From a speech given by our chief economic strategist, Dr Gerard Lyons, at a recent Netwealth event.
There are considerable near-term challenges. And there are excellent longer-term opportunities. The outlook for the economy depends upon the interaction between the fundamentals, policy and confidence. First, I will focus on the fundamentals for the global and UK economy.
The world economy may surprise on the upside this year. The UK, too, will see resilient growth, but I will highlight how a UK slowdown is inevitable in coming years - possibly next. My focus then moves to policy and the challenges that lie ahead, particularly for monetary policy. Lastly, I will highlight why we should be confident about the longer-term outlook.
At netwealth, in reaching our investment views, we focus on longer-term structural factors while identifying cyclical issues. Likewise, we focus both on the prospects for the financial market from the ‘bottom up’, taking into account market valuations and whether they offer opportunities or not, and on the ‘top down’, looking at key economic and financial drivers. I wish to look at some of these top-down issues.
In the wake of the 2008 financial crisis, two key cycles have been seen in Western economies: a liquidity cycle and an earnings cycle. Central to both has been accommodative stances from central banks, underpinned by low interest rates. Monetary policy has been the shock absorber. Liquidity has been ample and firms, particularly large ones, have enjoyed an almost benign environment. The earnings cycle has been good. Stock markets have performed well. Bond markets, too, have been particularly attractive, none of which should have been a surprise, given the lessons from Japan in previous decades.
Brexit, Trump and Le Pen
Now we are moving, perhaps, to a more traditional political and economic cycle. The political economy is moving to centre-stage. Brexit, Trump and Le Pen are all reflections of this, although each is very different. Brexit had broad cross-party support. In my view, Brexit was inevitable, meanwhile the electoral college system always suggested a Trump victory was very likely, and although France's two-round Presidential voting is geared to preventing a fringe candidate winning, the reality is that even many of Le Pen’s policies are now popular in France.
The higher probability of ‘tail-risks’
In this environment, what would once have been considered small probability, high impact events are now more likely than before. The possibility of ‘tail-risks’ are high and needs to be factored into decision-making. For instance, the collapse or more likely a change in the euro’s make-up could be one of them. There are others, although I will not focus on specific cases here.
Three economic paradoxes
Policy makers need to address three paradoxes that have impacted economies in recent years. One is the ‘economic paradox’, where a financial crisis triggered by a combination of factors including low rates, liquidity and debt has been solved by even lower rates, more liquidity and debt. This points to major policy challenges, to which I refer later.
Then there is the ‘balanced economy paradox’ - particularly relevant in the euro-zone. While each country may wish to avoid deficits and too much debt, if all collectively try to restrain spending then demand suffers. Austerity, if practised collectively, is a problem. The burden of adjustment is on those with deficits, while those with surpluses should do more. Within the EU, Germany and the Netherlands should do more. With each country trying to balance its economy, the net result is a lack of demand, lending and confidence. The euro-zone, thankfully, is seeing some cyclical improvement now, helped by the ECB's policy, but underlying fault lines remain.
The ‘regulatory paradox’
There is also the ‘regulatory paradox’. Individual pieces of regulation may look sound, but collectively the burden is excessive. The pendulum has swung from one extreme, of too light before the crisis, to the other, of too heavy now. This is particularly so for the financial sector. Pendulums settle eventually in the middle and so it may be with regulation, led by Trump's deregulation policies. If implemented, these too could provide a competitive boost to New York, versus London. They might also lead to a wider reassessment of the regulatory environment.
Where now for the world economy?
For six years growth has disappointed. Expectations have been revised down during the year. If the world economy grows above 4% it is strong, 3% and below is weak. In the decade before the crisis global growth averaged above 4%. Last year, based on the IMF measure, it was 3.1%. This year the IMF expects world growth of 3.4%, and next year 3.6%. Despite sluggish trade volumes, it looks set to be higher this year than last, and this may be the first year in seven where growth forecasts are revised up, not down. Since last summer’s UK referendum there has been a shift to reflationary policies across much of the globe; fiscal policies have been relaxed, and notwithstanding the fact the US raised interest rates last December and looks set to do so again soon, monetary policies have been supportive of global growth.
The state of the UK economy
How will the UK perform? If we had not had last year’s referendum the economic debate would likely now have been on when would the economy slow. For, after seven successive years of growth, the UK would be expected to slow. Gordon Brown, when Chancellor, said the UK had abolished boom and bust. It was clearly wrong, but many believed him. Brexit - or triggering Brexit - has not abolished the economic cycle. The economy will, as it always has done, slow and grow during the cycle. But, in my view, Brexit will allow the UK to enjoy stronger longer-term growth plus allow it more flexibility to cope with the cycle in future, as policy competencies return to the UK.
In this environment, we expect the UK economy to grow just over 2% this year, but it is likely to lose momentum as we enter 2018. The stronger pace of growth seen in the second half of last year was in line with our expectations ahead of the referendum if there was a Leave vote. In coming years there will be challenges; it is not easy to leave something you have been in for 43 years. But it is also vital to appreciate the UK’s wider challenges.
