Global Growth in 2018: Deciphering the Signals
Does 2018 represent a cyclical peak in global growth or are we finally embarking on a structural breakout?
- Peak growth? Global growth is adjusted upward to 3.9% from 3.7% for the year, slowing slightly in 2019
- Inflation contained: Some upward pressure in the US but not becoming entrenched
- Risks to the downside: Runaway protectionism or oil prices could roil growth and inflation
GDP Growth and Inflation
Trends and Implications
As we suggested at the start of the year, we expect global growth to be solid and steady in 2018 before slowing slightly in 2019. While inflation remains contained for the most part, despite some upward pressure in the US, momentum may be slowing sooner than anticipated in some markets. In light of these trends and rising geopolitical tensions, the risks to our view are now more skewed to the downside than to the upside.
Along with the International Monetary Fund (IMF), we have revised our 2018 expectations for global gross domestic product (GDP) growth upward to 3.9%, the best in seven years (Figure 1). This pick-up comes on the back of improvements in developing economies such as India. The advanced economies are unlikely to improve on the whole, as fiscally induced growth in the US is offset by slowdowns across the rest of the G7.
So while the remainder of the year appears constructive for risk assets, the bigger question is what comes next. Does 2018 represent a cyclical peak in global growth following a painfully slow, decade-long economic recovery, or is the global economy embarking on a structural break-out after years of subpar performance?
The IMF believes we are seeing elements of both. Indeed, it estimates that potential growth picked up, on average, by 0.4 percentage point between 2011 and 2017 for 10 large advanced economies, compared with an average uptick in actual growth of 0.6 percentage point.
Moreover, it believes the improvement is sustainable, arguing that:
“… about 40 percent of the 1.7 percentage point revision to cumulative growth in advanced economies during 2016–21 (relative to the October 2016 WEO projections) is attributed to faster closing of output gaps [a cyclical recovery in demand]; the rest is attributed to faster potential growth [implying a structurally stronger recovery].”
However, further progress may prove elusive. The acceleration thus far reflects the gradual weakening of crisis-related headwinds on total factor productivity; there is no sign yet of any pickup in the contributions from either capital or labor. Hence, in the absence of broad-based policy initiatives designed to stimulate investment and offset the effects of aging on the workforce, medium-term global growth prospects remain subdued.
Trade Policy Is the Wild Card
Our outlook for inflation in the advanced economies is little changed, with headline consumer prices expected to rise 1.8% in both 2018 and 2019. Admittedly, energy prices can affect inflation in the short term — and the recent runup in oil prices certainly skews the risks to the upside — but the flattening of the Phillips Curve in many countries likely prevents a more persistent deterioration. Indeed, we are anticipating that, by 2019, solid growth and moderate inflation prompt a gradual synchronous tightening cycle around the G7 (with the possible exception of Japan).
Trade policy is the wild card for the global economy. Nothing that has been done so far rises to the level of a macroeconomic event, but the situation could deteriorate into a serious threat to growth and inflation. The Organisation for Economic Co-operation and Development (OECD) has run simulations to assess the impact of a 10% increase in the costs of all goods imports to the US, China and Europe. (This would be roughly equivalent to raising the cost of international trade to the levels prevailing in 2001 — so certainly within the realm of possibility.) The effect would be to lower global GDP by 1.5%. European and Chinese GDP would come down by 2% and US GDP by 2.5% — a sizable impact around the world.
Gradual Tightening Amid Fiscal Stimulus
The outlook for the remainder of 2018 and 2019 is obviously affected by late-cycle fiscal stimulus. The multiplier from the US tax cut is unlikely to be large; we expect it to add only 20–30 basis points (bps) to growth this year and even less in 2019. Most of that increase is likely to come from business investment, reflecting the immediate expensing of capital expenditures. The budget (spending) agreement should add another 20–30 bps to growth this year and 40 bps next year. But, even in the absence of fiscal stimulus, we would still have expected a slight acceleration of growth this year, most likely to around 2.5%, given the current momentum in the mining and manufacturing sectors.
