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May 2017

Economic and Market Outlook, March 2017

Executive Summary

 

  • The biggest event for global financial markets in 2017 is likely to have already taken place on 20 January – when Donald Trump was sworn in as the 45th President of the United States.
  • How the Trump Presidency unfolds will clearly have a significant impact not just on the US, but on global markets in 2017 and beyond.
  • In terms of the global economic outlook for the remainder of 2017 – the US is also likely to dominate. A large scale US fiscal policy easing is expected to support growth, so global economic growth in the year ahead should be a little faster than recent years. This is likely to see global growth in 2017 close to 3.5%, from nearer 3% in 2016.
  • The big question is, will the pace of trend GDP growth in the US be raised permanently by Trump’s policies and outstrip the cost of higher US debt and the rising cost of capital. If so, then the rally being enjoyed by ‘risk’ assets will become more entrenched. If not, then we are in for a multi-year ‘boom-bust’ cycle. We see more risk of this eventuating in 2018 or 2019. While Trumps policies are likely to extend the economic cycle by a year or two, we do not believe we are at the foot of a multi-year bull market and expansion.
  • The main focus for this year is likely to be a trend to higher headline inflation, given the recent increase in key commodity prices – especially oil. Deflationary fears appear to have subsided since the change in US policy settings.
  • Global monetary policy settings are unlikely to be eased further in 2017. We expect further tightening/normalisation of monetary policy in the US and no change in monetary policy by the other major central banks in 2017 (ECB, BoJ and BoE). The RBA and RBNZ are also expected to be on hold in 2017.
  • Any fiscal policy easing in the US is expected to lead to further monetary policy tightening. This trend may also become evident elsewhere, especially in the UK and Japan.
  • Key risks remain in Europe, especially around political and policy developments such as The French Presidential election (April-May), the German general election (likely September-October), political uncertainties in Italy and the start of Brexit negotiations in the UK.
  • Concerns about a sharp slow-down in the pace of growth in China proved (once again) to be unfounded in 2016. Government investment spending and a depreciating currency both helped China grow by an estimated 6.7% last year.
  • For 2017, slower Chinese growth expectations still dominate, as government stimulus is likely to be reduced significantly. This should see growth moderate to around 6.0-6.5%.
  • The biggest risk in China in 2017 likely revolves around the political machinations of the five yearly reshuffle of China’s political leadership late in the year. Other key developments to watch in China include capital outflows and/or capital controls and any tightening in financial conditions – especially around the property market. No doubt concerns around the debt levels in China, especially at the local government and SOE level, will still linger in 2017.
  • China’s relationship with US President Trump will also be critical to watch.
  • In Japan, the focus is likely to be on the BoJ’s target of capping 10yr JGB yields at 0% and the expectations of further weakness on the Yen.
  • The Australian economy will likely continue to see growth average around 2.5%-2.75% in the year ahead, with housing, infrastructure and net exports (of both resources and services) more than offsetting weakness in business investment.
  • Concerns around Australian household debt levels have been raised by the OECD as a risk to financial stability. But household balance sheets remain in relatively good shape and with the RBA expected to be on hold we do not see significant downside risks to the Australian housing market in the year ahead. That is likely a 2018 or 2019 story also.

Since our most recent update in October 2016, the winds of change have blown through the global economy. The end to US hegemony is here and it is being driven internally as President Trump and his team focus solely on the needs of America and step back from self-imposing itself as both role-model and policeman for the globe. For the first time since 2007, global macro markets will react differently to economics and politics in a way that may seem counter-intuitive to what we have seen over the last couple of years. There is a risk that past correlations between asset classes will weaken further because the baton has been passed from central bankers to politicians, whose reactions are difficult to ascertain and change constantly with the political wind. While markets originally feared this switch, they are now embracing it wholeheartedly as the prospect of a move away from the regulatory hell of the last few years to more overt capitalism holds much allure. We believe the key beneficiary of these changes will be the US, the rest of the developed world should be pulled along in its slipstream. We have concerns though on two fronts: firstly that the Fed is likely to raise rates aggressively as fiscal stimulus risks overheating a capacity constrained US economy and this is likely to sow the seeds of the next recession sometime in 2018 or 2019. Secondly while we believe that US Dollar strength will be mild against the majors we fear that the emerging market economies and currencies (Asian especially) will suffer materially.

