In this second extract from BNP Paribas Investment Partners’ informative investment outlook for 2017, entitled Beyond the shadow quantitative easing, Joost van Leenders, chief economist with the Multi Asset Solutions team, poses some essential questions for investors to consider as the new year unfolds.
Is monetary policy reaching its zenith?
Scepticism about the efficacy of monetary policy has grown in recent years as the success of each subsequent round of easing has become more questionable. Negative interest rates have been frowned upon for the damage they do to bank profitability and household savings. So it does begin to look like central bankers generally are pivoting away from generous quantitative easing. While the Bank of Japan has the firepower to target 0% as the desired yield for 10-year bonds for a long period, the ECB in its December policy meeting decided to reduce the volume of its quantitative easing programme – admittedly prolonged until at least the end of 2017 – from EUR 80 billion to EUR 60 billion.
In a further attempt to boost policy success, some central banks have signalled that they are willing to let inflation overshoot their target. The ultimate unconventional policy step – injecting cash into the private sector directly – is not something we foresee in 2017. In many emerging markets, however, there is scope for the traditional rate cuts.
Will fiscal policy save the world?
Fiscal policy could kick-start growth in a world economy marked by lacklustre private sector demand. Moreover, with low or even negative bond yields, the hurdle rate for investment in infrastructure looks extremely low. But, overall, we expect fiscal policy to lift global growth only marginally in 2017, with fiscal expansion actually pursued mainly in Japan and China and looking likely in the US. Eurozone countries generally do not need to stimulate growth from a cyclical perspective.
Where does the US economy go from here?
Faster growth would see lower rates of unemployment leading to stronger wage gains, in turn triggering stronger demand, higher productivity growth and stronger business investment. However, the economic cycle in the US is now well advanced and higher wage costs would weigh on corporate profitability. Furthermore, since corporate sector borrowing has continued to rise, many companies are vulnerable to higher interest rates. Fiscal stimulus through tax cuts and increased spending on, for example, infrastructure or defence may support growth, but the impact may take some time to be felt.
Will inflation force the Fed’s hand?
Global inflation remains subdued. Headline inflation has started to rise in developed economies as the impact of falling oil prices wanes. Core inflation in the eurozone and Japan is still too low for comfort, but in the US, the core consumer price index (CPI) and labour costs have begun to increase. A low neutral rate should enable the US Federal Reserve to move cautiously on policy normalisation, unless inflation picks up speed. Just two rate rises in 2017 is our base scenario. We expect US inflation to peak in early 2017 and moderate thereafter. The Fed should tolerate a temporary overshoot in inflation, in our view. However, we see higher inflation through reflationary fiscal policy and the lingering effects of accommodative monetary policy, and consequently more aggressive rate rises by the Fed, as a notable risk for asset prices in general.
Will investment pick up in the eurozone?
The incentives for investment are in place: low interest rates, improvements in the credit cycle and higher capacity utilisation rates. Politically, Brexit-related uncertainty could hold back business investment in the eurozone, but we do not expect a sharp slowdown. In our view, the eurozone can grow by 1.5% in 2017, the same pace as in 2016. Fallout from the Brexit vote should not lead to a recession in the UK, but a sharp drop in business investment, filtering through to the rest of the economy, could slow growth significantly.
When will the ECB start tapering?
As eurozone growth starts to exceed the trend rate slightly and slack begins to diminish, we expect inflation to gradually rise in 2017, which could allow the ECB to start tapering its asset purchases from September, thus addressing the issue of asset scarcity and the controversy over the programme in some eurozone member states. Monetary policy will likely remain accommodative though: key interest rates will stay negative and any tapering should only be gradual.
Can China rebalance its economy?
A hard landing is still a looming risk for the economy. In our central scenario, credit excesses are gradually reined in, overcapacity in sectors dominated by state-owned enterprises is addressed and the rebalancing from investment to consumption picks up pace. This would, however, come at the expense of an annual growth rate at below 6%, which would be more sustainable, but would also maintain China’s role as a deflationary force in the global economy.
Will global trade revive?
Global trade growth has slowed in recent years. The IMF sees overall weakness in economic activity, in particular in investment, as the prime cause. It cites other causes, too, including the waning pace of trade liberalisation, growing political risk and a slower pace – and occasional reversal of – globalisation. We would add to that list the reduced availability of trade credit due to financial regulation and a reduction in China’s competitiveness due to rising wages. Unfortunately, we do not see these restraining factors changing quickly.
Currently, the risk of protectionism is higher than it has been for many years. Accordingly, we do not see trade growth returning to the heady rates before the Great Recession. This does not bode well for the export-led growth model in many emerging markets. Growth may accelerate in some Asian economies and may turn positive in Brazil and Russia, but slow trade growth, the need for budget austerity in some countries and financial risk from rapid increases in leverage are obstacles we see on the way to stronger growth.