In this, our base case scenario, we see the global economy continuing to enjoy steady growth with modest inflation. The gradual withdrawal of monetary accommodation in the form of higher interest rates and reduced quantitative easing (QE) is a headwind. Yet muted inflation pressures and flexible markets mean that this is likely to be a gentle breeze rather than a disruptive gale.
Europe moves from laggard to leader in the global growth race
For this scenario to be achieved, Europe must take over the lead in world growth. The U.S. has grown by a little over 2% annually, since the end of the Global Financial Crisis. But even this modest pace of expansion has involved a reduction in unemployment of close to six percentage points. Unemployment cannot fall much further and even with a pick-up in productivity, growth in the U.S. is likely to be lower in the next five years than it has been in the last eight. By contrast, Europe has ample spare capacity and can enjoy several years of above-trend growth without hitting the labor supply buffer.
Politics has been a key influence on Europe’s economy. A year ago, a series of political events loomed large in continental Europe, with confidence having been shaken by the recent Brexit vote in the UK. The UK remains mired in Brexit-related uncertainty but challenges in the rest of Europe were resolved in a market-friendly manner and the European project seemed firmly back on track. More recently, the German elections, which saw the right-wing nationalist Alternative for Germany (AfD) party sweep into the Bundestag, followed in Spain by the move to declare independence in Catalonia, suggest that the pendulum may be beginning to swing back the other way. Italy’s general elections must take place by May 2018; were the Five Star Movement to gain an overall majority, their anti-Europe stance could provoke a crisis. Although they have been moderating their views of late, they are unlikely to win an overall majority, particularly given the new electoral system.
Most peripheral eurozone countries, facing the challenges posed by European Central Bank (ECB) tapering, can respond by reducing the maturity of their new issuance. However, in the case of Italy, many of the long-term fundamentals are positive: it has a primary fiscal surplus, a wealthy private sector and a current account surplus of 2% of gross domestic product (GDP). What Italy and the other peripheral countries desperately need is sustained economic growth. Recent data and the financial environment suggests that is exactly what they are likely to get. Europe’s cyclical recovery is a key component of our relatively optimistic base case.
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The European Union may chart a different course without the UK
The UK is struggling as it adjusts to the reality of Brexit preparations and the markets’ focus has been on the immediate political and economic woes facing the UK. Yet Brexit has major implications for the balance of power within the remaining 27 countries in the Union. As one of the ‘big three’, the UK was a significant counterweight to the federalist, corporatist tendencies which characterize the founder members. The UK often led the way in international trade talks and was a prime mover behind the single market. Post Brexit, the EU may push hard towards further integration. Freedom within its borders would be maintained but a response to the rise in populism is likely to see increased barriers to migration from outside.
The ECB, like the U.S. Federal Reserve, has more than tripled its balance sheet through QE. This has been a successful strategy, and looks set to continue at a reduced pace. It is anticipated that Europe may have a slow exit from QE but this is not without risk as there are signs of core inflation picking up and fiscal policy may be turning pro-cyclical. Re-investment of existing holdings and dovish forward guidance from the ECB regarding tightening will aim to minimize market nerves.
Emerging economies to continue to recover
Emerging economies also have the capacity to grow more rapidly. But trend growth in China is slowing. Labor supply has peaked and is set to decline; China has reached maturity in this respect particularly quickly as a result of their ‘one child’ policy. Productivity has also been falling – following the path previously trodden by other Asian ‘growth miracle’ stories. The era of 8% annual economic growth is over and we expect to see annual Chinese growth settle down to a 5% pace over the next five years.
China also faces a major challenge in tackling corporate credit growth, which has been excessive and often misallocated. Much of the problem stems from loss-making, state-owned enterprises kept afloat by state-owned banks, encouraged by provincial governments keen to protect jobs. Many of these same indebted companies are responsible for pollution, another key challenge for the authorities. The central government is fully aware of the problem and has taken measures in response but whenever the economy has slowed, the credit spigot has been opened again and the economy duly responds. But each additional dose of credit seems to induce a diminishing amount of extra growth.
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Having said all this, we don’t believe that a hard landing is in store for China. Companies continue to expand and are moving up the value chain, and growth, now less focused on the congested ‘tier one’ cities, is spreading out more broadly.