While we have advocated a large exposure to alternatives such as Long/ Short, Market Neutral, Global Macro and CTA strategies to mitigate risks in portfolio construction as the US economic expansion ages, we believe this policy change will likely extend the current economic expansion cycle by 12-24 months, so a rotation back into cheaper beta strategies with a high correlation to the S&P500 and ASX200 will be more appropriate for the remainder of 2017.

The United States

In the United States, President Trump has inherited quite a good story in spite of the campaign rhetoric. As expected, the foundation for economic growth continued broadening in 2016, with the middle class finally participating more fully in the recovery. The base case expectation for the United States is that growth rates will accelerate marginally, over the period from 2017 to 2018, assuming substantially lower corporate tax rates and a sharp reduction or elimination of taxes on foreign earnings are implemented later in the year.

On the back of this slightly stronger growth, slightly more upward pressure on inflation is expected and marginally higher interest rates than anticipated prior to the election. Importantly, while inflation and inflation expectations are expected to continue to grind higher, a spike in inflation in 2017 is not expected. The view that the economic recovery is broadening is based on the recent strengthening of household income and balance sheets. After bottoming at 1.5% following the crisis, annual wage growth has been slowly accelerating since 2011, and reached 2.9% in December of 2016. This trend is expected to continue as the labour market tightens further, and for wage growth to reach its pre-crisis levels of approximately 3.5%, in the next one to two years. Together with wage growth, continued jobs growth is contributing to rising household income. In 2016, median household income adjusted for inflation rose by 5.2%, the strongest increase in this metric since the survey began in 1968. This is also important as it’s not looking at average, but rather median household income. This metric takes into account both the number of hours worked and the hourly wage and is a better reflection of what is happening for middle class households in the United States that drive the bulk of consumption. Consumer balance sheets are also improving. The most important asset for the middle class (defined here as households in the 25th to 75th percentiles of net worth) is housing. For the typical middle class household, housing accounts for 60% of total assets. The S&P/Case Shiller 20-City Composite Home Price Index has now recouped 80% of the losses experienced during the US housing bust. Momentum from accelerating wage growth and the nearly complete recovery in home prices should translate into stronger consumer confidence and spending in the years ahead. The most likely result of Trump’s election is corporate tax reform with provisions to encourage the repatriation of overseas earnings. However, markets seem to have largely ignored the increased uncertainty that Trump presents given the lack of a clear policy agenda. Trump’s election has broadened the range of potential scenarios investors need to consider. So far, investors have focused primarily on the positive scenarios in which lower corporate income tax rates and increased infrastructure spending could add momentum to growth and increase inflation on the margin. Some, but not enough, investors have focused on the likely increase in budget deficits that might result from the new administration’s plans. It is particularly important to consider how Trump’s election might potentially lead to structural shifts in the economy. There are three areas to highlight: rising anti-globalisation sentiment, inflation, and interest rates.

Therefore the implications for the US economy and financial markets from President Trump is likely to involve three phases.

Phase one was ‘risk off’, with the unexpected election victory by Trump seeing the US equity market and the US dollar sell-off and US bond yields rally. This phase, however, lasted less than 24 hours, with the market quickly moving into the second phase.

The second phase, which is expected to be the dominant factor throughout 2017, is supported by the view that Trump’s policies will be expansionary and stimulatory – especially his company and income tax cuts, increased infrastructure spending and reduced regulatory environment.

This phase has already seen a strong rally in equity markets, the US dollar, a sell-off in bond markets and is expected to be the primary factor driving markets throughout 2017. A noticeable increase in both business and consumer confidence has taken place since the election.

Figure 1:  US Business and Consumer confidence

Source:  Bloomberg as at 31 December 2016.

 

 

 

 

 

 

 

 

Further out, however, phase three may not be as positive. Although the timing for phase three is very difficult to determine, it could be anywhere between 2018-2020, this phase is likely to involve an increase in inflation and a more aggressive monetary policy tightening cycle from the US Federal Reserve.

