Quarterly Economic Outlook Q3 2017

The Trump “reflation rally” has continued however due more to the underlying expansion of the US business cycle than to any Trump effect.

Jul 6, 2017 | John Greenwood

Overview

  • The US business cycle expansion is still intact, owing much more to underlying fundamentals such as private sector deleveraging, the recovery of the banks, improved consumer finances, low inflation, and continuing low interest rates than any impact from the accession of Mr Trump to the Presidency.
  • In my view the US expansion should be able to continue for several more years, creating the basis for further upswings in equities, real estate and other risk assets as the expanding GDP or total spending is reflected in higher corporate and household earnings.
  • The main risk to this scenario is that the US Federal Reserve (Fed) tightens credit too sharply, not by raising interest rates but by curtailing credit growth in the private sector. This could happen as the Fed shrinks its balance sheet, even at very low interest rates.
  • Following the 0.25% hike in the US federal funds rate in June, I expect the Fed will raise interest rates once more in 2017, by 0.25%. I also expect the Fed to start shrinking its balance sheet in October or November.
  • US consumer price inflation will soften in the short term and rise only moderately in the medium term, and will not be much affected either by the tightening labour market or by any expansion of the federal deficit. The reason is that money and credit growth remain subdued, around 4-6%.
  • In the Euro-area growth has improved and the hurdle of political elections has passed without threat to the Euro currency system. The German elections in September are the remaining uncertainty, but there is no serious populist threat to the established parties of centre right or centre left.
  • The triggering of Article 50 on March 29 for Brexit will lead to protracted negotiations between Britain and the EU over the next two years. During that period I expect any progress or setbacks in the discussions to be directly reflected in sterling and gilt yields, which will inevitably be volatile.
  • Imported inflation from the depreciation of sterling is reducing UK consumer spending in real terms, while the overall uncertainty about the exit process will undermine foreign direct investment (FDI) in the country.
  • The general election called by Prime Minister Theresa May on 8 June produced a “hung parliament” with Conservatives having to ensure their survival by doing a deal with the Democratic Unionists of Northern Ireland. This outcome has greatly reduced the Prime Minister’s freedom of action across a range of policy areas.
  • Meantime, the Bank of England’s (BoE) credit promotion policies implemented last August risk adding domestically generated inflation to imported inflation from weak sterling. In response the BoE tightened capital requirements on 27 June.
  • The Japanese economy has seen slightly better growth, but inflation remains far below 2%. The combined policies of Prime Minister Abe and Governor Kuroda at the Bank of Japan (BoJ) are missing their targets.
  • China has continued to alternate between squeezing and easing credit with the aim of keeping the economy on the rails ahead of the autumn National Congress. External trade figures have improved slightly, but this does not mark the start of a renewed export-led boom. Overcapacity in basic industries such as coal and steel, and rising non-performing loans in the banking system are constraining the growth of new investment.
  • On the external side the Chinese authorities have been restricting capital outflows and attempting to encourage more inflows, enabling the currency to stabilise in recent months.
  • In the commodity complex, oil prices remain under downward pressure thanks largely to the developments in US shale and the difficulty of maintaining the OPEC cartel under current conditions. The majority of base metal prices increased in anticipation of a strong Trump infrastructure programme, but the failure of those plans to materialise has meant that the rally has failed to gain ground. The upside for commodities in 2017 is limited in my view.

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