India too faces many challenges, with demonetization and the introduction of a goods and services tax having led to a significant economic slowdown. But the slowdown is likely to be temporary and these plus other reforms should deliver long-term benefits. We are positive about the long-term outlook for India.
Canada’s growth spurt unlikely to endure
Canada grew by 3.7% over the last year, producing the biggest upside growth surprise among OECD countries, moving from the bottom of the list a year ago. This can be attributed to a number of temporary one-off factors including a strong come back from the wild fires in Alberta and fiscal changes giving a one-off stimulus. Expectations for the coming year are more modest at 2% growth.
Japan fights deflation and demographics
Japan’s continued recovery has been driven by net exports but domestic demand has also been firm of late, making this the third longest expansion post-war (56 months and counting – in October 2017). The impact of Japan’s declining population of working age has been muted by increased participation by women, a trend we expect to continue. The Bank of Japan has repeatedly failed to achieve its 2% inflation target but it cannot be faulted for lack of effort as it continues to pursue an aggressive and extensive QE program. Inflation may be below target but it is above zero and the threat of a return to deflation has receded.
What of the prospects for companies and importantly, the profits they make? Currently, profits are well above historical averages and although some analysts and investors fear that a substantial decline is imminent, we disagree. We believe that the near-term outlook for profits is good given the positive economic background and there are several factors which should support profits in the longer term, including:
- Low interest rates meaning it is relatively cheap to secure finance and service debt (even given likely rate hikes).
- Corporate taxes are low and, in countries like the United States and France, are heading lower.
- Labor power is weak.
- Monopolistic conditions prevail in many sectors with barriers to entry that allow companies to maintain margins.
Political change and uncertainty
The rise of populism that we saw last year has made world leaders attentive to the needs of their voters and sensitive to the impact of unexpected influences. Leaders are implementing domestic reforms and targeting improvements in corporate governance, tax and international trade.
In the U.S., President Trump remains a wild card and while his policies are typically fairly conservative, he is not always predictable and may change course on a whim. We are seeing that he is finding the implementation of some of his election promises a challenge; however, his current focus is on his tax plan, and we believe that here he may eventually be successful. He remains conspicuous and outspoken in his protectionist stance regarding various international trade agreements as well as in his hard-line defense rhetoric.
In October 2017 at the 19th National Congress of the Communist Party of China, President Xi Jinping, one of the most powerful Chinese leaders since Deng Xiaoping, has further consolidated his authority, establishing his agenda for the coming five years of power. His goal appears to be to secure the Communist Party legacy and continued stability in China. Xi wants to be a “Moderniser” rather than a “Reformer”, casting himself as a “Davos Man”, in contrast to Trump, on the world stage. To do this he needs to push through domestic market reforms that do not conflict with Party control and so avoid a ‘stalled transition’ as China moves from being perceived as a low value manufacturer to becoming a preferred producer for high value-added sectors and global brands. The focus is less on the quantity of economic growth and more on the quality, with a reduction in pollution a key goal. In our base case scenario, we believe that his conflicted reform agenda will face significant headwinds in the medium term (3+ years) as industrial policies will test the limits of political and economic sustainability.
In Japan, Prime Minister Abe called a snap election in October 2017 to take advantage of his higher opinion poll rating and has secured a stronger mandate. Recent years have seen him oversee the implementation of a number of structural reforms spanning corporate governance and tax, so called ’womenomics’, boosting in-bound tourism, trade liberalization, agriculture reforms, foreign workers and electricity deregulation. Corporate governance is also being transformed, with greater involvement of independent directors and accountability. Industry consolidation is occurring which is likely to lead to better returns moving forward. Domestic tax reforms have seen the introduction in 2016 of the first Japanese tax-payer ID system targeting the many individuals who used to evade paying tax as well as the 70% of Japanese firms who also paid no income tax by shifting the basis of taxation from profits to revenues and capital. While enforcement is still weak, it is felt to be moving slowly in the right direction.
