TalkingEconomics: Duelling in Davos
This month we look at the prospects for trade and the dollar, the case for withdrawing extraordinary stimulus measures in Europe, and forthcoming elections in emerging markets.
2 February 2018
- Global activity remains robust; however, we see some early signs that growth rates may be peaking.
- President Trump has had his wish and the dollar has weakened, but the signs from Davos are that the administration would like to see more depreciation in the currency.
- Confidence is high amongst investors for the prospects for the eurozone’s growth recovery. Despite a dovish stance from the European Central Bank (ECB), the hawks are finding their voices and are making a strong argument for ending quantitative easing (QE) in September. Our analysis on inflation supports this view.
- For many emerging market (EM) countries, politics threatens the strong run seen in 2017 and so far in 2018. There are a number of elections in EM this year, with both up and downside risk. Volatility could offer opportunities, if you have the stomach for a rougher ride.
Duelling in Davos
The global recovery remains on track but there are signs that the acceleration in global trade is peaking. We now await the effects of the tax cuts in the US which should begin to filter through later this quarter.
Scaling the ramparts: another step towards protectionism
Whilst the data remains encouraging, attention has moved to the politics of trade with the US imposing tariffs on imported solar panels and residential washing machines. The tone of recent remarks from US commerce secretary suggests we are in a new era with a more aggressive US approach to trade.
As a result, we will be increasing the probability on our “Rise in global protectionism” scenario which delivers a more stagflationary outcome for the world economy than the baseline forecast. Our analysis of cycles and markets suggests that the combination of weaker growth and higher inflation is not good for risk assets such as equities.
Will the dollar wither?
Meanwhile, US exporters and firms with international operations are enjoying the benefits of a fall in the value of the dollar yet signs are that the US administration is still unhappy with the strength of the currency.
In our view the path of the dollar over the past year reflects an unwind from a period of strength in 2014 to 2016. The dollar rose as it became clear that US rates were set to rise, overshooting its long run equilibrium, and is now in the process of returning to its long run equilibrium.
The current decline in the dollar is also no doubt influenced by the upturn outside the US and the recognition that monetary policy will also be tightening in Europe and eventually Japan.
The dollar is still above its long run average and other measures suggest it is still not cheap. Further dollar weakness seems likely and would be welcomed by markets that see this as an easing of global liquidity conditions and supportive of risk assets.
However, it was not that long ago that we were concerned about currency wars where countries sought an advantage over their neighbours by devaluation in the hope of gaining an increased share of global markets. Our valuation metrics suggest we are not at such extremes as yet and, more importantly, global trade is much stronger today.
Back then the world economy was in the depths of the financial crisis and countries were chasing scraps. Today there is more to go around. Nonetheless, currencies tend to move until they meet resistance. On this basis we would particularly watch the European Central Bank for signs that the euro has tightened financial conditions beyond what they would wish for in pursuing their inflation target.
The turning tide at the European Central Bank
As more evidence of the strength of the eurozone economy becomes apparent, we expect pressure to mount on the ECB to bring its quantitative easing programme to an end. This could be the start of the turning tide within the ECB.
Domestic inflation is gathering momentum
The evidence clearly shows that the eurozone economy is booming. Inflation at 1.3% year-on-year in December, is positive, but a little lower than where the ECB would ideally like it to be. However, there are signs that the eurozone is swapping the cost-driven inflation caused by higher energy prices seen last year with domestically generated demand-driven inflation. In considering this, our analysis offers two pieces of evidence.
First, domestic costs and/or demand are rising at a time when import prices inflation has slowed to nil. This suggests that a stronger euro is less likely to have a significant impact on inflation thanks to improving domestic demand. Moreover, it is worth noting that producer price inflation is back to levels not seen since 2012, which should help push goods price inflation higher.
Second, the reduced slack in services suggests services inflation should head higher in the near to medium term.
Conclusions: hawks and doves
The hawks within the ECB’s governing council are making a very strong case that the economy is ready to be relieved of its emergency life support. We expect the governing council to revise its forward guidance at its next meeting in March to state that it plans to end QE in September. Guidance on interest rates is likely to remain dovish for now as excessively hawkish language could push the euro much higher.
Further out, we expect the ECB to begin to discuss raising interest rates once it ends QE in September, and for it to eventually raise all three key interest rates in March 2019. We forecast the benchmark main refinancing rate to end 2019 at 0.50% and the deposit rate to rise to zero (from current rates of zero and -0.40% respectively). The deposit rate is the return that banks get for placing money with the ECB.
EM: back to the ballot box
After a strong 2017, EM have continued their run so far in 2018 but political risk could cause some turbulence.
Russia: And the winner is?
For Russia the risk lies not in the election (scheduled for 18 March), but what comes after. At the very least, it seems unlikely that policy will take a turn for the worse after the elections. Consequently, the elections seem to provide upside policy risk, although it will not materialise until after March.
As for downside risk, we would argue that this would manifest primarily as a weaker-than-expected vote share for President Putin. A significant fall in popularity could translate to populism, which may carry risks to the fiscal outlook.
Mexico: populism ascendant
A more uncertain election awaits Mexico in July. A left wing, populist victory by Andrés Manuel López Obrador, (AMLO) must be the base case given polling data. AMLO, to us, seems likely to greatly increase the odds of the North American Free Trade Agreement’s (NAFTA) dissolution but he is unlikely to gain a majority, constraining his ability to overturn key reforms. He was also fiscally responsible as Mexico City mayor, so need not be a total disaster. Still, private investment, and if NAFTA ends, exports, will likely suffer.
Brazil: Lula is down but not out
Like Mexico, Brazil faces an election where a left wing populist is the frontrunner. Unlike Mexico, however, Brazil may see its leading candidate (former president Lula) disqualified by the judicial system. His highest placed rival is an economic nationalist and his election would be negative for markets, but may well have been boosted by the ruling against Lula. The two candidates generating the greatest market concern are beginning to stumble so the political outlook is looking brighter, but it is still too soon to sound the all clear for Brazil.
Political volatility comes as liquidity fades
There are elections in a number of other markets, all with uncertain outcomes. This uncertainty typically brings volatility and with it potential opportunity for investors. Emerging markets have demonstrated that politics can and does matter for markets. This year, with the Fed reducing dollar liquidity, it is likely to be an exciting year to be invested in EM.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
 An economic condition in which growth slows while inflation rises.
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