cyclical rise or the beginning of a bear market in bonds. There are a number of reasons to fear the latter:

  • Yields seen over the past few years are only sustainable due to actual or threatened central bank intervention and central bank ownership of large proportions of government debt;
  • Without deflation or a global recession, neither of which are currently in the cards, bond yields should therefore continue to rise;
  • Normalizing inflation will add to upward pressure on bond yields—moreover, we can assume that for the foreseeable future, central banks will err on the upside with inflation; and
  • Finally, as central banks move to shrink their balance sheets, there will be further long-term upward pressure on bond yields.

Politics Looms Over Macro Environment, Increasing Downside Risks

In past years, dismal economic realities have called for political action. In 2017, this situation has reversed. The global economy is—broadly and cautiously speaking—looking good. Leading indicators are—again, cautiously—pointing up. But the threat from politics is looming larger than it was only three months ago.

The biggest danger comes from the U.S.—not only is the Trump administration confronting the adversaries and rivals of the U.S., it seems to be going out of its way to antagonize friends and allies over trade and security policy. This in itself is increasing the downside risk from politics to U.S. and global growth.

Moreover, it now seems more likely that trade threats will precede the fiscal stimulus, meaning U.S. output growth is likely to be somewhat lower than we previously forecast in 2017 (although 2018 should benefit correspondingly). This, too, will delay any related benefits to U.S. trading partners. We believe this increases the probability of our downside scenario (the catalyst for which is trade protectionism).

Meanwhile, political risk in Europe has also increased, with the French election up in the air and the Dutch election likely to result in difficulties forming a new government. Moreover, the ease of calling for referendums in the Netherlands means that Dutch and EU decision-making (for example, on a Brexit agreement, another Greek bailout or even Russia sanctions) is likely to remain unpredictable (Figure 3).

At the very least, financial markets will be subject to politics-induced volatility this year, at least until after the German elections, and possibly longer if Italy also goes to the polls. At worst, the uncertainty—not to mention the populist victories—could have a dampening effect on both household and corporate activity, offsetting the pickup we have penciled into our forecasts.

Figure 3: Key Events and Critical Uncertainties

Date

Event

RGE View/Significance

March 15, 2017

Netherlands: general election

Opinion polls imply Geert Wilders’ PVV could become the biggest party. Since 2015, Dutch law provides for a referendum if 300,000 voters demand it, with a valid result if 30% of the electorate takes part. While only advisory, the results are likely to be deciding in practice. A strong showing for a populist party at the election raises the likelihood of further referendums on any EU deal, including Brexit.

March 15, 2017

U.S.: next FOMC rate hike expected

We expect the FOMC to hike the target range for the overnight rate by 25 basis points at its March meeting. We expect three Fed rate hikes this year (totaling 75 bps), with another three in 2018.

April 23 and May 7, 2017

France: general election

Marine Le Pen could use the promise of an EU (or EZ) referendum to win the presidency, although her likely run-off rival, whoever that may be, remains the probable victor. If Le Pen does win, though, French voters might come down in favor of exiting the EU by a narrow margin.

April 16 2017

Turkey: constitutional referendum

Political risk and purges of key officials are likely to continue ahead of the vote to switch to a presidential system. The vote is likely to pass given the support of some of the Turkish nationalist opposition parties. We don’t expect meaningful improvements after the vote.

May 19, 2017

Iran: presidential election

President Hassan Rouhani is still the leading candidate, although the final run-up will be revealed only in the weeks ahead of the election. Dissatisfaction with the economic benefits of the nuclear deal is likely to be a major campaign issue, increasing the unpredictability of Iran’s economic policy in the preceding months. Meanwhile, U.S. enforcement of sanctions is likely to increase.

August-October 2017

Germany: federal elections

Political risk is running high in Germany, where the far-right populist party, Alternative for Germany (AfD), gained support at the expense of Chancellor Angela Merkel’s CDU in regional elections earlier this year. A more likely outcome is the AfD entering the Bundestag, complicating coalition-building by other parties.

September 2017

U.S.: 2018 federal budget due

The first federal government budget to be written under the Trump administration is getting underway in Q1. The full implication for government spending and for fiscal policy will only be known in September, when appropriations bills must be passed into law to fund government in fiscal-year 2018, which begins in October.

Fall 2017

China: National Congress of the CPC

China’s 19th Communist Party Congress will reinforce President Xi Jinping’s power over security and economic issues. Although Xi will likely be reaffirmed in his role, five of the seven members of the politburo standing committee will theoretically be replaced, along with cabinet members. Political jockeying ahead of these selections will likely put meaningful reforms on hold.

December 2017

South Africa: ANC leadership convention

South Africa’s political and economic risk will rise as the leadership convention approaches. The fight looks likely to be between Zweli Mkhize, ANC’s current treasurer general, Deputy President Cyril Ramaphosa and Nkosazana Dlamini-Zuma, African Union chair (and President Jacob Zuma’s ex-wife). Zuma continues as head of state until the end of his term in mid-2019, implying the fractious political environment is here to stay.

May 2018 (latest possible date)

Italy: general election

We see a considerable risk of Italians acting in line with the surge in support for populism elsewhere in the DM world and using the election to vent their dissatisfaction with the establishment. The populist Five-Star Movement, which promises to hold a referendum on Italy’s EZ membership, could well benefit from this.

Source: Roubini Global Economics

The biggest European risk remains the French presidential election. Although opinion polls continue to say that Marine Le Pen will lose in the second round (they all assume she will get the highest vote in the first round), this can by no means be taken for granted, and markets would do well to consider the potential consequences of a Le Pen victory, which we have outlined elsewhere.

The German election outcome has also become more uncertain with the surprising strength of the SPD’s chancellor candidate Martin Schulz. The likely entry of the anti-EU AfD (Alternative for Germany) party to the Bundestag will complicate coalition-making.

Although populism is mainly absent in EMs (with the odd exception, such as Philippine President Rodrigo Duterte), domestic political shocks could shake resilience to external threats, such as the constitutional referendum in Turkey and the leadership convention in South Africa, which we believe could increase credit-downgrade risk in those countries.

Key regional elections in India and Indonesia could also increase expansionary policies. The presidential election in Iran will make the regime fragile, increasing the risk of “accidents” and the testing of sanctions enforcement, while testy U.S.-Mexico relations create the risk of a backlash ahead of the latter’s 2018 elections.

Among the most important political events is the 19th Party Congress of the Chinese Communist Party, which will choose the leadership of the world’s second-largest economy for the next five years. Major policy changes are unlikely and the focus is likely to be on stability and security.

However, these pressures will up the ante for the authorities to support growth, prevent housing price surges and, potentially, increase the country’s aggressive posturing in the South and East China Seas—a difficult balancing act that suggests greater short-term macro volatility due to the past period of stimulus and its recent withdrawal.

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