Higher inflation, higher interest rates and the risks associated with Trump’s anti-trade policies could sow the seeds for an economic downturn late in Trump’s Presidency, seeing equity markets and the US dollar sell-off and bond yields rally again. As mentioned, however, the timing of phase three remains very uncertain and is unlikely to occur in 2017.

Indeed, after raising interest rates on 15 December 2016 by 25 bps, to a new range of 0.5%-0.75%, the US Federal Reserve is expected to remain on a gradual tightening path in 2017. With the Fed unlikely to pre-empt the impact of Trump’s fiscal policy easing, expect  two to three further Fed rate hikes in 2017.
Given the US economy is expected to experience a significant easing of fiscal policy from late 2017 onwards, which pushes inflation higher than previously expected and brings forth the need for more tightening from the Fed, the two- three rate hikes in 2017 are expected to be followed by another three rate hikes in 2018 and a further three rate hikes in 2019. This will give a peak in the Fed Funds target rate in 2019 of 2.5%-2.75%.

Figure 2:  Fed rate expectations

Source:  Bloomberg, data to 17 January 2017. Fed ‘dots’ as at December 2016. CFSGAM forecasts as at 15 December 2016.

 

 

 

 

 

 

 

 

 

 

Figure 3:  US Unemployment rate and Core PCE rate – Actual and forecasts

Source:  Bloomberg and Federal Reserve. Unemployment rate as at December 2016. Core PCE to November 2016. Fed projections from December 2016 FOMC meeting.

 

 

 

 

 

 

 

 

 

In terms of the main policy agenda for President Trump, we expect the following (with the +, – and ? symbols indicating the direction of impact on the economy and markets).

+ Significant fiscal stimulus through:

+ large income tax cuts (three rates 12%, 25% & 33%),

+ company tax cuts (to 15% or 20% or 25% from 35%) and

+ a 10% repatriation tax for cash currently held off-shore.

+ Increase in Infrastructure spending, ie. $US300bn government money, with private sector involvement potentially up to $US1 trillion.

+ Increase in Military spending – current and veterans.

+ Reduce regulatory burden – especially on energy to achieve “complete American energy independence”.

– Strongly protectionist stance – name China as a ‘currency manipulator’ and impose 45% tariffs on selected imported goods.

– No support for TPP and change/withdraw from NAFTA.

– Scale back climate change regulations.

– Critical of Fed policy, pro-audit, Chair Yellen to be replaced in early 2018.

– Isolationist stance of foreign policy – critical of NATO/some allies and China. Closer to Russia.

– Tough stance on immigration – build a wall.

? Repeal and replace Obamacare.

 

It has been estimated that Trump’s policy agenda will increase the level of US government debt by around 20% of GDP over the coming decade – as shown Figure 5 below. Other estimates put the cost of the Trump tax policies at between $US2.4tr – $US5.3tr.

The key question for markets over 2017, and beyond, is: will this be money well spent? Will President Trump’s policies lead to a permanent shift higher in the US’s potential economic growth rate?

The optimists are saying ‘yes’ – that the suite of expansionary fiscal policy actions will lead to an increase in business investment, a rise in productivity and an increase in the wages share of the economy that drives growth higher.

This would then lead to an increase in the neutral level of interest rates, and an increase in the rate of return on investments.

The pessimists are much more sceptical and fear a ‘boom-bust’ cycle over coming years.

Figure 4:  US Debt expectations

Sources:  CBO as at August 2016. CRFB as at October 2016. CFSGAM.

 

 

 

 

 

 

 

 

Another factor that markets will need to consider in 2017 is the leadership of the Federal Reserve. President Trump will get to nominate people to fill two Governor vacancies at the Fed in 2017 and, most critically, find a replacement for Chair Yellen in early 2018 – assuming that he will not reappoint Dr Yellen. In terms of Janet Yellen’s possible replacement as Chair in early 2018, neither President Trump nor the new Treasury Secretary (Steven Mnuchin) are likely to be looking for a monetary policy hawk.

Given the extent of fiscal policy easing that is planned, the new Fed Chair will more than likely be somebody that favours a conservative approach to monetary policy and would be less inclined to hike rates substantially.

