Will the pillars of growth hold in 2018?

Richard Yetsenga

Chief Economist, ANZ

The year 2018 looms as a testing time for the global economy. While growth has strengthened further and the breadth of it has been impressive, we expect rates of growth to moderate as the year progresses.

The global recovery thus far has been helped by serendipity. Political risks in Europe have diminished and US president Donald Trump hasn’t done much damage to global trade (at least so far).

" While the global economy does look quite stable, these pillars will need to hold in 2018 for that to remain the case."

China has again managed its leverage issues well (to the surprise of many) and consumers have continued to spend. While the global economy does look quite stable, these pillars will need to hold in 2018 for that to remain the case.

Already political news looks to have passed its high watermark. Germany, the US, UK, Australia, New Zealand and Spain, among others, appear more politically fractious. The deleveraging efforts from China’s policy authorities should reach their peak impact over the next six to nine months.

A flattening in yield curves implies the recovery in bank lending which has been important to the global upswing will struggle to accelerate, at least in the US. Household saving rates have substantially retraced their post-crisis rises when consumers hunkered down. Consumers now seem ill-prepared for shocks to asset prices.

The health of the global trade cycle is important to maintaining the upswing. As such, while conditions are improved, they don’t yet seem to be regionally self-sustaining.

Demand

In Asia domestic demand hasn’t been a particular robust driver of the cycle. India and Indonesia have suffered as banks respond by slowing credit growth. Chinese domestic demand has been solid, but supply side reform has been aided by an improvement in the contribution of net exports to GDP over the past year.

While advanced economies have seen domestic demand contribute to growth, against the backdrop of weak income growth, this has come at the cost of the household sector’s resilience.

What to watch in 2018

Tightening liquidity is only expected to add volatility until later in the year.
How stretched consumers respond to the tightening in liquidity will be crucial.
The vulnerabilities of risky assets suggest any rise in bond yields will be modest.

Household saving rates in Europe, the US and Australia are all around their lowest since the crisis. We expect some volatility in risky asset prices as liquidity tightens which - barring a robust rise in income growth - is likely to pressure consumption profiles.

For policymakers, inflation seems likely to remain frustratingly low, even with a modest rise in headline inflation likely into mid-2018 driven by some gains in commodity prices. While there remains substantial debate about this issue, it does seem to us that technology is changing the nature of the economic cycle.

Moreover, we are doubtful of those who argue that the tightness of labour markets implies a high risk that inflation could surprise by accelerating rapidly. Ironically, those who argue this often also argue for a tightening of monetary policy in response. The problem is that money growth itself, is not strong.

Despite a relatively benign inflation environment, we do see the monetary policy tightening cycle broadening. China, Canada, South Korea, the US and the UK were the only tighteners this year and in 2018 we expect them to be joined by Malaysia, the Philippines, Australia and NZ.

Along with a confirmed a change in the policy cycle in the antipodes, the Fed is likely to hike three more times in 2018, after delivering its final 2017 hike in December.

While this represents a modest tightening cycle by historical standards, in a world where debt levels in many countries are high, savings rates low, nominal growth is modest and risky assets seemingly quite fully valued, it is likely to represent a reasonably significant reduction in liquidity.

Additionally, with central banks hiking despite little apparent inflation pressure, often driven instead by concerns that policy settings are simply unsustainably stimulatory, further evidence is emerging that monetary policy is de-correlating from the economic cycle.

This reduces, or in some cases may even remove, the natural hedge that central bank policy has provided with the cycle. This implies that floating rate debt exposures may well have become commensurately riskier.

Rangy

With growth broadening, commodity price gains and headline inflation a little higher, some modest increases in bond yields are in prospect. A strong trend to higher yields, however, is difficult to envisage, and the unfortunate reality is that there are a range of scenarios where bond yields remain frustratingly rangy.

For the first time since 2011 there is some prospect that commodity prices might see sustained gains. Certainly for the bulk of the past couple of years the idea of the rangy, slightly upward sloping but idiosyncratic price action developing into a bull market seemed far-fetched. That is no longer the case.

Commodity demand is broader, shareholders are focussed on returns (limiting new investment), China is broadening supply side reform (taking out inefficient supply), new sources of demand are emerging (such as electric vehicles) and the commodities complex is showing stronger technical price action.

We suspect the uptrend will remain in place but will still have an element of de-correlated price action. The prospect of something more linear, however, can no longer be dismissed.

Currency markets, conversely, are likely to remain non-$US centric, and hence continue to be frustrating for those expecting a strong $US trend. The tightening in liquidity means the best of the risk seeking, carry environment is over.

With global growth still robust, however, carry returns are likely to remain positive into 2018, even if more selectivity will be required and Sharpe ratios will likely be lower. The euro is tracing a medium term top around 1.20, the Yen is likely to weaken into mid-2018, the Australian and NZ dollars are conversely likely to strengthen into mid-2018.

Richard Yetsenga is Chief Economist at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.