United States

2018 global economic outlook

Synchronized growth across much of world for first time in a decade

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International economic growth in 2018 will increase by 4 percent with the potential for a much faster appreciation due to a likely increase in demand for finished goods by the United States and broad-based strength across other developed and emerging markets. With most developed economies, and a good number of emerging economies, operating well below their long-run growth levels and capacity to produce, there is potential for acceleration well before global central banks take steps to cool growth rates.

The International Monetary Fund recently indicated that 75 percent of the global economy, measured by the gross domestic product (GDP) at purchasing power parity, is sharing in the acceleration in economic activity with the United States, Europe, Japan and China leading the way. Meanwhile, global industrial production is robust and export volumes are now accelerating.

Late cycle fiscal expansion in the United States figures to stoke global demand for commodities and finished goods, which should provide a growth buffer as emerging markets adjust to modest increases in rates and the U.S. dollar.

MIDDLE MARKET INSIGHT: The global middle market community should see one of the best years of the expansion. The Trump tax cut should spur consumer demand by US consumers that should help mop up excess supply globally, and a widening of the US trade deficit should boost the fortunes of middle market firms across the globe.

While growth will continue to moderate in China, growth in India is going to be one of the major economic narratives in 2018. The consensus forecast is that India will grow by 6.7 percent, and economic activity in China will expand by 6.5 percent. Coupled with growth in the European Union (EU) likely to expand at a 2 percent pace, and with the United States likely to see better than 3 percent growth in the next year, 2018 is shaping up as the best year for global economic growth in more than a decade.

Risks to the outlook: The major risks to the global economic outlook this year will revolve around policy uncertainty in the developed world, growing trade tensions between the United States and its major trading partners, a tightening of financial conditions and the potential reversal of capital flows linked to central bank policy.

Policy uncertainty around the ongoing negotiations between the U.K. and the EU over Brexit will be one of the two major global economic risk narratives this year, with the other being the attempt by the U.S. political authority to withdraw from or weaken both the North American Free Trade Agreement (NAFTA) and the World Trade Organization. Potential disruptions to the North American and global supply chains would result in damage to value chains and pricing, causing global productivity to slow.

MIDDLE MARKET INSIGHT: The UK middle market will face a challenging 2018. Middle market businesses will likely need to look to push forward on innovation to improve their own revenues, profits and growth.

With the U.S. central bank likely to hike its policy rate by 75 basis points in 2018 with risk of another 25 basis points still on the table, and the European Central Bank (ECB) likely to begin its long journey toward policy normalization, which will end its negative interest rate policy and large- scale asset purchases. Given the direction of rates in the developing economies and risk of a quicker than expected policy normalization in the United States, there is a risk that capital flows may move toward the developed economies out of emerging markets and developing economies.

Central banks and financial conditions: 2018 will see the U.S. central bank modestly quicken its pace of normalization due to an economy growing well above trend. In our estimation, the Fed will raise rates by 100 basis points this year, versus the three rate increases the central bank has forecasted.

In Europe, the ECB will, by the end of the year, conclude its quantitative easing and negative interest rate policies, which will certainly lead to modestly higher rates along European maturity spectrums. While the Bank of Japan will retain its extreme accommodative policies, the two major central banks make the case that, despite modest policy tightening, large balance sheets will continue to suppress long-term rates, push risk-taking out along the curve supporting equity prices and tight credit spreads, which should be supportive of strong financial conditions. Just before the end of 2017, financial conditions in the United States stood at 2.254 standard deviations above neutral, while those in Europe and Asia, excluding Japan, were roughly neutral. In our estimation, the central banks of China, Brazil, Mexico and Canada will be closely monitoring the pace of policy in the United States, and that will likely dictate the direction of capital flows this year.

Eurozone: Growth continued to firm across the Eurozone last year, which grew by 2.6 percent through the end of the third quarter of 2017 and is expected to grow at a 2.1 percent rate in 2018. Strong business investment and export growth imply a self-sustaining expansion amid signals by the ECB of the first move toward policy normalization in late 2018. Growth in Germany is expected to be 2.2 percent, France should expand by 1.8 percent, Italy 1.4 percent and Spain at a 2.5 percent pace. The major risks to the Eurozone outlook are the exit by the U.K., the difficulties forming a government in Germany and the Italian election in spring 2018.