Headline inflation has accelerated over the last two years, partially because of rising oil prices. But we believe the latest run-up in oil has been overdone, and prices will retreat over the next two years. Hence, inflation should stabilize close to current levels, especially as there has not been the spillover to wages necessary for it to become entrenched.
Core Personal Consumption Expenditures (PCE) inflation has also accelerated, reaching 1.9% year over year in April, close to the Federal Reserve's (Fed's) target (Figure 2). But there appears little reason to anticipate a significant deterioration, even though we expect the unemployment rate to fall further. Inflation expectations have risen, but remain close to 2.0%. Productivity growth has begun to recover after years in the doldrums. And wage inflation remains contained, although the employment cost index suggests some pickup among private industry workers.
Solid but unspectacular growth together with relatively benign inflation keeps the tightening cycle gradual. We anticipate two more hikes this year (although concede that depending on the size of the fiscal multipliers and the associated degree of labor market tightening, it could be three more). We expect three hikes in 2019, leaving the funds target around 3.0% by the end of next year.
Mixed Signals Due to Manufacturing & Transitional Brexit Agreement
Europe was the upside growth surprise of 2017, largely reflecting an improvement in net exports. However, there are signs that momentum is waning, particularly in manufacturing where the purchasing managers’ index (PMI) has retreated from last year’s highs (Figure 3).
We expect growth to reach 2.3% this year and moderate to 1.9% next year, in part a reflection of the lagged effect of the euro’s appreciation during 2017. But we believe growth will remain solid enough for the European Central Bank (ECB) to end its asset purchase program by the end of this year.
In the United Kingdom, the transitional Brexit agreement is likely to reduce business uncertainty over the near term, which should help to reduce the unusually large gap that opened up between high capacity utilization and muted business investment. We still expect that the Bank of England (BoE) will raise rates once in 2018, perhaps in November, and continue tightening in 2019.
Tightness of Labor Market May Slow Growth
There is some evidence that Abenomics may finally be working. And growth certainly surprised to the upside last year, with GDP rising 1.7%, about twice its potential pace. But we think that represents the highwater mark for growth, given the extreme tightness of the labor market. Indeed, with the unemployment rate at 2.5%, the economy is simply running out of spare workers, forcing growth to slow to potential.
Emerging Markets Outlook
Much Riding on US-China Relationship
We see GDP growth in the emerging markets reaching a five-year high of 5.0%. That would typically be cause for celebration, but our sanguinity is dampened by fears surrounding the US-China trade relationship. Additionally, rising interest rates and the loss of the liquidity injection associated with the dollar’s 2017 depreciation could challenge EM economies via reduced capital flows and higher borrowing costs.
However, while it may be a bumpy road, we do not expect a full-blown trade war. Ultimately, we feel that, similar to the Brexit negotiations, the US-China relationship is “too big to fail” (Figure 4). If cooler heads prevail, China should do well, and, by extension, so should EM commodity exporters.
We believe that China wants to deal with its debt problem and make progress deleveraging. However, should the economic outlook deteriorate, we expect the government to ease policy. We see this in the softer wording regarding the financial and housing markets. It seems the government is positioning for the possibility that trade tensions result in a prolonged period of uncertainty and will probably not exacerbate the situation by tightening. Debt is an issue, but trade is the issue du jour.
Meanwhile, the nascent recoveries emerging in Brazil and Russia are now threatened by political developments. In the case of the former, we are concerned about the upcoming elections and a lack of progress with the reform agenda. In the case of the latter, sanctions risk is offsetting optimism from rising commodities prices. India is probably one of the better EM stories in the near term as it does not face any of the political clouds that hang over China, Brazil and Russia. They have pushed through policies to boost productivity and competitiveness and are over the hump in terms of last year’s growing pains.
The opposing forces of US fiscal stimulus and trade tensions will dominate the macro picture for the remainder of the year, while strong corporate earnings should provide a favorable backdrop for risk assets.
Breakout Dependent on Corporate Spending and Productivity
The medium-term prospects will at least partially reflect how US companies react to the recent tax changes. If they boost capital spending, that should ultimately aid productivity growth. The current recovery might then morph into a genuine structural breakout.