Perspective on global economy in 2017

After Donald Trump’s election as 45th US President, his future economic policy is the subject of much speculation. December was an opportunity for us to present our economic outlook for the coming year. This time, however, we are not putting forward a main scenario, as this seems an impossible task given the relatively high degree of uncertainty regarding future political developments in both the US and Europe. We explore two basic scenarios:

If all goes well, only pro-growth measures will be implemented – a scenario that we are labelling “reflation – ‘Trumponomics’ works”. In the second scenario, which we think is less likely and refer to as “stagflation – ‘Trumponomics’ fails”, the measures taken will not only promote growth, but potentially act as a brake as well. Developments in the euro zone could also be negative and hit trade especially hard. Here the main concerns are the uncertainties created by Brexit and the possible disintegration of the European Union.

Scenario1                                                                                                                                                       

“Reflation – ‘Trumponomics’ works” (Probability of occurrence: 60%)

US: GDP growth of 3 percent

This scenario includes public spending on infrastructure in the region of 1 trillion US dollars (Trump’s transition team has not yet clarified the period over which this investment is to be made) and tax cuts (for private households, especially the middle classes and corporation tax is supposed to be cut from 35 to 15 percent). Trump also wants to reduce excessive regulation on companies in the energy and financial services industries.

In this scenario, economic growth could pick up to 3 percent in 2017. Since the US is currently enjoying almost full employment, wage growth is likely to gather momentum – it already stands at 2.8 percent. This will probably push inflation above 3 percent, especially since productivity gains are minimal and companies are hardly likely to sacrifice their margins. In such a scenario we, therefore, anticipate four interest-rate hikes next year, with bond yields rising to 3 percent.

Euro zone: upturn despite political uncertainty

We expect to see far fewer fiscal measures in the euro zone than in the US, but there will also be much greater political uncertainty. Despite this, the effect on growth prospects should not be too negative. Given the solid economy at the moment, we expect GDP growth to pick up to 1.9 percent, and inflation to rise to 1.7 percent. The European Central Bank (ECB) is likely to leave benchmark interest rates around zero percent. The yield on German 10-year Bunds will rise to 0.8 percent: At the most, we expect modest tax cuts. In particular, the forthcoming general elections in France and Germany next year could potentially deliver some tax giveaways. In this pro-growth scenario, we also anticipate increased public spending in the euro zone, although only on a very modest scale.

On the political front the upsurge of the anti-EU and anti-euro parties will be limited and it should be possible to form governments after elections in the Netherlands, France and Germany without having to rely on the support of populist parties. This is an important aspect for the reflation scenario, as it helps to block “disintegration tendencies” in Europe or the euro zone, as well as ensuring that national debts remain tolerable and companies continue to invest.

The start of British negotiations on the country's exit from the EU in March 2017 would also have no significant consequences for trade with continental Europe. In a similar vein, the new administration of Donald Trump would refrain from erecting barriers to trade with the countries of the eurozone. The ECB’s monetary policy remains very expansive. In this scenario, the ECB will extend its bond-purchasing programme by six months (beyond March 2017) and then gradually taper its purchases over the course of three months.

Japan, China and the globe: trade picks up

Generally speaking, we expect rising yields to have a dampening effect on emerging economies. At the same time, geopolitical tensions would be eased in the reflation scenario, allowing global trade to grow without restriction.

Japan maintains additional fiscal stimulus to promote economic growth and continues with very loose monetary policy. The Bank of Japan (BoJ) will keep yields on Japanese government bonds around zero, which will significantly weaken the Japanese yen if international interest rates increase.

In global terms, the strategic flashpoints in regions such as Syria, Iraq and the South China Sea will ease in this scenario because the US under Trump will contemplate pragmatic solutions. China maintains almost constant economic growth which prevents its property bubble from bursting. Moreover, there is no increase in default rates or calamitous company failures.

Scenario 2                                                                                                                                                      

“Stagflation– ‘Trumponomics’ fails” (Probability of occurrence: 40 percent)

"US: restrictions impede growth and fuel inflation"

In our scenario of stagflation – a combination of concurrent stagnation and inflation – infrastructure programmes and tax cuts are also implemented in the US with very little opposition. At the same time, however, a number of points in Trump’s election manifesto are implemented which simultaneously act as a brake on economic growth (the terms of the North American Free Trade Agreement (NAFTA) are renegotiated, the Transatlantic Trade and Investment Partnership (TTIP) and the Transpacific Partnership (TPP) are not ratified, there is a massive hike in import duties on goods from China).

If the new US administration adopts an “anti-globalisation” stance, this would most likely impair international competition on goods markets. In addition, any limits on immigration would also reduce competition in the labour market. Both measures would have negative effects on productivity growth and would also drive up price and wage inflation. In our stagflation scenario, inflation would therefore increase to 3.2 percent, whereby economic growth, at just 1.8 percent, would be far more modest than in the reflation scenario. This would force the Fed to moderate any interest-rate hikes, so that yields would not rise as sharply.

Euro zone: trade barriers and disintegration tendencies

In our stagflation scenario, European economic growth would be neutralized by new trade barriers and the increasingly obvious tendencies towards the disintegration of the European Union. This would result in minimal economic growth and a modest inflation rate of only 1.2 percent. This puts pressure on the yields of bonds issued by “safe-haven” countries such as Germany, where the level of yields on 10-year Bunds could be around 0.2 percent at the end of 2017. In this case, the ECB would leave base rates around zero: The start of formal discussions for the UK to leave the EU and potential trade barriers erected by the US against the European export industry have clearly negative consequences.

Political turmoil, such as the inclusion in governments of anti-EU and anti-euro parties (e.g. the right-wing Front National in France or the Party for Freedom in the Netherlands) raises concerns about the disintegration of the European Union, or at least the single-currency area. Companies might become reluctant to invest. The migration crisis flares up again and tensions in Turkey’s domestic politics become a European problem.

The ECB maintains its ultra-loose monetary policy to bolster the economy in the face of predominantly negative political developments.

 

Japan, China and the globe: trade war

In this scenario, the restrictive trading policies of the world’s biggest economies – led by the US – act as a brake on the global exchange of goods. Military tensions escalate in some cases:

Failure to ratify the Transpacific Partnership (TPP) upsets Japan’s trading relations with the US. Domestic political tensions make a new economic stimulus programme impossible and the minimal rise in global interest rates forces the BoJ to pursue a less expansionary monetary policy. Global trade is badly affected by the barriers to international trade erected by the US, which is particularly hard on China as the world’s biggest exporter. In this scenario, we also expect a relatively sharp drop in Chinese house prices. In addition, one of the major emerging-market companies would become insolvent.

Our forecast: weighted combination of both scenarios. Relatively few details are known about the president-elect’s programme. Donald Trump has already backtracked on some of his earlier statements. For example, he has now thanked his election opponent Hillary Clinton for her service to the country, having previously threatened her with prosecution for a long time. More surprises are likely to follow. Political uncertainty is also growing in the euro zone given the important agenda facing the core EU countries such as Germany and France (both holding general elections in 2017), as well as Italy, which is facing a referendum on constitutional reform whose negative outcome led to Prime Minister Renzi’s resignation. We estimate the probability of the pro-growth reflation scenario occurring at 60 percent, and the less favorable stagflation scenario at 40 percent. We are also predicting a higher rate of inflation for the US for the first time – irrespective of the economic climate – and therefore anticipate higher interest rates and yields as well.