Schroders: Political risks fade, macro concerns return

The recovery in global activity remains intact, whilst inflation appears to have peaked following the stabilisation in energy costs. We continue to forecast global growth at 2.9% this year after 2.6% in 2016, but have trimmed our inflation forecast to 2.4% from 2.7%. On inflation, we have reduced our forecasts across the board to reflect a lower oil price profile and subdued core readings. Looking into 2018, global growth is expected to stabilise at 3% with modest downgrades to developed markets offset by a small upgrade to Japan.

Divergence is a growing theme on the growth side as an upgrade to the eurozone is offset by a downgrade to the US and emerging markets. Leading indicators such as the purchasing managers’ new orders indices show that the euro area continues to strengthen whilst the US and Japan have begun to roll over. The divergence has been a factor behind the relative strength of the euro. In the emerging world, our forecast for China has not changed and the downgrade to our growth forecast for 2017 reflects cuts to Brazil and Russia.

Meanwhile, we are passing the peak in inflation with the turn in commodity prices. Headline inflation rates are now expected to decline as the increase in energy prices fades from the annual comparison. The UK may prove to be an exception to this trend as weaker sterling is likely to push inflation higher.

The inflation dog has yet to bark

Despite the increase in headline inflation, there has been little spillover to core inflation or wages in any of the major economies. In the US, we had been looking for some pick-up in both, and have had to scale back our consumer price inflation forecasts. The continued weakness of wage growth in the face of lower unemployment has been a surprise. In the past wages would have been accelerating at this level of unemployment, but there is little sign of accelerating pay.

This combination of falling unemployment but subdued wage growth is often referred to as the ‘flat’ Phillips curve and has had two effects. First, it has limited the pickup in real income growth which normally accompanies an economic upswing and the feed through into stronger consumer spending. Second, it has restricted the increase in costs and hence inflation, which in turn has kept central banks comfortable with their easy monetary stance.

Thus, rather than rising real wages and increasing consumption, the economic recovery in this cycle has been sustained through a persistently loose monetary policy stance accompanied by low wage growth and low inflation. The lack of wage growth in the face of ever-lower unemployment has proved to be a puzzle to economists. In the long run this links in with the puzzle over low productivity growth, but at this stage we would have expected a cyclical pick up in pay. As well as the US and UK, it is also apparent in Japan and Germany where unemployment is low but wages remain subdued.

Local factors will have played a role, but the international nature of the phenomenon suggests broader explanations. For example, the opening up of labour and product markets to greater international competition can effectively increase available resources and economic capacity. Others have pointed to the decline in trade union representation. Technology and increased automation has also played a role in displacing workers, reducing bargaining power and keeping real wages subdued.

In a recent study of the changing trade-off between inflation and unemployment in the developed world, the International Monetary Fund (IMF) concluded that although the above factors were important, the key to low inflation was well anchored inflation expectations underpinned by central bank credibility. That study is now four years old and at the time there were worries that the recovery would bring rising inflation, but its key conclusion remains intact: despite considerable quantitative easing and ultra low rates, long-run inflation expectations remain stable and central banks are seen as credible. The inflation dog remains muzzled. 

What might change this?

Stronger growth is one possibility. Should we see greater fiscal stimulus in 2018, then the acceleration in growth would drive unemployment even lower and alongside higher demand would probably push inflation higher. We have this as one of our scenarios (US fiscal boost), but if anything the probability on this outcome has fallen as President Trump has struggled to reconcile his plans with Congress. We are currently assuming net fiscal stimulus of around 0.75% GDP in 2018, primarily tax cuts and slightly less than in our previous forecast. We should also be mindful of the fact that although there is a close relationship between US growth and inflation, an adjustment has to be made for the long lag of around one and a half years. From this perspective, the recent slowdown in core inflation in the US reflects the slowdown between 2015 and 2016. The subsequent recovery in growth is consistent with core inflation running at around 2% through 2018. 

From a global perspective, a peaking of European growth and slower expansion in China will keep a lid on inflationary pressures in 2018. Outside of stronger growth, the other inflation risk would be a shift in the relationship between unemployment and wages. We explore this below in our new “inflation accelerates” scenario. The continued good behaviour of inflation is critical in shaping the outlook for monetary policy and markets. We still expect a modest upward increase in core inflation in 2018 as unemployment falls further in the US, but not enough to prompt an aggressive tightening of monetary policy by the central bank. We expect the Fed funds rate to rise to 1.5% this year (three hikes) and to 2% by end 2018 (two hikes). Within this time period, we see a pause in the first half of next year as the Federal Reserve (Fed) begins balance sheet reduction. Our rate profile may be slightly more aggressive than the market is currently pricing, but it is more of a normalisation than a deliberate effort to slow the economy. The crucial point is that should the economy stall the Fed could ease back in an environment where inflation is well behaved. In this respect there is still a Fed “put”.

