Global Rates Mild reflation, Wild Politicisation, US Yields and Outlook
In a ‘post truth’, ‘fake news’ world, economic forecasters are troubled. After the political shocks of last year, the financial markets are banking on ‘peak populism’ this year. But the promise of mild reflation from the new Trump Administration in the US could easily be upended if his strong arm tactics backfire. And while polls in the Eurozone suggest that mainstream political parties will prevail in forthcoming elections, the question is at what price. The markets have taken on trust that incoming President Trump will deliver on his progrowth agenda. But the combination of fiscal reflation and deregulation will take time to deliver. Meanwhile, growth will face headwinds from the uplift in bond yields and the potential for Trump’s hawkish Cabinet to deliver on his hawkish rhetoric on trade. The US economy has regained the momentum it has lacked since 4Q15 with a strong 3Q16 GDP figure. We expect this to continue, with investment playing a stronger role than it has for years. But inflation is picking up too – providing the Federal Reserve with a headache in terms of further rate hikes, or instead shrinking its bloated balance sheet later this year. Any mid-year dip in bond yields will likely give way to rises later in 2017.
For the Eurozone promising economic signals are overshadowed by the potential for fresh political shocks. Markets are drawing comfort from polls that suggest that it will be much tougher for populists to take power in the Netherlands, France, Italy or Germany. However, even if the mainstream prevails, it may only do so by leaning towards populist themes and backing off on closer integration. The UK economy shrugged off the ‘Brexit’ vote in 2016, benefiting from the inadvertent easing delivered by a big fall in sterling. But 2017 is looking more challenging. With Article 50 set to be triggered in the next three months, worries about the prospects of a deal may see businesses choosing to sit on their hands. At the same time, household spending power will be squeezed by rising inflation, leading to a marked slowdown in growth. This is likely to become the BoE’s main concern rather than inflation. In Japan the Bank of Japan (BOJ) is enjoying success in resisting the global upturn in bond yields, which has had the additional benefit of pushing the Japanese yen lower by around 9% on a trade-weighted basis, and the US dollar above the JPY120 barrier. With that stimulus in hand, the Japanese government is likely to hold off until the second half of the year before considering a further fiscal impulse.
The US dollar has largely held onto its late 2016 rally. We expect further gains through 1Q17 as the market further adjusts to the prospect of looser fiscal/tighter monetary policy in the US. EUR/USD could be dragged close to parity during this period, but our year-end forecast of 1.12 is above consensus. This is based on the view that a Trump Administration will not want the dollar to strengthen too much and that an undervalued EUR can recover. Japan aside, global bond yields are being led higher by the US. Firming economic data, a re-evaluation of economic growth post-Trump and a more aggressive Fed have driven up inflation expectations and real yields. Both aspects could rise further in our base view, with the major downside risks being failure of Trump to deliver growth promises, and political disruption stemming from Europe.
2017 could be transformational for the US. Questions about the aggressiveness or otherwise of trade policy will hopefully be answered. And uncertainty about the degree of any fiscal easing will also likely dissipate. Against this backdrop, the Fed will be trying to balance its cautious tightening, against growth and inflation that may be substantially stronger than its own forecasts. 2016 ended with market optimism about expansionary fiscal policy from an incoming Trump administration. The macro backdrop also ended on a more supportive note. After a soft-patch lasting three quarters, the final 3Q16 GDP growth estimate was an impressive 3.5%. This will make very little difference to the full year figure, finishing the year on a strong note is a very good way to ensure healthy figures for 2017.
We are forecasting growth for the US of 2.8% this year – substantially in excess of the 2.2% forecast shown in January by the Bloomberg consensus. Still absent, however, is a clear recovery in investment. Business investment recorded another negative score in 3Q16. But optimism is growing for a tax amnesty for America’s multinational firms and their $2tr-plus of retained overseas earnings. We expect this policy to be made contingent on some demonstration of increased domestic investment spending. The prospect of lower corporate tax rates could provide a further lift. In contrast, structures investment has shown a big improvement – a trend we think will continue. The rise in oil prices in recent months, helped by OPEC’s announced production caps, is lifting an already-rising rig-count, and with it structures investment. We retain some caution with respect to the scale of fiscal expansion that President-elect Trump will announce in February in his “President’s budget”. The timeline for such expansion is not a rapid one, and much of the benefit from whatever Congress actually decides to adopt will likely not emerge until late 2017 or early 2018. However, if that extends the growth spell from 2017 to 2018 (albeit at a rate closer to 3% than the 4-5% Trump suggested during the election campaign), whilst not generating too much alarm in terms of inflation or debt expansion, that would not be a bad thing. Longer dated bond yields will likely rise, but we think increases will be limited, and potentially suffer a mid-year pull back from higher levels as impatience over the delivery of fiscal stimulus plays with market nerves.
The outlook for trade, which is potentially far more threatening to US growth, remains concerning. Trump’s senior trade appointments include Wilbur Ross (Commerce Secretary), Peter Navarro (Head of White house National Trade Council), Robert Lighthizer (tipped for Head of US Trade Representative Office) and Dan DiMicco (transition team trade advisor). With a trade team that is heavy in terms of China critics, this is the big downside risk to both US and global growth prospects. Our base case is that this will be more of a war of words than a full blown trade war. Trump has already seemingly managed to influence Ford’s investment decisions to Michigan instead of Mexico through Tweets alone. And whilst aggressive rhetoric may weigh on the USD, that may not worry the incoming administration if it helps support US manufacturing.
The Fed threw a forecasting grenade into the mix at the end of 2016, signalling that it saw scope for three rate hikes in 2017. Like markets and the bulk of economic forecasters, we have our doubts. But while most forecasters can fall back on moderate growth forecasts as an excuse for Fed inaction, we think that the Fed will hike again in 1Q17 and potentially 2Q or 3Q17, before switching its attention to its balance sheet. The Fed has said repeatedly that it would not change its re-investment policy until the rate ‘normalisation’ process was well underway. “Well underway” probably equates with a Fed funds range of 1.0-1.25% – just two hikes away. In effect, this will remove from the bond market a substantial “buyer” each month, pushing up yields. In the meantime, we see evidence that the Fed is adjusting its holding of assets from longer to shorter dated assets, in a sort of “reverse twist” operation that is consistent with a steeper yield curve. If this becomes the Fed’s preoccupation in late 2017, there will be little need for additional tightening by conventional rate hikes, and we envisage a pause in rate movements in late 2017 and early 2018 whilst the market gets used to the new environment.