A near term source of risk to the current rosy market outlook occurs on March 15th, That’s the day that the debt ceiling holiday negotiated in 2015 expires.  The debt ceiling will freeze in at $20 trillion and will then be law.  The risk is that conservative Republican’s do not support the increase in debt so much of Trump’s promised agenda requires and that the market is expecting- so the tax cuts and infrastructure stimulus is deferred or compromised. We will be monitoring the US political situation in March to see how this issue progresses. At the time of writing the market is not viewing this issue as a credible risk.

China

From an economic perspective, China was an upside surprise in 2016 as the government boosted spending meaningfully and as credit flowed freely into the domestic economy. However, easy credit inflated fears of a housing bubble across the largest cities leading to incremental measures to clamp down on borrowing and speculation. As the year wound down, the Chinese renminbi depreciated further, increasing the pressure on the capital account as Chinese companies and residents tried to move capital outside of the country.

Looking forward, expect growth to decelerate further in 2017 and the renminbi to continue to weaken against the US dollar despite ongoing intervention by the Chinese authorities. Also expect to see the transition from an export-oriented industrial economy to a more middle-income service economy sustained.  As shown in Figure 5 below, the high-frequency data in China has been very solid through H2 2016 and so some slowdown from this strong pace of growth should be expected in 2017.

One of the bigger risk factors in China in 2017 revolves around the political machinations – with the five yearly reshuffle of China’s political leadership in late 2017.

No doubt the political leadership will be looking for economic stability ahead of the political changes in late 2017. This could imply a growth target for the year of “around 6.5%”, as opposed to the 6.5%-7% target on 2016.

Inflation in China could trend a little higher through 2017, especially given the accelerating in the PPI evident over H2 2016.

Other key developments to watch in China include capital outflows and/or capital controls and any tightening in financial conditions – especially around the property market.

 

Figure 5:  China GDP growth and Premier Li index

Source:  Bloomberg. GDP data to 31 December 2016. Li Keqiang Index data to 31 December 2016.

 

 

 

 

 

 

 

 

No doubt concerns around the debt levels in China, especially at the local government and SOE level, will still linger in 2017. It is doubtful that 2017 will be the year that these debt concerns come to a head. This is especially so given the strong desire there will be for ‘stability’ in 2017 ahead of the political changes towards the end of the year.

China’s relationship with US President Trump will also be critical to watch in 2017. Key areas of focus/concern will revolve around the currency and trade policy, as well as security issues in the South China Sea, China’s trade response and ultimately growth.

 

Europe

After adjusting its monetary policy stance in late 2016, the European Central Bank (ECB) is expected to maintain the stance of monetary policy in 2017 – with €60bn of asset purchases per month planned until December 2017.

This should help limit the sell-off in the EU bond market from any pressure for higher bond yields – especially coming from the US. A narrowing interest rate spread with the US should also put further downward pressure on the Euro – something the ECB is unlikely to resist.

Ongoing low interest rates and a weaker Euro should act to support the European equity markets and the economy more generally.

As detailed in the forecasts, the EU economy is expected to continue to grow modestly in 2017, with growth of around 1.7%, compared with the 1.6% for 2016.

Figure 6:  EU GDP growth and Core inflation

Source:  Bloomberg. GDP data to 30 September 2016. CPI data to 31 December 2016.

 

 

 

 

 

 

 

 

 

 

Growth should be supported by the very easy stance of monetary policy, and some minor support, if not neutral, from fiscal policy. The weaker Euro should also help those EU countries that are heavily export orientated, ie. Germany.

The risks remain, however, to the downside, with both US and UK anti-trade developments likely to weigh on the EU and the fragile nature of the banking system limiting credit supply.

Further clouding the outlook, Euro zone inflation surged to a four-year high last month, zooming past the European Central Bank’s target and piling pressure on rate setters to open talks about when and how extraordinary stimulus measures will be scaled back. Inflation in the 19 countries sharing the euro rose to 2.0 percent from 1.8 percent in January, Eurostat data showed on Thursday, the highest since the start of 2013 and just above the ECB’s target of a rate just below 2 percent.

Producer price inflation, which feeds into overall inflation with a lag, meanwhile surged to an annual 3.5 percent rate from 1.6 percent, hinting at building pressure for underlying price growth. Still, the ECB is likely to resist any call to step off the accelerator when it meets next week, arguing that the oil price fuelled inflation surge is temporary, growth is fragile and the outlook is fraught with uncertainty given elections in France, Germany, the Netherlands and possibly Italy.