United States: The growth outlook in the United States remains strong, with the increase in overall economic activity likely to expand by 3.1 percent in 2018 and 2.9 percent in 2019. Solid household consumption and fixed business investment, which both were already the major drivers of the above trend growth that middle market firms will be bolstered by the fiscal boost agreed upon by the U.S. Congress at the end of 2017. Given the changing growth dynamics, we expect the U.S. dollar to appreciate against a trade weighted basket of currencies, the 10-year yield to test 3 percent before the end of the year, the trade deficit to widen and the U.S. annual operating fiscal deficits to arrive near $900 billion in 2018 and $1 trillion by the end of 2019. This reinforces our call for four rate hikes by the U.S. Federal Reserve this year, versus the three hikes signaled by the central bank.

United Kingdom: The lagged economic impact of the 2016 Brexit referendum is beginning to bite the British economy. Rising prices on the back of sterling depreciation and much slower pace of consumption imply growth will limp ahead at a 1.4 percent pace. Inflation likely peaked at 3.1 percent in the final quarter of 2017. While the Bank of England (BOE) will have to send a letter to Parliament on missing its long- term inflation target, the outlook is far more tilted toward a period of mild disinflation in 2018 and in the out years as the economy adjusts to a post-EU reality. The BOE will not be in the business of hiking rates anytime soon.

Both household consumption and fixed business investment are likely to grow by an anemic 1 percent this year with risk of a slower pace of expansion. In particular, policy uncertainty around the pace and direction of UK/EU negotiations is likely to damp capital expenditures. If the Brexit negotiations appear headed toward an unruly exit starting in March 2019, risks to foreign direct investment flows, of which the UK economy is dependent, will rise. Given the differentials in growth rates and likely central bank policy between the UK EU and United States risk of further currency deprecation is skewed to the downside for the British pound.

Canada: We expect the Canadian economy to expand at a healthy 2.4 percent in 2018 boosted by demand from the United States, which should stoke exports of goods, services and oil this year. While there are risks around household debt levels and the pace of consumer spending, we expect that growth will be driven primarily by a combination of household spending, government spending and fixed business investment, which all should expand near a 2.2 percent pace this year. We anticipate a modest increase in the policy rate by the Bank of Canada to 1.75 percent by the end of 2018 from the current 1 percent level, and deprecation of the looney against the greenback, which should result in an improvement in the terms of trade. The USD/CAD exchange rate should fall to 1.22 by the end of the year. The major risk to the Canadian economic outlook is the potential withdrawal of the United States from NAFTA.

Mexico: Growth in Mexico, along with its North America trade partners, will likely surprise to the upside this year due to the fiscal boost to consumer demand in the United States. We expect growth to be near 2.5 percent, above the current 2.2 percent consensus, driven by strong exports, private consumption and rising oil prices. While growth in 2017 was lackluster, much of it had to do with the impact of the twin natural disasters—earthquakes and hurricanes— that negatively impacted the economy. With inflation climbing higher, investors should anticipate further rate hikes out of the Bank of Mexico that will be focusing closely on the pace of monetary policy in the United States and direction of NAFTA modernization discussions in the early portion of 2018. Should Trump pull out of NAFTA, Mexico would bear the largest burden of adjustment and pose significant risks to the domestic economic outlook.

MIDDLE MARKET INSIGHT: While the Mexican middle market is well positioned to prosper in 2018, if the Trump administration withdraws from NAFTA, businesses in the manufacturing, agricultural and apparel ecosystems will bear the disproportionate burden of adjustment in the near term as the economy contracts in 2019 and 2020.

China: We expect China’s growth to continue to slow to a 6.5 percent pace this year. In our estimation given China’s economic transition, this is a positive development, and it is only natural that an emerging market moving toward a more mature phase would see its overall growth rate moderate over time to more sustainable levels and pace. The major driver of growth will continue to be the consumer sector as the fixed investment and industrial production growth moderates in alignment with the longer-term transformation of the economy to one organized around domestic consumption.

The major risk to the economic outlook is debt in the nonfinancial business sector and in the prefects and cities that will tend to act as a net drag on overall investment. In addition, the housing market appears to have tentatively stabilized, with prices still elevated in the major cities. The debt overhang from the long expansion and growing trade tensions between China and the United States underscores the domestic risk. The recent hike by the Chinese central bank is indicative of how sensitive the monetary authority is to rising rates in the United States and capital outflows this year. This will be one of the major global economic narratives this year.

