NN IP: Global growth remains robust

It is now roughly one year ago that global growth embarked on a remarkable acceleration trend following nearly two years of steadily declining momentum. The main driver is the waxing and waning of a global disinflationary shock exerted by the combination of falling commodity prices and a sharp dollar appreciation.

This shock interacted negatively with the high level of private sector leverage in EM space as well as the reliance of some sectors (energy) and countries on the continuation of the level of commodity prices seen before the summer of 2014. Needless to say, there were the usual knock-on effects on other countries and sectors in the financial and real spheres of the global economy. What kept the vessel of global growth afloat in these times of turmoil were essentially two issues.

First of all, even though DM consumer savings rates increased somewhat, part of the increase in consumer purchasing power benefited the domestic service sectors which is by definition labour intensive. This kept the feedback loop between DM domestic demand and employment growth intact.

Secondly, DM central banks provided a strong put option against negative real economy and financial shocks, which put a floor under private sector confidence and risk appetite in financial markets. The re-acceleration in global growth began when commodity prices had recovered somewhat and the dollar had more or less stabilized. The most important feature was a strong upturn in global profit growth, which went hand-in-hand with strong rise in confidence. This mix finally ignited what had long been the missing part of private demand; i.e., capex spending.

The global output PMI is at the top of the range seen over the past years and global IP momentum remains pretty robust. In the end, the latter is of course underpinned by global retail sales and capex momentum. Here the message is one of stabilisation at a very decent pace. What’s more, absent any big shocks, this momentum is likely to carry itself forward in the next few months: the employment component of the global PMI remains on an upward trend, which suggests that consumers will continue to benefit from rising labour income growth, which should underpin consumer demand. Furthermore, new orders remain pretty strong, also in the manufacturing sector, which suggests capex demand maintains a decent momentum. This is also underlined by data on core durable goods orders and shipments, global capital goods imports as well as various business surveys.

Still, one important implication of the stabilisation of the global PMI and global growth momentum is that profit growth will come down from the giddy heights seen over the past year. This makes sense as profit growth can only increase through an increase in revenue growth and/or margin growth. Revenues are of course directly related to nominal GDP growth and this explains a fair part of the bonanza seen over the past year. Yet at the same time profit margin growth picked up as well, on the back of a combination of rising pricing power, an improvement in productivity growth and unit labour cost (ULC) growth which remained pretty subdued. Now that global GDP growth, and presumably also productivity growth, are hitting the ceiling, profit growth will come down but will probably remain positive unless there is a detrimental combination of strongly rising ULC growth in the face of sluggish pricing power. This is not beyond the realm of imagination but it is certainly not our base case, given the failure of wage growth to respond more strongly to slack.

In a sense it was the nexus between accelerating profit growth, rising business confidence and rising capex and labour demand that pushed global growth towards the ceiling. Hence, a sustained and clear push above the ceiling, if it happens, will rest on this nexus becoming stronger. In the foreseeable future, the base case is that growth will not break the ceiling but remain close to it at the same time. The “not breaking the ceiling” hypothesis rests on the aforementioned slowdown in profit growth which, in turn, is driven by the view that for now the cyclical rebound in productivity growth has mostly run its course while pricing power will not surge ahead. After all, core inflation rates in DM space remain remarkably low and PPI inflation rates seem to be rolling over. At the same time we should see some very moderate increase in wage growth, especially in the US and Japan. The slowdown in profit growth goes hand-in-hand with a stabilisation in DM business confidence since the start of the year which indeed suggests that corporate spending momentum should remain robust but will not accelerate further. At the same time our view that growth will not falter rests to a large extent on the fact that growth is more broad-based than at any time since 2008. This certainly holds across sectors but also across countries, which probably explains why global trade has bounced back so strongly over the past year. Finally, both consumer demand and capex are currently rising strongly, which means the risks to fiscal policy are somewhat on the side of easing, suggesting that growth is also broad-based across demand components.

The big question we have been pondering for some time now is whether growth will break the ceiling. The short answer is chances are improving but it is far from assured yet. A few weeks ago we argued that it will depend on the interaction between the degree of imbalances, the constructiveness of the policy response, animal spirits and the state of productivity growth. The mix between these issues will determine how resilient growth will prove to be in the face of shocks which are hitting the system all the time. It is important to bear in mind that these shocks can be both positive or negative. What’s more, over the past years the importance of shocks stemming from the political arena has increased. Let us briefly review each of these four items.

Imbalances have decreased

The main improvement in the realm of imbalances over the past year has taken place in EM space. Ever since 2011 EM space has seen a deceleration in credit growth which was induced by contractionary moves in EM credit supply and credit demand curves. Credit supply was negatively affected by a deterioration in EM bank balance sheets driven by rising NPL’s and bouts of rising external and/or domestic funding costs. Credit demand was dampened by the EM non-financial private sector’s desire to reduce debt. This desire increased especially during periods in which dollar appreciation increased the burden of EM hard currency debt. Domestic demand growth is influenced by the change in the flow of new lending. Not surprisingly, EM domestic demand was hammered, especially on those occasions in which deleveraging accelerated. This often happened when EM capital flows deteriorated causing foreign funding costs to rise directly and indirectly as EM central banks were forced to stem currency depreciation. The good news is that EM credit growth is showing some tentative signs of stabilisation. Perhaps this is not too surprising, given the constructiveness of EM capital flows over the past year. The important implication of all this is that the drag on EM domestic demand will turn into a very small positive tailwind if credit growth continues to stabilize. The odds for the near future are pretty good in this respect, as the IIF EM Bank Lending Conditions Survey shows that the number of banks tightening lending standards has decreased while EM credit demand increased in Q2. This could allow deleveraging to proceed mostly via a pick-up in nominal growth.

