Rising economy and policy uncertainty

04 April 2017

Economic climate and the return of sunny days

Global political effervescence dominated markets over recent times and as a result it has managed on many occasions to diminish the impact of much of the good economic news. But despite this backdrop, the reality is that economic growth has continued to improve. In the euro area GDP has strengthened steadily in the past two years, the United States seems to be near the peak of its economic cycle while emerging markets have enjoyed growth rates on average of 4% or more. This improved GDP expansion is however largely cyclical – it is the result of monetary, and to a lesser extent, fiscal policy. Hence the recovery remains modest and further improvement will depend on more structural changes, such as those brought on by the digital economy.

The rise in populism, epitomized by the UK’s decision to leave the European Union and Donald Trump’s ascension to the White House has, as of yet, had no real economic impact. In the UK, this is largely because it has a national currency which allows it to smooth shocks in the short term.  Long term consequences of Brexit still remain largely unknown, like the arrangements with Europe or other partners that will dominate in the medium term. Besides, markets have focused on a specific part of the American programme, namely fiscal stimulus. Notably they have also deliberately ignored short term policies, such as the trade restriction with Mexico, which would put a question mark over large facets of the American manufacturing production chain.

European elections, particularly in France, raise a different question. Here market anxiety reflects fears over the possible destruction of the euro area, if right or left wing extremist parties manage to come to power. The probability of such a scenario looks small today for many diverse reasons but such a situation would have substantial consequences, as it could spread to the entire monetary union, and its impact would go well beyond economic, towards political and geo-political factors.

For many analysts, such worries have blotted out good economic news but this has begun to change as the electoral dynamics in France have started to favor Emmanuel Macron over the extremist candidates from both the left and right wing - and right now the figures are very positive, for example:

  • Quarterly GDP growth has averaged 2% since 2015 in the US, 1.8% in Europe and 4.2% in emerging economies, with Brazil and Russia now out of recession. Even growth in China remains steady.
  • Unemployment rates have declined by 13% over the past two years, 14.5% in the US and 15% in the euro area.
  • Inflation is back: US, euro area and emerging countries have inflation rates of around 2%, as they turn their back on the deflation threats of previous years.

This last point is perhaps the most important because it is fear of an environment of persistently-weak inflation that has kept downward pressure on hopes of a solid recovery. This situation was exacerbated by former US Treasury Secretary, Larry Summers’ speeches, where he warned of the threat of secular stagnation and a shallower than usual economic cycle in the US. We cannot deny that trend growth remains weak, nor that the doubts concerning the ability of modern technology to boost growth that characterised the turn of the century remain alive. Similarly, the benefits of financial deregulation and trade openness belong to the pre-crisis period.

It must also be acknowledged that European growth only kicked off after the summer of 2014, following a speech by European Central Bank President, Mario Draghi who called for, in addition to the ECB’s accommodative monetary policy, the implementation of fiscal stimulus and national structural reforms. But the impact on political officials was small and Draghi was left alone with his asset purchase programme and negative interest rates, with which he managed to drive exchange rate depreciation. The impact of these policies usually occurs a year later, which in this case happened and the process worked as all of the countries in the euro area now have growth and inflation rates of between 1% and 2%. The difference between nations mainly comes from their openness to trade, which allows them to generate more demand and thus additional growth.

The experience will only be successful if countries embrace the next big challenge - the digital economy. The analogy with information and communication technology (ICT) is striking. But countries who produce and use digital technology will see a higher boost to their growth rates. The OECD shows that not only are companies at the technological frontier already much more productive and enjoying greater growth than those further behind but also that countries which have produced and use ICT have driven their growth higher by around one percentage point of GDP, compared to those which have not done so, where expansion was 0.3ppt. Ultimately, the more agile a country is, the better able it is to restructure itself and create new avenues for businesses to begin and the more it will be able to benefit from this major change.

Growth is back, but it is boosted by cyclical economic policies, mainly monetary. But without a structural change to our economies to enable them to seize such opportunities, not only will growth remain sluggish, the shadow of normalization policies will continue to weigh on prosperity.

Key messages :

US policy in the driving seat 

  • Political risks mostly in the US again
After the Dutch elections, and as the French campaign seems to normalise, European political risk is fading
But on the other side of the Atlantic, with Obamacare repeal rejected, policy risks are on investors’ mind again
  • US Policy: focus on corporate tax reform
Four key pillars appear to be under consideration: (i) lower statutory tax rate; (ii) non-deductible interest & capex expensed upfront; (iii) switch to destination-based system with border adjustment tax; (v) cash repatriation amnesty
Border Adjusted Tax (BAT) is a pivotal part of the Corporate Tax Reform but is considered complex, protectionist and regressive. Support for BAT may not be strong enough to carry it through. Without BAT, and following failure to repeal Obamacare, the ambitious tax reform package may be curtailed in scope with the statutory tax rate reduced to only 25%.
While the scale and scope is yet to be finalised, our simulations suggest a positive impact of around 10% to earnings in a scenario where a tax reform package on the lines of the House Republican blueprint is implemented
  • Elsewhere
Growth is gaining momentum in Europe, scenarios on ECB tapering to become a focus
EM is also sailing more briskly though risks remain (NAFTA, China)