25 July 2017
Reflationary forces emerging
The Global recovery continues to strengthen
The global recovery continues to strengthen.
The latest global growth forecasts indicate that world real GDP growth accelerated to 3.0% y-o-y in H1 2017; the strongest start to a year since 2011. Encouragingly, both emerging markets and advanced economies are now reporting stronger growth, suggesting that we are seeing a more synchronised global expansion.
Inflation is expected to start trending higher.
Despite the strong start to the year, inflationary pressures remain subdued, at least for now; core inflation in the G7 slowed to just 1.4% y-o-y in May. Nonetheless, a number of major central banks have expressed concerns in recent weeks that the risks to the inflation outlook are now increasingly to the upside, reflecting the improved momentum in the global economy.
Central banks are moving to a tightening bias.
This suggests that central banks are now slowly moving to a tightening bias. Leading the way is the US Federal Reserve, which raised its federal funds rate by 25 bps to 1.0% in June and announced plans to begin to unwind its Quantitative Easing (QE) programme (by selling bonds) as early as this September. In the UK, the Bank of England also surprised markets by narrowly voting by 5-3 not to raise the bank rate from 0.25%. Meanwhile, European Central Bank (ECB) president Mario Draghi delivered an upbeat speech about the Eurozone's prospects, arguing that "deflationary forces have been replaced by reflationary ones".
Tighter labour markets should boost wage growth.
Part of the reason for increased central bank concern is the continued improvement in global labour markets, spurred by robust global domestic demand. The US, the UK, Japan and some Eurozone countries are now all operating at close to full employment. In this environment, wages should begin to outpace inflation, generating tangible real wage increases.
Credit risks remain a potential area of concern.
With interest rates likely to start trending higher, the key question remains: can borrowers withstand higher interest payments? Our analysis suggests that credit risks remain a potential area of concern. While most sectors have deleveraged slightly since the crisis, absolute debt-to-GDP ratios remain elevated relative to pre-crisis levels (Chart 1). Governments are most conspicuously at risk, with current average public debt-to-GDP in advanced economies now significantly higher than the pre-crisis average. Current non-financial corporation and household leverage is not materially higher than pre-crisis levels, but still sit above early-2000s levels, or before the 2003-2008 run-up in debt.
Key regional developments:
In the US, policymakers continue to express faith in the strength of the domestic economy. Following the 25 bps rate rise in June, the Fed has indicated that it will continue to normalise interest rates in the coming months, as the unemployment rate stood at 4.4% in June. Overall, we would characterise the US as being at a relatively late stage of the cycle, with US real GDP expected to increase by around 2.2% p.a. in 2017.
The strength of the recovery in Europe has been the biggest upside surprise of 2017 so far. Real incomes in the Eurozone grew by 1.9% y-o-y in Q1 2017, with particularly strong performance in Spain (3.0%) and Portugal (2.8%). Real-time indicators point to a continued robust performance in Q2, with manufacturing and services Purchasing Manager Index's (PMIs) now at multi-year highs in serval key Eurozone economies. Nonetheless, there are still pockets of weakness, most notably in the Italian banking sector where the government recently orchestrated a 17bn bailout. In this environment, we expect the ECB to continue its QE programme for the remainder of 2017 and begin to taper off in 2018.
Despite its strong performance immediately following last year's EU referendum, the UK economy has started to slow in 2017. UK manufacturing and construction PMIs hit a three-month low in June as output and new orders slowed, potentially due to increased political uncertainty from the surprise UK general election result, which stripped the governing Conservative Party of its outright majority. This has further complicated the Brexit negotiation process. Meanwhile, inflation remains above the Bank of England's target, reaching a four-year high of 2.9% in May. Higher prices are starting to dampen domestic consumption as retail sales data begins to soften. Overall, this suggests a slower near-term growth outlook, which will continue over the next two years.
Chinese authorities remain focussed on achieving stable growth, maintaining employment and preventing financial stability risks. In March, the Chinese government announced a GDP growth target for 2017 of "around 6.5% or higher". This target looks achievable, with the economy expanding by 6.9% y-o-y in Q1. The Chinese residential property market has remained a key driver of growth in 2017, but more cities have introduced tightening measures to dampen speculative activity and slow growth in property prices.