US economy robust enough to take interest rate increase: HSBC's Janet Henry

US economy robust enough to take interest rate increase: HSBC's Janet Henry
US economy robust enough to take interest rate increase: HSBC's Janet Henry


As we head into 2017, there are many reasons to view prospects with distinct nervousness.

Will the new US president follow through with his isolationist and protectionist rhetoric from the campaign trail?

How will growing populism affect the outcome of key eurozone elections, and particularly the French presidential vote?

There are huge uncertainties facing the UK over its Brexit negotiations and the medium-term growth outlook.

Moreover, very real challenges are facing certain emerging markets, particularly those with high external debt levels and now suffering from currency depreciation.

All these give real cause for concern. However, some things are going in the right direction, at least for now. Global PMIs are at their highest level for more than a year.

The US economy is robust enough for the Fed to have just carried out its second interest rate increase this decade.

Growth in China has held up remarkably well, defying financial market concerns at the start of 2016. Inflation, long thought dead, is showing signs of stirring, albeit thanks to higher oil prices and varying degrees of FX depreciation.

And fiscal measures are supplementing monetary support in many key economies, led by the US where a reflation trade is confidently underway in the expectation of broad-ranging tax cuts and higher spending.

All of the above help explain why this quarter we can offer a rare treat: for the first time since early 2012, we are increasing our forecasts for both global growth and inflation for the next two years. Unfortunately, it is still a world where global growth is likely to hover around the mediocre growth rates of the past few years.

The Trump factor Political shocks typically mean uncertainty about the future direction of policy and a negative impact on investor sentiment. Not this time.

Since the election of Donald Trump as US president, global markets have taken a clear view on what it means for policy and the real economy. Concerns raised before the election over Mr Trump’s campaign pledges – such as protectionism and limits on immigration – have been put on the back-burner, even though they could change the world order in unpredictable ways.

For now the mood is firmly risk on. Equity markets have rallied. Bond markets have sold off and the dollar has strengthened across the board. Signs of cyclical improvement evident in the global economy survey data before the election have largely been confirmed and the expectation of a sizeable fiscal stimulus and lighter-touch regulation have added to the optimism.

The first positive prints for China’s producer price inflation since early 2012 and the first deal between OPEC and non-OPEC producers to cut oil supply for 15 years, pushing oil above USD55/barrel, are the icing on the cake for the reflation flag wavers.

Some of this buoyancy is justified. We recently revised up our US growth forecasts for 2017-18 on the expectation that the Republican Congress will back some degree of tax cuts for US households and companies.

European growth is also expected to be stronger than had seemed likely in the immediate wake of the UK’s Brexit vote.

Expectations may be getting too high though. An upturn in the global industrial cycle does not tell us much about long-term growth prospects. Nor do we doubt the ability of fiscal stimulus to support near-term demand.

If it does not raise long-term nominal growth by supporting other structural policies to improve productivity then it might just mean larger deficits that keep adding to government debt stocks.

So, while expansionary fiscal policy may erode spare capacity and mean the Fed can raise rates a little more quickly (we expect two rate rises in 2017, rather than the one we previously envisaged), the jury is still out on whether the incoming US administration’s policy mix will raise long-term potential growth and the historically low natural rate of interest.

Even in the near term there could once again be constraints on the Fed. The election of Donald Trump may have been a vote in favour of more isolationist policies but the US is not (yet!) a closed economy and Fed policy will continue to be influenced by developments elsewhere.

US headline inflation will rise in the coming months as higher oil prices feed through and nominal wage growth should tick up slightly, but we expect the strong dollar to keep down import prices and therefore core goods prices. In the other large developed economies, signs of cyclical improvement do not alter the deflationary influence that the eurozone and Japan still exert: internal imbalances and external surpluses are still too large and wage settlements too low.

Political risk in the coming year will focus on the eurozone, given the elections in some of its key economies: the Netherlands, France and Germany and, possibly, Italy.

There is also a pressing need for EU institutions to take decisions to address the population’s primary concerns of immigration and terrorism, ideally through joint budgetary spending on defence. But with the ECB having now extended QE until at least the end of 2017 and a very welcome bout of yen depreciation having taken the pressure off the Bank of Japan to step up its monetary easing any time soon, the immediate monetary policy risks will focus on EM.

Given the broad-based currency declines since the US election, emerging economies with high external debt and a high degree of foreign participation in local bond markets are most vulnerable to a rise in debt service costs and capital outflow as US rates rise.

Even for countries that have less foreign-currency-denominated debt but which are still reliant on credit growth, a slightly more active Fed and a stronger dollar imply less ability for many EM central banks to provide support through monetary policy.

We believe Brazil’s central bank will now be able to deliver less easing than previously seemed likely.

Many of the rate cuts we had been forecasting in Asia have been removed, while Turkey has already started a rate-rising cycle we did not envisage three months ago. Nor can emerging markets really pin their hopes on a big boost to competitiveness from the currency as exchange rate weakness has been broadly based across EM.

They must be hoping there will be some kind of lift from stronger US demand. The main boost on the demand side is likely to be to the US consumer from the planned tax cuts. To some extent the boost to disposable incomes will be offset by the rise in oil prices and a small rise in debt service costs but at least the US consumer has undergone so much deleveraging and now holds far fewer adjustable rate mortgages that the impact of modest rate rises should be limited and slow to come through.

Nonetheless the US will be a long way from regaining its former title of the world’s consumer of last resort. The US now accounts for a much smaller share of global demand than it did over a decade ago and its high income level and ageing population mean that more than two-thirds of US consumer spending is now on services. There will also be the risk of protectionist measures being put in place, particularly if the dollar continues to strengthen and the US current account deficit widens significantly in the coming year. Fed will still be constrained by global developments Political risk in Europe USD strength and higher rates puts the focus back on EM Mixed blessings for the US consumer.

Despite the clear risks for many emerging countries in the near term, the emerging market growth story is far from over given its superior long-term growth potential. In this report, we have re-visited the projections made for emerging economies in 2010 in our World in 2050, 11 January 2012 report. China, India and Indonesia are the main countries that have surpassed our estimates of growth potential. The rest under-delivered and, as in much of the developed world, disappointing investment growth has been a big part of the reason.

Demographics still look better in most EM countries though and other key drivers of future growth – notably education levels and life expectancy – have improved. This implies that potential per capita growth rates are still fairly high. As these countries develop and the nature of growth becomes more domestically driven, the influence on developed markets may pick up once more.

Emerging market crises of one sort or another will no doubt feature from time to time in the coming decades, as will unpredictable political developments. But these countries should continue to gain in importance in terms of their share of global demand.

Turning to our actual growth forecasts, we have raised our developed world forecasts more or less across the board. Aside from the US, the biggest upgrades are in the UK (smaller nearterm damage following the Brexit vote) and Japan, but there also seems to be a bit more momentum in the eurozone, particularly Germany and Spain.

In the emerging world, the revisions are mainly downwards, with the main exception of China where the recent run of data have revived and we believe an additional bout of public spending will maintain growth at 6.5 percent in 2017-18. In India, there is a near-term hit to growth from the government’s decision to abolish the existing stock of high-denomination currency notes.

The other notable revisions are in Latin America due to weaker-than-expected recent activity data and the reduced scope for monetary easing in the face of currency depreciation.

The full report can be downloaded here.

Janet Henry is Global Chief Economist at HSBC and can be contacted here.

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