We have already discussed the political changes in Europe, with the German election result certainly presenting Angela Merkel with challenges. She will likely end up forming a ‘Jamaica’ coalition, named for the party colors of the Christian Democratic Union (black), Free Democratic Party (yellow) and the Greens. Yet these parties have conflicting positions on issues ranging from eurozone integration and immigration, to the economy and the environment. It remains to be seen how the Franco-German alliance develops. President Macron is unlikely to achieve his goal of a European Finance Ministry with a budget designed to redistribute funds from rich countries to poor. Chancellor Merkel is likely to push for a strengthened European Stability Mechanism with powers to curtail imprudent financial policies in the periphery, a European version of the International Monetary Fund (IMF). Further measures to free up markets and deepen integration are necessary if Europe is to avoid a repeat of their recent problems.
Demographic headaches: might robots ease the pain?
There is a common trend across developed markets regarding the demographic profile of their labor markets. Baby boomers, the most experienced labor group, are retiring, contracting the talent pool and in turn putting pressure on wages and production costs. Japan is seen to be the first developed market to get close to full employment, with 50% more jobs than Japanese seeking work (industry average).
As a consequence, they have been exploring various solutions, and seeing some success in addressing the attrition rate, especially through initiatives aimed at encouraging women back to work. There is a higher proportion of women in the workforce in Japan than in the U.S. They are typically in part-time roles (70% are held by women), with part-timers now accounting for 40% of Japan’s total workforce.
Developments in robotics and artificial intelligence are seen as one of the main solutions to this problem, although in some markets there is a worry that this will lead to more problems as we disenfranchise untrained workers. Governments remain sensitive to this impact as it links to the rise in populism, driven by concerns regarding quality of life and wage inequality.
Japan is embracing technology versus the other developed markets who have some concerns regarding low-paid and unqualified workers. It is also anticipated that some Japanese companies would be beneficiaries of this phenomenon, providing components for the machines and equipment.
We are also seeing that China has committed to this ‘robot race’, investing very heavily in robotics, artificial intelligence and quantum computing projects at a high cost, without necessarily determining the true value of the businesses and without the benefits of a free economy efficiency to hone the business proposals. However, China cannot afford this level of waste and inefficient allocation of resources indefinitely and we believe this overinvestment will be a core issue when political constraints become more urgent.
Monopoly power is growing within the corporate sector
There is growing evidence that companies are enjoying super-normal profits as a result of their monopoly positions. We are seeing a significant increase in concentration in some industries and that is a possible concern. The ‘disruptors’ of the past are becoming the new, controlling companies as they secure market share, possibly abusing their status by restricting output and limiting investment.
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Global connectivity feels like a good thing when everyone is going in the same direction but this level of interconnectivity is a worry to us in this scenario, when paces of growth could differ significantly or change direction, exaggerating any gap.
In the question of whether China is ready to take global leadership from the U.S. it is felt that, while the U.S. does not want to give up their position, equally China is not quite ready yet to assume the role, preferring to address a domestic agenda for a while longer. Instead it looks as though we could be heading towards rival centers of power.
Similarly, China has limited its participation in the process of global financial integration because of its closed capital account, but that may change gradually as China “liberates” capital flows. The internationalization of the renminbi is seen to be a strategic priority, however, there will be more volatility as it transitions to become a more global currency.
Energy for change
The world energy market is undergoing dramatic change and in our base case scenario we see continued adoption of electric vehicles with spectacular growth in batteries, providing that both their weight and price continue to decline. Beyond transportation, batteries could play a key role in centralized energy storage, allowing the grid to take on a greater proportion of supply from renewables, many of which are inconsistent sources, and at the decentralized level.
Protectionism: a growing threat
As we’ve discussed, the flip side of global connectivity is the desire to remain protective of domestic industries. World leaders have a strong domestic agenda to be supported and managed.
As a major partner (both as consumer and supplier) in global trade, the voice of America is amplified and Donald Trump is very vocal in his aggressive determination to put ‘America first’, with particular focus on the country’s deficit of exports relative to imports. He has made some controversial decisions, for example, withdrawing the United States from the Paris Agreement on climate change and threatening to tear up the North American Free Trade Agreement (‘NAFTA’) with Canada and Mexico.
NAFTA trade accounts for 39% of Canada’s GDP and 49% of Mexico‘s, but just 5% in the case of the United States, the world’s largest economy. Both Canada and Mexico sell more than three-quarters of their exported goods to the United States. Canada’s Liberal leader, Justin Trudeau, is seeking some resolution with Trump regarding the U.S.’s protectionist trade demands that are threatening the NAFTA talks, following the U.S. decision to impose punitive duties on Bombardier jets and disputes around softwood lumber and recently Canadian dairy supply management policies.
