The political earthquakes of 2016 have upended conventional thinking about the global economy and have – ironically – brightened the outlook.
The expectation that the incoming Trump administration will enact sizeable fiscal stimulus has increased optimism about the United States and global growth. This, in turn, has pushed US stock indexes to record highs, while pushing up both interest rates (with a resulting rout in the bond market) and the dollar.
A stronger dollar is mostly good news for Europe and Japan, helping to boost both export growth and inflation expectations. On the other hand, much higher US bond yields are bad news for the emerging world, where currencies have already taken a beating in recent weeks, significantly reducing the scope for further monetary easing.
Fortunately, these financial-market gyrations are occurring at a time when commodity prices are rising and both consumer and business sentiment have improved. IHS Markit believes that the balance of these trends will be moderately positive for global growth, which is expected to increase from 2.4% in 2016 to 2.8% in 2017, and 3.1% in 2018. That said, high levels of political and policy uncertainty could hurt growth in 2017 and beyond.
These are our top 10 risks for the economy:
1. The US economy will accelerate – even before any Trump stimulus. During the coming year, a much smaller drag from inventories and a rebound in energy-sector capital spending will boost growth to 2.3%, from 1.6% in 2016. Moreover, with tax cuts and infrastructure spending likely to be enacted next year, growth will pick up to 2.6% in 2018. Consumer and business confidence, which rebounded right after the election, are likely to be boosted further as growth improves. On the downside, the rise in both interest rates and the dollar, in anticipation of stimulus, will erode some of the positive effects of stimulus.
2. Europe’s economic momentum will slow a little, primarily because of Brexit and political uncertainties. A contentious Brexit, the fallout from the recent referendum defeat in Italy, and upcoming elections in France, Germany and the Netherlands could all hurt growth next year. In particular, the political turmoil in Italy could trigger a crisis in the banking sector, which is already in dire straits. On the positive side, the European Central Bank has extended its bond-buying programme (albeit at a more modest pace), and a weaker euro will help to lift export growth and (along with rising oil prices) raise inflation rates. IHS Markit continues to believe that these conflicting forces will weaken Eurozone growth from 1.7% in 2016 to 1.4% in 2017.
3. Japan’s economy will gain a little traction, thanks to a weaker yen. In recent years, Japan’s economy has struggled. Going forward, a weaker yen will help boost exports and lift the economy out of deflation. The demise of the Trans-Pacific Partnership diminishes the chances of meaningful structural reforms in Japan. On the other hand, the fiscal package passed by Japan’s parliament in October, albeit modest, will provide earthquake relief and more infrastructure spending. On balance, IHS Markit believes that Japanese growth will stabilize at around 1.0% in both 2017 and 2018.
4. China’s growth will grind down further, led by a housing construction slowdown. The Chinese government is in the process of removing stimulus. This will hurt the housing sector, construction and heavy industries, lowering real GDP growth from 6.7% in 2016 to 6.4% in 2017. China also faces another source of stress because of capital flight. Foreign exchange reserves are at a five-year low and the renminbi is back to 2008 levels. In response, the government has already imposed some capital controls and will likely do more soon – in an attempt to relieve pressure on the currency and limit annual depreciation to no more than 5%.
5. Emerging markets will do better, despite recent financial market pressures. With moderately stronger US and global expansions and rising commodity prices, emerging markets should do better over the next year. However, capital flight and depreciating currencies are creating headaches for some central banks. On the downside, plunging currencies are unwelcome for at least two reasons. First, to prevent further capital flight, central banks have to pursue more restrictive policies than they would like. Second, dollar-denominated debt in the emerging world has risen rapidly in recent years, reaching around $3.5 trillion. As the value of the dollar goes up, so does the burden of these debts. The good news is that the economic fundamentals (e.g. current-account deficits) in most emerging markets have improved in the past couple of years.
6. Commodity prices will continue their upward trend. A gradual acceleration in demand and more supply restraints mean that commodity prices will keep rising over the next year – the recent OPEC agreement on production cuts will help. Between January and September of 2016, commodity prices (as measured by the IHS Markit Industrial Materials Index) rose more than 40%. Subsequently, they retreated a little through early November and then surged after the US election. Perhaps even more important, rising oil prices will encourage more US production, which will dampen any future price increases.
7. Inflation rates will move up in many parts of the world. After many years of facing the threat of deflation, the world economy is poised on the threshold of an increase in inflation. With the US economy at or near full employment, wage inflation is already beginning to rise and is set to climb even faster with the implementation of fiscal stimulus. Along with increases in commodity prices, this will translate into faster price inflation (exceeding 2% in the coming two to three years). A similar upward trend is also evident in other parts of the world. Mounting inflationary pressures in the US economy, accompanied by a stronger dollar, means that the United States will be “exporting” inflation.
8. US interest rates will keep rising – also pulling rates up in some emerging markets. With expectations of stronger US growth and inflation, the Federal Reserve will raise interest at least three times in 2017. This has already forced some emerging-market central banks to raise interest rates and others to halt any further rate cuts. Elsewhere, anxiety among central banks has risen recently. Both the Bank of England and the European Central Bank have warned that higher interest rates in the US and political uncertainty on both sides of the Atlantic could “reinforce existing vulnerabilities” in the global financial system, especially in the emerging world and Europe. Higher US interest rates have also triggered a run on emerging-market currencies, forcing some central banks (e.g. Mexico and Turkey) to raise interest rates and others to halt any further rate cuts (e.g. India, Indonesia and Malaysia). In Europe, there are concerns about banking problems and a new round of sovereign-debt pressures.
9. The US dollar will appreciate more. An already-strong dollar climbed even higher in the wake of Donald Trump’s victory. By the end of November, the dollar had risen to an eight-month high against the yen and a 20-month high against the euro. Some of this was because of the US election, but some was also due to anxiety about the Italian referendum. Emerging-market currencies were also hit hard. In Asia, exchange rates fell between 2% (offshore Chinese renminbi and Thai baht) and 7% (Japanese yen). In light of expected stronger growth in the US economy and higher interest rates, IHS Markit predicts that the greenback will keep appreciating over the next year. On an effective (trade-weighted) basis, we expect the dollar to rise another 2-3% against key trading-partner currencies in 2017. By the end of 2017, the euro will briefly touch parity and that the yen will fall to around 120 per US dollar.
10. The level of uncertainty has risen, but the risks of recession remain low. The risk of either a US or global recession in 2017 is no more than 25%, according to IHS Markit. The usual “recovery killers” are in abeyance. To begin with, even with the Fed expected to raise interest rates over the next year, global monetary conditions remain extremely accommodative. Thus, chances of central banks killing off the recovery are slim to none. Second, despite the recent OPEC agreement to cut production, global oil markets are well supplied. This means that the risk of an oil shock is low. Finally, notwithstanding the recent euphoria in US equity markets, there is little (if any) evidence of asset bubbles in most parts of the world. In other words, the odds of a repeat of the 2008-09 financial crisis are also pretty remote. Unfortunately, political and policy uncertainties (and risks) are higher now than they were a year ago. The rise of anti-globalization movements in the US and Europe could result in policies that hurt growth. In particular, a trade war could push the US and global economies into recession.
Nariman Behravesh is the Chief Economist at IHS Markit. He leads an award-winning team of over 400 economists. He has been ranked as one of Bloomberg's Top 10 Economists, MarketWatch's Forecaster of the Year and has received several Forecaster of Month awards. He is the author of Spin-Free Economics.