Three Sur­prises in 2017

Financial Nigeria Magazine - - Finance -

Eco­nomic pun­dits tra­di­tion­ally of­fer their (tra­di­tion­ally in­ac­cu­rate) New Year pre­dic­tions at the be­gin­ning of Jan­uary. But global con­di­tions this year are any­thing but tra­di­tional, so it seemed ap­pro­pri­ate to wait un­til US Pres­i­dent Don­ald Trump set­tled into the White House to weigh in on some of the main sur­prises that might shake up the world econ­omy and fi­nan­cial mar­kets on his watch. Judg­ing by cur­rent mar­ket move­ments and con­di­tions, the world could be caught off guard by three po­ten­tially trans­for­ma­tive devel­op­ments.

For starters, Trump’s eco­nomic poli­cies are likely to pro­duce much higher US in­ter­est rates and in­fla­tion than fi­nan­cial mar­kets ex­pect. Trump’s elec­tion has al­most cer­tainly ended the 35-year trend of dis­in­fla­tion and de­clin­ing rates that be­gan in 1981, and that has been the dom­i­nant in­flu­ence on eco­nomic con­di­tions and as­set prices world­wide. But in­vestors and pol­i­cy­mak­ers don’t be­lieve it yet. The US Fed­eral Re­serve Board’s pub­lished fore­casts sug­gest only three quar­ter-point rate hikes this year, and fu­tures mar­kets have priced in just two such moves.

As Trump launches his poli­cies, how­ever, the Fed is likely to tighten its mon­e­tary pol­icy more than it had planned be­fore the in­au­gu­ra­tion, not less, as the mar­kets still ex­pect. More im­por­tant, as Trump’s poli­cies boost both real eco­nomic ac­tiv­ity and in­fla­tion, long-term in­ter­est rates, which in­flu­ence the world econ­omy more than the overnight rates set by central banks, are likely to rise steeply.

The ra­tio­nale for this sce­nario is straight­for­ward. Trump’s tax and spend­ing plans will sharply re­verse the bud­get con­sol­i­da­tion en­forced by Congress on Barack Obama’s ad­min­is­tra­tion, and house­hold bor­row­ing will ex­pand dra­mat­i­cally if Trump ful­fills his promise to re­verse the bank reg­u­la­tions im­posed af­ter the 2008 fi­nan­cial cri­sis. As all this ex­tra stim­u­lus fu­els an econ­omy al­ready near­ing full em­ploy­ment, in­fla­tion seems bound to ac­cel­er­ate, with pro­tec­tion­ist trade tar­iffs and a pos­si­ble “bor­der tax” rais­ing prices even more for im­ported goods.

The only un­cer­tainty is how mon­e­tary pol­icy will re­spond to this “Trumpfla­tion.” But whether the Fed tries to coun­ter­act it by rais­ing in­ter­est rates more ag­gres­sively than its cur­rent fore­casts im­ply, or de­cides to move cau­tiously, keep­ing short-term in­ter­est rates well be­hind the ris­ing curve of price growth, bond in­vestors will suf­fer. As a re­sult, yields on ten-year US bonds could jump from 2.5% to 3.5% or more in the year ahead – and ul­ti­mately much higher.

In Europe and Ja­pan, by con­trast, mon­e­tary con­di­tions will re­main loose, as central banks con­tinue to sup­port eco­nomic growth with zero in­ter­est rates and quan­ti­ta­tive eas­ing (QE). And this pol­icy di­ver­gence sug­gests a sec­ond po­ten­tial shock for which fi­nan­cial mar­kets seem un­pre­pared.

The US dol­lar could strengthen much fur­ther, es­pe­cially against emerg­ing-mar­ket cur­ren­cies, de­spite Trump’s stated de­sire to boost US ex­ports. The cat­a­lyst for ex­chang­er­ate ap­pre­ci­a­tion would be not only higher US in­ter­est rates, but also a dol­lar squeeze in emerg­ing mar­kets, where for­eign debts have in­creased by $3 tril­lion since 2010. A con­flu­ence of dol­lar strength and ex­ces­sive for­eign bor­row­ing caused the debt crises in Latin Amer­ica and Asia in the 1980s and 1990s. This time, Trump’s pro­tec­tion­ism could make mat­ters even worse, es­pe­cially for coun­tries such as Mex­ico and Turkey, which have based their de­vel­op­ment strate­gies on rapidly ex­pand­ing ex­ports and have fi­nanced do­mes­tic busi­ness ac­tiv­ity with dol­lar debts.

So much for the bad news. For­tu­nately, a third ma­jor de­vel­op­ment that is not priced into fi­nan­cial mar­kets could be more fa­vor­able for global eco­nomic con­di­tions: the Euro­pean Union – an even more im­por­tant mar­ket than the US for al­most every trad­ing coun­try apart from Mex­ico and Canada – could do much bet­ter than ex­pected in 2017.

Eco­nomic in­di­ca­tors be­gan to im­prove rapidly in most EU coun­tries from early 2015, when the Euro­pean Central Bank stopped the frag­men­ta­tion of the euro­zone by launch­ing a bond-buy­ing pro­gram even big­ger than the QE pi­o­neered by the Fed. But this eco­nomic re­cov­ery was over­whelmed last year by fears of po­lit­i­cal dis­in­te­gra­tion. With the Nether­lands, France, Ger­many, and Italy all fac­ing pop­ulist in­sur­gen­cies – and at least the first three hold­ing elec­tions this year – the Brexit and Trump shocks have nat­u­rally pro­voked anx­i­ety that the next domino to fall will be one of these EU found­ing mem­bers, fol­lowed per­haps by the en­tire EU.

These ex­pec­ta­tions cre­ate the pos­si­bil­ity of the big­gest sur­prise of 2017: in­stead of dis­in­te­grat­ing, the EU sta­bi­lizes, fa­cil­i­tat­ing an eco­nomic re­bound and a pe­riod of strong fi­nan­cial per­for­mance sim­i­lar to the US “Goldilocks pe­riod” from 2010 to 2014, when the econ­omy re­cov­ered at a pace that was nei­ther too hot nor too cold. The key event will be France’s pres­i­den­tial elec­tion, which will most likely be de­cided in a sec­ond-round runoff on May 7. If ei­ther François Fil­lon or Em­manuel Macron wins, France will em­bark on an eco­nomic re­form process com­pa­ra­ble to Ger­many’s in 2003, un­der­taken by thenChan­cel­lor Ger­hard Schroeder.

Even a mild fore­taste of such re­forms would en­cour­age a re­lax­ation of the aus­ter­ity terms de­manded by the new Ger­man gov­ern­ment that emerges from the gen­eral elec­tion there on Septem­ber 24. A more co­op­er­a­tive and con­struc­tive Fran­coGer­man re­la­tion­ship would, in turn, erode sup­port for the pop­ulist Five Star Move­ment in Italy.

The risk to this be­nign sce­nario is, of course, that Marine Le Pen wins in France. In that case, a breakup of the EU will be­come a re­al­is­tic prospect, trig­ger­ing panic in Euro­pean fi­nan­cial mar­kets and economies. Every opin­ion poll and se­ri­ous anal­y­sis of French pol­i­tics in­di­cates that Pres­i­dent Le Pen is an im­pos­si­ble fan­tasy. But isn’t that what every opin­ion poll and se­ri­ous anal­y­sis of US pol­i­tics in­di­cated last year about Pres­i­dent Trump?

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