Ultimately, however, we believe in our base case scenario that despite Trump’s rhetoric the impact will be limited. In the Asia Pacific region, China is a dominant player, and it is likely to dominate further, although it is a crowded region, and it may not be that simple as other countries such as India and Japan strengthen their own alliances and independence.
In Europe, as the reality of Brexit comes closer, we are seeing some spite entering into negotiations between the politicians, which is creating uncertainty regarding what will ultimately be determined. We believe in our base case scenario that any trade deal will be weaker than the current arrangements under the single market. It will take some time for the UK to adjust to its future outside the EU.
Without doubt, the next five years are not necessarily all going to be plain sailing for the global economy and we need to consider the issues that could be challenging and disruptive.
The problem of North Korea
There are a number of geopolitical risks in the Pacific area. Top of the list is the threatening behavior of North Korea and the impact it is having, bringing Japan, U.S. and China into an uneasy coalition.
We believe that despite all the uncertainty, the chances of a catastrophic outcome are very low. China’s involvement is a key factor. No one wants a war in the region. At present, it seems as though Trump and Kim Jong-un are sprinting to gain maximum leverage. Kim Jong-un wants nuclear missiles at the heart of his regime’s arsenal and the only way to keep the U.S. and South Korea off his territory. Trump in turn wants the North Korean leader’s eventual removal as he is a threat to stability in the region. It is a test of U.S. and China relations, as the U.S. increasingly pressurizes China to push North Korean trade sanctions. China is increasingly unhappy with North Korea and does not want volatility in the region. In a major initiative, President Xi has proposed that North Korea and the U.S. both limit their military activities, the so-called ‘freeze-freeze’ plan. The immediate reaction of the U.S. towards the plan has been cool but if progress is made in this area, it could allow the resumption of talks.
Japan, meanwhile, is leveraging the threat to push on their own defense agenda. This requires a national referendum to allow a change to their constitution enabling them to develop their own nuclear program. This in turn would deliver a lift to their spending and give some further stimulus to their economy.
Disputes around islands in the Pacific and South and East China Seas remain a source of tension, but we believe that diplomatic solutions will be sought rather than warfare.
Middle East troubles continue to rumble on, but the declining dependence of the U.S. on oil from the region is changing the dynamic into a more regional and less global conflict.
Fears of U.S. recession
As the major economy most advanced on its economic recovery, fears of recession focus on the U.S. But recoveries do not die of old age. There are several leading indicators of recession that are worth considering. Some note that a rise in the unemployment rate of 0.5 percentage points has always been followed by recession but that begs the question of what caused the increase. At any rate, unemployment is at present on a firm declining trend and economic fundamentals do not point to any change. Another warning sign would be a sharp decline in overall corporate profitability. Once again, we see this risk as limited. Finally, there is the risk of excessive tightening by the U.S. Federal Reserve. This risk would rise if inflation were to increase markedly above the Federal Reserve’s 2% target. As we discuss in the “back to basics” explanation, inflation pressures are likely to build only gradually and with the Federal Reserve tightening strategy well underway, there seems little risk of their falling behind the curve. Over a five-year horizon, the risk of recession is always there but that threat seems to us neither heightened nor imminent. For the rest of the world, where capacity constraints are less severe, the risk of recession seems even less.
Better conversations. Better outcomes. podcast
Looking ahead: 2018 Five-Year Outlook
Jon Adams, Senior Investment Strategist & Portfolio Manager at BMO Global Asset Management, joins our latest episode of the Better conversations. Better outcomes. podcast to discuss the importance of the forum, the three scenarios that could drive markets in the next five years and what each could mean for investors and portfolio positioning.
Additional scenarios and investment implications
View the investment implications on equities, fixed income, alternatives and currencies for all three of our scenarios in our over- and under-emphasis table.
Our downside scenario, where we are concerned that there will be policy errors that could start the chain reaction that leads the U.S. and then the rest of the world into a recession.
Our upside scenario takes a look at what happens when the policies all go according to plan and the policymakers get it right.