Japan: While growth remains somewhat soft in Japan, the economy has put together its strongest rate of expansion in over 16 years. The Japanese economy will likely expand by a 1.5 percent pace driven by above 3 percent increases in exports, fixed business investment and industrial production. Yen depreciation, which improved the terms of trade, and a strong global economy are the major economic narrative in Japan at the moment. Inflation continues to be muted due to sluggish wage growth, and the Abe government appears determined to push through economic reforms that over the long term will put a firm foundation underneath the aging economy.

Australia: The Australian economy figures to be one of the primary beneficiaries of the synchronized improvement in global growth this year. The economy will likely expand at a 2.8 percent pace driven by a strong increase of 6.7 percent in exports and solid household, government and fixed business spending. The Royal Bank of Australia kept its cash rate at 1.5 percent at its December meeting, citing soft expectations of labor market and wage growth, which signaled the likelihood of only one 25 basis point rate hike this year and sustained low inflation. Given the rebound in commodity prices, the Aussie will likely appreciate against the USD this year, which will improve overall purchasing power by domestic consumers. This will somewhat mitigate the risks around slow wage growth and elevated levels of household debt that damped household spending in 2017. The levels of household debt remain the major medium- term risk to the economic outlook.

Brazil: We anticipate a strong rebound in growth around 2.5 percent in 2018 driven by strong increases in gross fixed investment and household spending. Real exports should continue to support growth due to overall improvement in global commodity demand. Given that the economy is currently recovering from the deepest recession on record, growth trends imply sustainment of the recovery. Despite an increase in inflation to 2.8 percent through November 2017, the central bank will likely continue to reduce its policy rate which stood at 7 percent at its December 2017 meeting. Left alone, the Brazilian economy will continue to recover at a modest pace. However, the political uncertainty linked risks around the Brazilian political sector will continue to hang over fixed business investment this year.

Argentina: Growth in Argentina will likely accelerate to 3.2 percent this year as the lagged impact of recent reforms begin to take hold. Growth will be fueled by robust expansion in private consumption and fixed capital investment. Improvements in demand for commodities should stoke growth in mining after a two-year industry recession, while the construction industry should remain hot throughout 2018, albeit at a slightly modest pace from the 25.3 percent increase on a year-ago basis through October. The primary risk to the economic outlook remains the inflation rate which stood at 23.2 percent at the end of the September 2017 and is likely to slow to near 17 percent next year. Given that the peso will likely depreciate against the USD amidst a central bank reluctant to hike rates, risks around the outlook remain linked to rising inflation.

India: Overall economic activity should expand by 6.7 percent driven by exports, industrial production and gross fixed investment. Through the end of September 2017, fixed investment increased by 5.8 percent, industrial production advanced at a 5.5 percent pace, while private consumption remained strong despite inflation above the 4 percent target of the Reserve Bank of India. The globally synchronized expansion notably stoked demand in the mining and quarrying sector which was up 5.5 percent heading into the final three months of the year. We expect that sector to observe robust growth in the year ahead. We expect the RBI to hold the policy rate near its current 6 percent.

Dollar exchange rates: We expect a gradual tightening of policy rates by the world’s central banks, led by the United States. While the consensus expects modest dollar depreciation this year, we have an outlier expectation that the greenback will appreciate against a trade weighted basket of currencies as the Fed quickens the pace of its policy normalization campaign on the back of a much stronger growth in the United States over the next two years. The 5 percent decline in the value of the greenback in 2017 in our estimation makes it ripe for appreciation in 2018.

Global energy markets: Oil prices continue to rebound from the 2016 nadir, and we look for them to rise above $60 per barrel on a sustained basis in 2018. Given the strong probability of above-trend growth in the United States, India, the EU and Japan, it is difficult to make the case for lower energy prices. Moreover, with Brazil, Russia and other emerging markets looking toward improvement after years of stagnation, there is a higher risk of rising oil prices this year. Efforts by OPEC to curb production and the global economic recovery that is in train, both support higher prices this year. Natural gas prices near $2.88 per MMBTU and low inventories and a cold winter should send prices higher this year.

Commodity prices: Global organic demand for commodities is accelerating. The Bloomberg Commodities Index is up 2.58 percent since June 2017, while prices paid index in the US ISM Manufacturing survey and the United Nations Food Price index, both imply strong growth in demand and nascent pricing power going forward. The front month contract for copper is up 25.64 percent from a year ago, while costs of aluminum, corrugated metal and hot rolled steel all surged into the final days of 2017, and will likely put upward pressure on finished good prices to kick off the new year.  

Download The Real Economy Vol. 37


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