Of course there are other areas of improvement. In DM space, Euroland has also reached the point where the credit side of the equation is becoming a small tailwind after having been a headwind for a very long time. The combination of low nominal rates and rising nominal growth does a lot here to reduce the burden of the debt in some sovereign and private sectors. Combined with a substantial private sector savings surplus (the most important driver behind the current account surplus) there is ample room for the private sector to shift into higher spending gear, which is exactly what seems to be happening. All this having been said, the Eurozone still has other imbalances to worry about. Peripheral current account deficits have all but disappeared but some peripherals are burdened with a pretty large net external debt position, which will require them to run current account surpluses for a while (a current account surplus is essentially an excess of national income over national spending). In this respect, their competitiveness must improve further, which is not easy in an environment where German and Dutch core inflation and wage growth rates remain at low levels. In addition to this, let us not forget the huge institutional imbalances still present in the euro area. A well-functioning monetary union requires a substantial degree of integration in the real as well as the financial spheres of the economy.

Policy response surrounded by risks

The second point, the constructiveness of the policy response, obviously shares some overlap with the imbalances issue when it comes to the need for EMU institution building. Besides these considerations this point is mostly about the growth pulse exerted by fiscal and monetary policy. This goes well beyond the current monetary policy stance or the discretionary change in the budget deficit. It is also very much about the perception of risks around these policy stances. One of the clearest examples of the latter is the taper tantrum, where the market’s assessment of the Fed’s reaction function made a sudden sharp hawkish shift when Bernanke openly toyed with the idea of tapering. We have seen a repetition many times since in central banking space, most recently in June during Draghi’s Sintra speech. The good news is that central bankers have learned a lot from these experiences, which is why any move towards less easing or tightening is surrounded by a lot of caution and gradualism. Still, especially in unconventional space this does not completely eliminate the risk of tantrums because market expectations of future policy action lack a clear anchor in terms of past experience. In fiscal space we have also seen many examples of political brinkmanship which sent shivers through markets. We all remember the US debt ceiling and fiscal cliff debates. In Euroland, the debate on the required size of the Greek fiscal primary surplus was closely connected to Grexit risks. At present most of the risks in fiscal space reside in the US. In the near term the risks are to the downside due to political brinkmanship surrounding the FY2018 spending resolution and the debt ceiling, but in the longer run the risks are to the upside because fiscal reflation hopes in the market have been completely deflated.

The crucial role of animal spirits

The third point is animal spirits, which are difficult to measure in practice. Confidence indicators come pretty close but are also a coincident indicator of growth momentum. Confidence indicators corrected for growth momentum would thus be a better one, which is why we never were too worried about the discrepancy between confidence and real data earlier in the year. Animal spirits do not really play a role in mainstream macroeconomic models, which have a unique long-run equilibrium defined by preferences, technology and endowments (stock of capital, labour, knowledge etc.) and where agents have rational expectations (consistent with the underlying model and without any systematic mistakes). Sticky wages and prices are the main reason why shocks cause the economy to deviate from the unique equilibrium and the role of policy is to speed up the adjustment process. In contrast to this there is a strand of research that revives Keynes’s original idea that an economy can get stuck in a bad equilibrium even if wages and prices are flexible. In these models, the expectations of private agents are not a function of the fixed set of “fundamentals” but are modelled as being a fundamental themselves. A big negative shock to beliefs can create its own self-fulfilling reality, which is exactly what we believe happened after 2008. The role of policy is then to shock beliefs towards a better equilibrium.

Conclusion

Adding it all up, the global economy is holding the best cards since the start of this decade to break the ceiling, but whether or not this will happen is far from certain. The Chinese financial system and geo-political and US political risks could have a powerful negative effect on animal spirits. In Europe, political risks/institutional progress seems to be moving in the right direction but a lot of work needs to be done and the risk of a backlash remains present. The latter could reside in the Italian elections leading to an anti-EU government, but also in a refusal of the core countries to engage in more burden and risk sharing despite the constructive efforts made by Macron to increase French credibility. If all that were not enough, a continuation of downside surprises in nominal wage growth may put the focus on growing inequality again, with the risk of a resurgence of populist sentiments. Meanwhile, in the real economy, there is a risk that low productivity growth is driven by structural factors which will not change even if animal spirits improve. The only honest answer to the “breaking the ceiling question” is thus that only time will tell.

Emerging markets: solid PMIs

The August PMIs gave a positive picture for growth prospects in the emerging world. Of the 14 main PMIs, only three had a reading below the neutral 50-mark. Also only three deteriorated over the month. This is one of the best and most consistent PMI results in years. Particularly encouraging is that new orders and new export orders were strong across the board.

These results confirm our view that the EM growth picture remains good, and that the recent deterioration in our own EM growth momentum indicator (to a level just above zero) can be explained by a temporary weakness in global trade in June and July. With the data now available, such as the Korean export growth and the last PMIs, we can clearly see that August trade is much stronger.

On a country level, it is important to mention that the Chinese PMIs were considerably better than expected, at 51.7 and 51.6 for the official and the Caixin PMI, respectively. The three countries with a below-50 PMI were South Africa, Thailand and South Korea. The latter two had readings just below 50, reflecting weakness in the non-electronics sectors in Korea and ongoing uncertainty about economic policy direction in Thailand. South Africa remains the big outlier in EM, with a PMI of 44. Political uncertainty ahead of the big ANC congress in December is still the dominant factor here.