Elsewhere interest rates should remain on hold, reflecting the earlier stage of the cycle in Europe and Asia. Rates in China are now expected to be on hold this year, but fall further in 2018 as activity softens. We expect the European Central Bank (ECB) will continue quantitative easing (QE) over the forecast period, but will begin to taper in 2018. The Bank of Japan is expected to keep rates on hold, but maintain QQE (quantitative and qualitative easing) as it struggles to reach its target of above 2% inflation. Despite higher US “carry” we still expect the US dollar to depreciate following its very strong appreciation of the past two years.

Following the French election result, we have dropped our “Le Pen breaks EU” scenario. Whilst political risk still exists in Europe, we believe it has moved on from the acute phase experienced over the past six months. President Macron is likely to unite rather than divide Europe, and on current opinion polls it looks as though he will be doing so alongside Angela Merkel. The remaining risk is Italy where a general election is due by next May, but could happen sooner, and the Five Star Movement is level with the incumbent Democratic Party in the opinion polls. However, should the Five Star Movement win, they would still have to form a coalition and it is not clear that they would garner sufficient support for a referendum on the euro/EU membership. 

We believe that the risk on Italy is more of a chronic one where growth remains weak and the government loses control of the budget deficit. In this respect, Italy and the EU are vulnerable to some of the downside scenarios which reduce global growth, a factor which would have negative repercussions for the heavily indebted. Another area where risk has declined is on trade and tariffs and we have dropped our “rising protectionism” scenario. We previously attached significant weight to this following the election of President Trump. However, although we have seen one-off tariffs in areas like lumber – and relations with Mexico have been fractious – there has been no outbreak of major protectionist policy. In particular, relations with China have thawed considerably, with President Trump saying that China is not a currency manipulator and finding common interest over North Korea. China recently announced it was opening up more markets to US products. We have also dropped the “Russian rumble” scenario as, notwithstanding the investigation into Russian involvement in the US election, relations have thawed with the west.

The first new scenario is “inflation accelerates” where the relationship between growth and inflation takes an adverse shift. In terms of our earlier discussion, this would mean a steepening of the Phillips curve with wages rising significantly in response to low unemployment. This would be a global shift, with output gaps being found to be smaller than currently estimated. For the eurozone and Japan such a development would initially be welcome as they seek to dispel deflation. However, both the ECB and Bank of Japan (BoJ) could be expected to begin raising interest rates. Meanwhile the Fed would be engaged in more aggressive rate hikes with the policy rate rising to 3.5% by the end of 2018. Growth slows as policy tightens and economies hit capacity constraints, the net result is a period of stagflation. 

The second new scenario this quarter is “secular stagnation” where growth and inflation continuously underperform. This of course is a return for the deflationary scenario which appeared regularly before the economic recovery in 2016. 

Another scenario making a come back is “China credit crisis” which is a variant of the various China hard landing scenarios we have presented in the past. In this version, the recent monetary tightening goes too far and sparks a seizure in the financial system which chokes off the supply of credit to the real economy. China growth slows to 4% in 2018 with a significant impact on the rest of the world economy. Deflationary pressure is increased by a fall in the renminbi (to 8.0 versus the US dollar).

In terms of the remaining scenarios; “bond yields surge” has been adjusted with the trigger now an adverse reaction to the Fed balance sheet reduction programme. The scenario expounds a significant tightening of financial conditions in the US, with contagion to markets in the rest of the world. The impact is deflationary as credit and growth slow whilst inflation eases lower.

“US fiscal expansion”, “old normal” and “OPEC deal breaks down” remain intact. Compared to our last forecast update in February, the balance of risk has shifted in a more deflationary direction with the return of hard landing concerns over China and secular stagnation. The stagflationary risks have diminished with the loss of the “rising protectionism” scenario. The political risks associated with the Trump administration have also diminished with the decline in weight on the “fiscal reflation” scenario. On balance, lower political risks in Europe and the US have been replaced by some of the traditional macro risks around China, secular stagnation, inflation and the unwinding of QE by the Fed.