09 Dec 2016

2017 - The Birth of Reflation?

Philip Shaw

Chief Economist

Please find below our thoughts for the year ahead.

Regards, London Economics Team

In a momentous year for political surprises, the stand out in terms of economic policy is the prospect of fiscal ‘reflation’ from the new US administration. Markets are currently in the dark over how much stimulus may be agreed between the White House and Capitol Hill. We do expect stronger global growth in 2017. This has been our expectation for some time and is largely unrelated to our new US fiscal policy assumptions. But there has been a major effect on market sentiment. Risk assets in developed markets have rallied, yields have risen (albeit from extremely low levels) and commodity prices have gained. There may be pressure on other economies to follow suit and alter the mix between monetary and fiscal policy.

Also, deflation fears appear set to be consigned to the history books. This was our primary downside risk 12 months ago. And while China appears to be experiencing a repeat performance of selling pressure on the currency and falling official currency reserves, it is on a much more modest scale than at this time last year. As we have noted before, even the IMF’s assessment suggests that the downside risks are less pronounced. Alongside a fiscal boost, Mr Trump risks also bringing a bellicose approach to trade and foreign policy more generally – but our central view is that markets will shrug off these geopolitical risks.

Key calls for 2017

  • 2017 should be a year of firmer global GDP growth; our call is 3.7% from 3.1% in 2016, above historic averages and market expectations. A stronger US economy will be a supportive factor, but by no means the primary story; this is broad based global growth with a solid Chinese performance.

  • Our 2017 forecasts envisage the Chinese economy expanding by 6.5%, similar to 2016 (6.6% forecast). We have upgraded our view of US GDP for 2017 to 2.8% from 2.5%; this would be its firmest growth rate since 2005. Mr Trump’s stimulus would likely have a more significant boost yet for 2018.

  • We see a breakaway from the era of ‘lowflation’. The end of the energy price drag has helped to lift inflation numbers, but crucially we envisage reflation being driven by broad based economic improvements and tighter labour markets, particularly in the US, Euro area and in the UK, where fiscal policy now looks set to be less restrictive and even supportive in the US.

  • Bond yields should continue to track upwards, lifted by reflation expectations. Markets now share our view that two Fed hikes are likely in 2017. But we are also now forecasting a further three 25bp rate moves in 2018; We see US 10-year Treasury yields reaching 3.00% by end-2017. We look for UK 10-year yields at 2.00% end-2017 and 10-year Bunds at 1.00%.

  • We see the USD losing ground against the euro through 2017. A key driver in late-2017 will be talk of the ECB curtailing its QE buying from 2018 onwards. Our EUR:USD call is $1.14 at the end of next year.

  • Too much bad Brexit news is factored into the pound - a sterling recovery seems on the cards, at least against the USD, given the scale of its undervaluation. Our end-2017 target is $1.35 from $1.26 now. Note a GBP rebound could weigh on the FTSE100 index as dollar denominated earnings are devalued in sterling terms.

  • The rise of anti-establishment parties in a run of Euro area elections will be a key theme. But we do not see these threatening the stability of the Euro or the EU. We expect markets to remain calm in the presence of this political noise.

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2017 - The Birth of Reflation?