Underlying inflation is also weak, holding steady at 0.9 percent last month, suggesting that once the oil price surge passes through the numbers, inflation will fall back down, staying below the ECB’s target possibly through 2019.

The key factor behind the expected upward drift in core inflation is the gradual tightening of the labour market underway and some signs of wages pressures.

The biggest sources of risk in the EU in 2017 are likely to be found in the political and banking sectors.

On the political front, three events are expected to dominate – the French Presidential election, the German general election and the negotiation strategy with the UK on Brexit.

  • The 23 April/7 May French Presidential Elections. While Marine LePen (Front National) is currently trailing in the polls behind Francois Fillon (The Republicans), as we saw last year in the UK and US, the polls are not always reliable. The key risk if LePen is elected President would be a referendum on EU membership. If this were to occur, and be successful, the EU would likely disintegrate. This is not the base case, but will likely keep markets on edge until the election outcome is known.
  • The German general election is expected to take place around late August-late October 2017. Chancellor Angela Merkel is running for a fourth term – a very difficult achievement. But opinion polls continue to suggest that Merkel will be able to form some sort of coalition government and remain in place. The Alternative for Germany (AfD) could do well, however, and have a strong influence on the election and the type of government formed afterwards.
  • The expected activation of Article 50 by the UK in March will set the two year clock-ticking to negotiate the UK’s exit from the EU. EU negotiators have a strong incentive to drive a hard bargain with the UK and this could well be a critical factor for markets in the year ahead.

On the banking front, the Italian banking crisis is likely to continue to unfold. While the government is in the process of raising capital, it seems unlikely that it will be able to bail out the banks without support from the broader EU, which has so far signalled little appetite for this. This could be a source of tension between Italy and Germany as the Italians push further back against austerity.

 

The United Kingdom

The most significant event in the UK during 2017 is likely to be the start of the Brexit negotiation process. Article 50 is expected to be invoked in March 2017, triggering the two year process of negotiating the terms and conditions of the UK’s exit from the EU.

Not only will the terms and conditions of this exit be a source of uncertainty for financial markets in 2017, but questions still remain over the role of the UK Parliament during the negotiation phase and the final agreement.

The economic data in the UK has outperformed expectations in the months since the unexpected Brexit vote. 2016 GDP growth looks like coming in close to 1.6%.

GDP growth of 1.6% is expected in both 2017 and 2018 based on the 2016 easing of monetary policy, the weaker GBP and the expected easing of fiscal policy in the years ahead.

The downside risk remains, however, if negotiations around Brexit fail to come up with a solid new model for the UK’s trading relationship with the EU.

The pace of inflation in the UK has accelerated in recent months, driven largely by the sharp weakening in the GBP and rising oil prices. Inflation is expected to be above the BoE’s 2% target in 2017 and 2018, before returning to target in 2019.

The BoE has recently signalled that monetary policy is likely to remain on hold for the foreseeable future, with the base rate at 0.25% and a £425bn annual pace of QE. These monetary policy conditions are expected to be retained through 2017, with some minor normalisation of policy in 2018 and 2019.

 

Japan

The big event for the year in 2016 in Japan was the “comprehensive reassessment” of monetary policy. This reassessment resulted in the decision to move away from targeting the size of balance sheet expansion to targeting the 10 year JGB yield at 0%.

Figure 7:  Japan 10yr JGB and Short-end rate

Source:  Bloomberg, data to 17 January 2017.

 

 

 

 

 

 

 

 

For 2017 the BoJ is expected to try and hold monetary policy steady throughout the year – with the short end rate at -0.1% and 10yr yields at 0%. The trend to higher global bond yields, especially from the US, works strongly in Japan’s favour, if the BoJ can successfully hold 10yr yields down at 0%.

This would act to lower Japanese interest rates relative to the rest of the world, which in turn should weaken the Yen and strengthen the Nikkei. All this should help create some inflationary pressure in Japan and support nominal GDP growth.

Economic growth and inflation are both expected to remain modest in Japan in 2017.