Four imbalances in the UK economy
The UK faces four imbalances that need to be considered. One is the current account deficit, sizeable for some time. Such has been the scale that it justified the pound’s depreciation seen last year. Even without the referendum, it seemed likely to weaken. Secondly, there is the sizeable budget deficit, which continues to restrain government spending and discouraged it from cutting taxes.
Thirdly, is the scale of London's importance. The challenge is to boost productivity in other regions without undermining London's global competitive position. The fourth is often the one that causes problems: household indebtedness. Having fallen slightly following the crisis, this is rising again and contributing to the current pace of stronger UK growth. But rising household indebtedness has contributed to some of the UK's post-war booms and busts.
So the fundamentals suggest stronger global growth and solid UK growth this year, but perhaps a slower pace in 2018.
In the wake of the financial crisis and subsequently there was a convergence in policy thinking. Not all countries carried out the same policies, but there was general agreement. Now, we must prepare for greater divergence.
Regulatory policy and policy towards the financial sector could provide an example of this. They have tended to move in tandem across many Western economies. Now this may change as domestic factors drive more of policy thinking.
The Trump effect
President Trump's election has already seen markets discount much good news, seeing his policies as a combination of 1930s Roosevelt - boosting infrastructure spending - and 1980s Reagan - being pro-business and cutting taxes. Trump is seen as anti-globalisation, but it appears more nuanced than that. He appears wary of existing global institutions, preferring bilateral deals and relationships. One indirect consequence, largely overlooked, is the potential impact on monetary policy. Since the crisis, it has acted as the shock absorber but now a major rethink appears long overdue.
The consequences of quantitative easing
One of the main reasons to be wary of financial markets in the near-term is a consequence of Western monetary policy. Quantitative easing has contributed to asset price inflation and fed rising inequality. Low interest rates also have meant financial markets not pricing properly for risk and being overvalued. What now constitutes a risk-free asset? Government bonds and housing are seen as safe havens but challenges overhang both. So what lies ahead? The role of money, finance and credit must be central. As, too, must the relationship between micro-prudential, macro-prudential and monetary policy.
The UK budget deficit
The latest government borrowing figures for January point to an undershoot of the deficit target in this financial year. Despite that, the deficit’s scale limits the government's room for fiscal manoeuvre. Although the deficit of close to 90 per cent of GDP is the highest it has been in peacetime, the UK witnessed a larger deficit after the Second World War, when it was above 240 per cent of GDP. While it makes sense for the government to control spending, austerity is not the best way to reduce the deficit. A focus on stronger nominal growth - alongside financial repression - is the key. Increased infrastructure spending is justified.
The outlook for inflation
UK inflation has increased, as a weaker pound since last June has added to higher input costs. It is, however, often overlooked that inflation has risen across many other countries and regions too. US inflation has risen from 1% last June to 2.5% now. Likewise, inflation in the euro-zone has increased from 0.1% last June to 1.8% now and in Germany from 0.3% to 1.9%. Thus the rise in UK inflation from 0.5% last June to 1.8% now can be put in a global context.
Could high inflation return?
The combination of global reflation since last summer, alongside firmer oil and commodity prices, has added to inflationary pressures. However, it is premature to suggest that high inflation could return. In our view UK inflation will peak early next year. Input costs are continuing to rise, but domestic cost pressures are still relatively subdued. The rate of inflation will depend upon the extent to which profit margins may be squeezed as firms restrain price rises to maintain market share.
Also, higher inflation will restrain consumer spending, the full extent of this also depending upon how much this is offset by rising wages and increased household borrowing. Although UK inflation is currently rising, and will continue to do so - in our view, peaking early next year - factors suggest it will remain low beyond that. Wages are increasing now but continue to be restrained by a combination of factors.
In the past, the relationship between owners and workers was key. That remains important but, in recent years, globalisation has been another factor. Now, technology and financialisation are also holding back wages and inflation. So, despite rising inflation over the next year, in coming years we are still likely to remain in a relatively low inflation environment. In the absence of an active fiscal policy, low interest rates will not lead to a sustained inflation rise. Until then, bond yields, while off their lows, remain relatively low.
Confidence: perspiration and inspiration
Although there are considerable near-term challenges, it is important to not lose sight of longer-term opportunities and drivers. The key global relationship is the US-China, and other relationships need to be seen in this context. Indo-Pacific is the key region - stretching from the US, Japan, South-East Asia, China and India – and likely to be the world economy’s innovative region in coming decades. It is also where potential hot-spots are, such as North Korea and the south and east China seas.
In addition are what I call ‘perspiration and inspiration’. Perspiration is the size of global populations and of potential markets. Based on those already born, Africa's working age population is set to increase to 435 million in the coming fifteen years - an increase twice that of India and China combined. Inspiration is reflected in the new industrial revolution sweeping across parts of the world, from stem cell research and new life sciences developments, to the new green economy, robotics, artificial intelligence and a host of other areas, including fin-tech. The net result is multiple, including increased growth opportunities and new ways of doing things. Disruptive technology will help cut costs and reinforce the low inflation environment.