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Good economic news and ominous tail risks

6th January 2017

It’s not for nothing that economics is sometimes called the dismal science. Yet it isn’t always true that economists are gloomy. Now is such a moment, especially compared with this time last year, when equity markets were in free fall, and everyone was concerned about a China meltdown and a US recession, the current environment looks almost panglossian. At the same time, it would be churlish not to highlight the so-called tail risks, or low probability or hard-to-measure events that have far-reaching outcomes if they occur.

Think food poisoning or serious sports injuries – mostly, they don’t happen, but we know they happen often enough to fear very unpleasant consequences. In the world of political economy, think the financial crisis, Brexit referendum result and the election of Donald Trump.

In the good news stakes, the UK isn’t the most obvious, but it isn’t there worst either. The Markit/CIPS manufacturing survey for December rose to 56.1 to put the index at its highest level since 2013-14. This follows upbeat news at the end of 2015 for car production and sales, and housing starts. Self-evidently, the predictions of economic meltdown after the referendum proved wide of the mark. The fall in Sterling, and the incremental easing in both monetary and fiscal policies have all helped, and Brexit, of course, hasn’t happened yet. Most forecasters now expect UK inflation to rise to 2.5-3 per cent this year eating away at stable nominal income growth, and lowering GDP growth to about 1-1.5 per cent.

Needless to say, the UK’s main tail risk continues to be the corrosive and gradual effects of Brexit, and so far, the absence of a Brexit mitigation economic strategy. With the government seemingly set to trigger Article 50 negotiations by March, it can’t be too long before we get a glimpse of what the government wants Brexit to actually mean. Suffice to say that the tipping factor for business and economic confidence is likely to be rising belief or disbelief in the likelihood of a transition arrangement following the 2 year closure of Article 50 negotiations.

Even before Trump was elected, the US economy snapped a 5-quarter long slump in economic growth and corporate profits, characterised by one of the largest and longest inventory adjustments on record. Partly as a result, capital investment fell for 6 of the last 8 quarters. But this seems to have ended with the third quarter in which GDP rose by 3.5 per cent at an annual rate. Most forecasters expect the US to grow by 2-2.5 per cent in 2017, putting further downward pressure on a 4.6 per cent unemployment rate and causing inflation to rise from abut 1.7 to roughly 2-2.5 per cent a year from now.

With the economy more or less fully employed using some measures, financial markets have become very optimistic about Trumponomics – the use of fiscal policy to stimulate the economy at a late stage of the cycle and focused on corporate tax reforms, tax cuts and infrastructure spending. Partly as a result, markets now expect US interest rates to gradually normalise this year, rising another three times, and putting further upward pressure on the US dollar. You could say that the ‘new normal’, according to this narrative, is starting to look very much like the old normal.

All of this said, there is a major question as to whether, after an economic bounce, Trump’s economic policies would end up with unsustainable deficits on trade and in the budget; and there is little question that Trump’s election represents the end of an era in which the US nurtured global free trade and championed a liberal rules-based world trade and investment regime. His rhetoric as a candidate and since winning has been firmly anti-free trade, and his choice of nominees to head the Commerce Department, National Trade Council, and US Trade Representative’s Office are all cut from the same protectionism, and anti-free trade cloth. We will wait with some trepidation to see how the Trump presidency chooses to manage US trade in the world, and especially vis-a-vis China, and whether retaliation and trade wars become more conventional. This would cast a dark cloud over global growth, especially in emerging countries, and sour the trade aspirations of our own Brexiteers.

Even in the Euro Area, things are looking up. The December manufacturing Purchasing Managers Index rose from 53.7 to 54.9, its highest reading since 2011. The levels of activity are at a 3 year high in Germany, Spain and Greece, and a 5 year high in France, Austria and the Netherlands. The European Central Bank is, as everyone knows, still fully engaged with QE, but by Euro Area standards, fiscal policies are set to become a little more relaxed. Not as in the US, but headed in that direction, and that is important in a European context. Euro Area growth could even run at about 1.5-2 per cent for a couple of quarters as things stand, which would be twice the region’s trend rate of growth.

All of this could be negated, however, if European politics continued to lean towards disintegration of the EU, courtesy of national elections in the Netherlands in February but more importantly France in May and also perhaps in Italy, though as yet there has been no call for elections ahead of schedule in 2018. If Marine Le Pen were too be defeated in France, and if the Italian Five Star Movement were held at bay, there would doubtless be a huge sigh of relief, but we would have to ask whether the Euro system or the EU were really any safer if the status quo continued for much longer. If Le Pen did win, we might have to be nifty in preparing quickly for extraordinary instability as existential questions about the EU would surely be the main priority.

In the emerging world, things are definitely looking brighter for beleaguered oil and commodity producers after a dire couple of years. So we should expect improved performances in countries such as Brazil, Russia, and South Africa for as long as the rebound in prices holds. India which had ben the emerging darling, looks to be suffering the consequences of Prime Minister’s overly hasty currency reform, but provided a tricky period of change can be managed appropriately, India should do better again before long.

Beyond these immediate consequences, many emerging markets could again find instability arising this year if US interest rates and a rising US dollar drain too much capital towards the US.

China is a bit like the curate’s egg. After a terrible start to 2016, fiscal easing and still more credit creation have helped to stabilise the economy. With the important 19th Congress of the Communist Party due at the end of 2017, where Xi Jinping wants to advance key constitutional and personal goals, the government cannot afford for the economy to be other than stable. The trouble is that the consequence of credit growth of 20 per cent or more when the economy is growing by much less than half that is excess liquidity that is leaking abroad causing the authorities awkward problems in managing capital outflows and currency depreciation.

Sooner or later, China’s financial system will blow a gasket, either as capital outflows accelerate and the currency depreciates more quickly, and or as the liability structure that is supporting China’s lending boom falters. With luck, for President Xi, these things won’t happen in 2017, but you never can tell.