For 2017 a little more economic growth is expected than that experienced in 2016, with an annual rate around 0.9%. Growth in 2017 should be supported by the renewed weakening of the Yen, further fiscal policy easing and the maintenance of extraordinary monetary policy easing.

For 2018 and 2019 growth is expected to remain modest, in a 0.5%-1.0% range, with Japan’s very negative demographics likely to hold the growth rate back on an ongoing basis.

Like elsewhere, headline inflation has shown some pick-up at the end of 2016 as energy prices rise again. Some slight improvement in underlying inflation should be seen in 2017 and 2018, but the pace of inflation is very unlikely to meet the BoJ’s 2% target in the years ahead.

Figure 8:  Japan GDP growth and Inflation

Source:  Bloomberg. GDP data to 30 September 2016. CPI data to 30 November 2016.

 

 

 

 

 

 

 

 

 

 

The other big event for Japan in 2017 is expected to be (another) snap Lower House election by Prime Minister Abe. This election, which could be expected before mid-year, is expected to see the re-election of Abe and the LDP – giving Abe the opportunity to remain Prime Minister until 2021 – ie. after the 2020 Tokyo Olympics Games.

In Australia, throughout much of 2016 the economic data continued to show relatively solid growth, although there was an evident slowdown in the September quarter relative to the first half of the year. Economic growth continues to be driven by exports of both resources and services, especially tourism and education, and the strength in residential construction. Infrastructure spending also remains strong, especially in NSW, while the largest source of weakness remains business investment.

The coming year is likely to bring more of the same. Consumer spending growth looks set to remain relatively modest, as consumers continue to use the low interest rate environment to pay down debt, rather than increase spending given the high amount of private debt in Australia.

The weak spot for the economy is expected to remain business investment – where both mining and non-mining investment continue to decline. Although it does appear that we are past the worst of this slowdown with resource prices beginning to climb again.

One of the most important developments in recent months and which could dominate the discussion in 2017 is the improvement in the income side of the Australian economy.

As shown Figure 9, after running well below GDP growth for the past few years, national income growth accelerated from mid-2016 onwards (even as GDP growth slowed).  While a new commodity price boom is a long way away the rebound in commodity prices of iron ore, metals and energy is pushing up national income. Amongst other things, this along with booming export volumes is leading to a dramatic shrinkage in Australia’s current account deficit which could soon be in surplus for the first time since the 1970s and the associated surge in resource company profits could knock $8-10bn pa off the Federal budget deficit.

Figure 9:  Australian GDP and income growth

Source:  ABS. GDP data to 30 September 2016.

 

 

 

 

 

 

 

 

 

Inflation in Australia is expected to remain low in 2017, but with the headline rate likely to drift up closer to the RBA’s 2%-3% target range over the medium term.

After having cut interest rates in May and August 2016 on the back of the low inflation environment, the Reserve Bank of Australia, under the new leadership of Dr Phil Lowe, is signalling a reluctance to lower interest rates even further.

Indeed, after the election of Donald Trump and on concerns around the level of household debt in Australia, the markets are now expecting that Australia’s cash rate has bottomed and the 1.5% interest rate will be the low in this cycle. Indeed, no change is expected in the 1.5% cash rate throughout 2017.

Figure 10:  Australian household debt levels

Source:  ABS; RBA Governor CEDA speech, 17 November 2016. Note: Household sector includes unincorporated enterprises; disposable income is before the deduction of interest payments.

 

 

 

 

 

 

 

 

 

 

Conclusion

In conclusion, there is reason to be generally optimistic in terms of the growth outlook for 2017. Growth should be slightly stronger than was expected before the US election. While inflation has clearly bottomed, don’t expect a sharp acceleration in 2017. Instead, inflation is likely to grind higher on the back of wage growth with the potential for more rapid increases if protectionist policies are put in place. Interest rates are likely to rise in sympathy with inflation expectations and in reaction to Fed policy decisions, but there is a self-governing feedback loop that limits how high long-term rates can go without undermining the very economic strength that led to higher inflation expectations and interest rates. The environment for equities is positive, barring unforeseen geopolitical and policy shocks, on the back of potentially positive tax policy changes and low global interest rates. While there are some very real risks in the global economy, we doubt the will come to a head in 2017.