“There are two types of problems in life, political problems that are insoluble and economic problems that are incomprehensible”, said Sir Alec Douglas-Home, who was briefly British Prime Minister in the 1960s. He was not entirely wrong.
In recent years, the way in which the financial markets have moved and the emergence of negative rates do not match anything that is taught in the economics textbooks, according to Christopher Dembik, Head of Macro Analysis at Saxo Bank.
Fortunately, 2017 should confirm the return to normal that began at the end of this year. That’s the good news.
The good news
Ultra-low interest rates, cheap oil and ‘lowflation’ are about to end. Since last summer, inflation expectations in developed countries are once again on the rise due to higher global commodity prices and, also, the confirmed exit from deflation of China. After years of decline, inflation within the G7 reached an average of 0.8% by the end of 2016 in comparison with a low point of 0.35% in May of the same year.
Global sovereign bond yields (all maturities included) have dropped to a floor of 0.6% in early summer but are now getting up again. By early 2017, they should reach an average of 1.5% although this level remains quite low by historical standards. Finally, oil prices have started to increase in the wake of the recent OPEC agreement, even though it has little chance of being fully enforced by member states of the cartel. In fact, history teaches us that they have systematically pumped more than their targets, especially over the period 2000-2007.
This new economic paradigm confirms that economic conditions are getting back to normal. Negative interest rates, resulting directly from ultra-accommodative monetary policy of central banks, were an anomaly. On the contrary, oil price around 40 USD per barrel was much more “normal” considering that the average oil price from 1862 to 2016 is around 34.20 USD. From this point of view, the anomaly is not so much the recent period but rather the period prior to mid-2014 when oil prices was above 100 USD per barrel.
The first bad news
The first bad news is that 2017 should confirm that sluggish global growth is here to stay longer. Once again, growth will be below the average level of the period prior to the financial crisis of 2007-2008. Since 2011, the continuous reduction of the share of international trade in world GDP (less than 22% expected in 2016 versus a peak at 25% in 2008) is a symptom of this long-lasting slowdown of growth that has been noticed since the GFC.
The main economic drivers at the global level – the United States, China and Europe – are currently in a slowdown phase. Nevertheless, a new crisis has little chance of happening next year, especially when taking into consideration business and economic cycles. In the United States, the continued process of policy rate normalization (that has started in December 2015) should have a marginal direct economic impact. It is hard to imagine that households and companies will change their behaviour because of a half-point or three-quarter point increase in short-term interest rates.
Even if interest rates reach 1.5%-2% by late 2017, they will still be set at very low level by historic standards, both in absolute terms and relative to inflation. The possibility cannot be ruled, however, that the Fed might adopt a more hawkish stance than expected in order to offset the economic impact of the building fiscal push decided by president-elect Trump. In such a case, the market will have to get used quickly to this change of tone.
Our vision for China remains positive. Growth rate should be around 6-6.2% next year. Our optimism is based on three main arguments:
1) the fast incorporation of new technologies into the production process, thus increasing productivity,
2) the constant increase in the contribution of the service sector to GDP (40% in 2005 versus more than 50% in 2016) and
3) a prudent and more effective monetary policy. In this respect, we can mention the better management of foreign reserves since they only fell by -5.5% in 2016 versus -16% in 2016 and the stabilisation, yet to be confirmed, of the CNYUSD around the level of 7.00 by next year.
Europe will be the real loser since the continent has not really experienced a strong economic recovery (with the exception of the United Kingdom). In the euro area, growth is expected to reach 1.3% in 2017 versus 1.6% this year (considering that growth in Q4 will be identical to the one’s in Q3) and 2% in 2015. If the 2017 forecast is confirmed, it will, obviously, increase the pressure on the ECB to take additional measures during the course of the year.
Political risk in Europe, linked to the forthcoming elections in the Netherlands, France and Germany, and the UK triggering Article 50, remains in the foreground. Investors, whose have been caught off guard by the outcome of the UK referendum and of the US presidential election, are now getting used to this new normal. The financial markets reaction in the aftermath of the Italian constitutional referendum is the best proof that investors are more resilient to political risk in developed countries than a few months ago.
It can thus be wisely assumed that the economic and financial repercussions of the upcoming political events will be quite low (or at least manageable). Even Poland, whose risk premium spread has increased strongly in 2016 due to the unorthodox economic measures taken by the ruling PiS (for the first time since 2002, Poland’s spread is higher than that of Hungary!), should see its financing conditions improving.
The second bad news
The second bad news is the strengthening of the US dollar resulting both from the policy rate normalization in the United States and the recycling process by emerging countries of their surplus in USD in the US market. A strong US dollar is the fear number one of investors and policymakers because it means that global growth is likely to get down further.
According to a study published by the BIS in November 2016: “a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending”.
Obvioulsy, emerging countries are the most vulnerable, especially those that have the specificity of being heavily dependent on foreign financing and that are subject to a high level of political risk. This is, especially, the case with Turkey.
Its financial system depends on financing in USD due to its low foreign currency reserves, low level of domestic savings and high external debt. Furthermore, its currency could experience greater instability next year due to the risk of government takeover of monetary policy.
Turkey’s issues are exacerbated by the consequences of the failed coup, which continues to destabilise the democratic institutions and weigh negatively on economic sentiment. The case of Turkey, however, raises the question of the exorbitant economic cost supported by many countries that are dependent on transactions indexed in USD (and, at some extent, in EUR).
This system is unsustainable in a strong dollar world. The risk is to trigger the collapse of several EM currencies as was the case last June when Nigeria had to abandon the currency peg to the US dollar or last November when Egypt did the exact same thing on the advice of the IMF, which resulted in a depreciation of almost 100% of the Egyptian pound.
The basic rule of economics is that a country with weak political institutions and a weak economy must have a weak currency. The countries that fit this rule should better abandon the currency peg to the USD, when it exists, in order to implement real monetary reforms.
They can either adopt floating exchange rate, or establish a currency board (which immediate greatest advantage is to reinforce monetary policy credibility) or implement a hybrid system by fixing the currency exchange rate based on a basket composed of US dollar and oil price, when it concerns oil-exporting countries.
This last solution would be particularly timely for Venezuela which could default by the end of next year unless it receives a new financial package from China.