In his latest quarterly Economic Outlook, Looking into 2017, Neil Williams, Group Chief Economist at Hermes Investment Management, sets out the six core beliefs that lie behind his macro view of 2017.
After a year of political surprises, we could see tectonic shifts in economic policy. Speculation, rightly, that major economies will open their fiscal box is currently causing ‘reflation trades’ to puff up growth assets, raise inflation expectations, and make the 30-year bull-run in government bonds look even staler.
Reflation, inflation, & political contagion, but too soon for the ‘great rotation’...
Yet, while this should be better for growth, financial markets may be ignoring the new global risk emerging. Rather than the financial distrust of 2008-09, we may need to brace for political distrust, with the threat of beggar-thy-neighbour policies - from the US to Europe - rising.
Amid these conflicting growth forces, our macro outlook is based on six core beliefs.
First, governments in 2017 will offer fiscal solutions to add stimulus, try to appease electorates, and take the policy ‘baton’ back from central banks. President-elect Donald Trump is set to reflate the US, and austerity in the UK is being deferred again. It makes sense too for slower-growth Japan and the euro-zone to loosen fiscally using the aggressive QE they’re doing anyway to cap any rise in bond yields.
Second, this will come on top of – not instead of - further monetary expansion. We are nine years since the first traces of crisis, yet central banks still daren’t lift the tide of liquidity hiding the sharp rocks beneath. Real policy rates will stay negative, with peak rates lower than before, and central banks unable to turn off their liquidity taps without unintended consequences.
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Third, once protectionist forces build, inflation will reappear. But, it will be the ‘wrong sort’ – cost push, led by tariffs, goods and labour shortages, rather than demand-pull. In which case, central banks will ‘turn a blind’ eye as their economies stagflate - meaning the inflationary flame may snuff itself out without policy action.
Fourth, China has the tools to soften its landing. Its main macro dilemma is supporting growth, yet minimising a boost to the housing market. There, affordability in the main cities has deteriorated faster than in other world financial centres. The deflationary and leveraging risks need watching. The PBoC may yet have to delve into its massive $3.1tn reserves to cushion the indirect blow of a ‘trade war’ on China’s balance sheets.
But, fifth, for those non commodity-exporting emerging markets with high exposure to short-term US dollar debt and/or foreign saving needs, the outlook’s less rosy. For these countries, clear vulnerabilities exist. But, for others, external debt-ratios are lower, with fewer currency pegs to have to protect. And, where domestic debt climbs, they too can run QE.
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Finally, without convincing recoveries, any contagion, unlike 2008, may be political rather than financial. Passage of Italy’s Constitutional referendum result sets up the euro-zone for a highly charged political year.
With elections coming in France, Germany, The Netherlands, and maybe now Italy and Spain, there may be little sympathy for a quick, ‘no-strings’ UK Brexit deal once Article 50 is triggered. Our exit negotiations could thus take much longer than the three years needed in 1982-1985 by Greenland.
In which case, while reflation trades look appropriate in the short term, political disruption, protectionism, cost inflation, and dissipating growth suggest ‘lower for longer’ and the grab for yield will persist.
And, with the liquidity taps still on, chasing the ‘great rotation’ of an en masse shift out of bonds means taking on the central banks. Because, for more fiscally-active governments, to initiate also the end of QE would be like a ‘turkey voting for Christmas’.
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