The global economic environment and corporate profits remain in a strong position and economic growth in 2018 will run at its fastest pace since 2011.
It’s too early to fear a significant lift in global interest rates. Central banks in Europe and Japan will keep interest rates unchanged in 2018. US rate hikes will continue.
Inflation is likely to lift – especially in the US. Watch for upside inflation risks this year.
Political risks are important to monitor – especially in the US and the Eurozone.
The global economy remains in a strong position this year and is poised to grow at its fastest pace since 2011. Synchronisation of growth across countries has enabled a more sustainable global growth recovery. We expect world growth to lift to 3.9% in 2018 (vs 3.7% in 2017). As 2018 begins, global business conditions (as indicated by manufacturing PMI indices) continue to sit at around record high levels (see chart below) which is good news for the outlook.
Despite the numerous positive signals for the growth outlook, there are also reasons to be cautious. Central banks around the world are slowly becoming more hawkish. Will there be a stronger push to raise interest rates across more countries in 2018 and how will this impact the growth outlook? Given that economic conditions are already so positive, how much more upside is there for the global economy over the near term? And what are the key risks to watch for this year that could deter the outlook? We answer these questions in this Econosights note.
Which regions will be driving growth?
In 2018, the major developed economies will be growing above their potential (similarly to 2017) with manufacturing conditions in developed markets outpacing emerging nations (see chart below).
Our forecasts for world growth and inflation are listed below, with numerous economies running above potential this year:
The upturn in developed markets was initially driven by the rebound of the US economy. Above-potential US GDP growth will be maintained in 2018. Consumer trends still look strong and corporate balance sheets are in a good position, with the drop in the corporate tax rate and business investment likely to add further upside to corporate profits and sentiment.
But, it’s not just a US story. Eurozone activity is running above its potential, with convergence in growth across countries. Central bank support, a stronger global economy and structural reforms in product and labour markets implemented in individual Eurozone economies have all assisted in lifting growth, productivity and competitiveness in the Eurozone.
Emerging market growth is reliant on the Chinese economy. The outlook for China is still stable for 2018 and recent data has been supportive of these solid conditions. The key challenges for the Chinese economy are around managing firms that are highly leveraged and that have excess capacity. Watching the US dollar (USD) is also important because emerging markets in Asia are sensitive to USD changes because of large USD-denominated debt, so a noticeably stronger US currency would be negative for emerging market growth.
Will major central banks raise interest rates soon?
The US Federal Reserve continued lifting interest rates in 2017 but rate hikes are only occurring at a steady pace, keeping borrowing and investing conditions positive. Overall, global monetary conditions remain easy, with European and Japanese central banks still embarking on monetary stimulus programs.
The European Central Bank has been slowly reducing its overall asset-purchase program and will keep buying assets at €30bn/month until September 2018. Towards the end of 2018, the Eurozone economy and core inflation are expected to be strong enough to justify an end to asset purchases. But, actual monetary tightening (interest rate hikes) are not expected to occur until 2019.
The Bank of Japan is expected to maintain its current monetary policy program of negative interest rates and yield control until core inflation is well above zero (currently at 0.3% over the year).
The risk around central banks is if they move too fast to normalise monetary conditions as growth improves which would have negative consequences on growth and inflation.
Can profit growth improve from here?
Global earnings soared in 2017, following a very weak 2016 (partly related to the oil price slump). The profit outlook remains positive over the near-term (see chart below). Corporate balance sheets look healthy, particularly in the US, with the strength in the global economy supporting corporate expansion and growth.
The profit outlook in Europe and Japan is beating Australian profit guidance for 2018. The US profit outlook also looks strong, boosted by the corporate tax rate cut.
Risks – watch capex as an upside risk for 2018
The global capex cycle is finally turning higher in the advanced economies (see chart below), which is expected towards the late stage of a cyclical recovery. An improvement in capital expenditure is a welcome driver for broader GDP growth.
Risks – an upside inflation surprise
Inflation is likely to rise across developed markets as growth improves and spare capacity (particularly in the labour market) is used up. Commodity prices are holding up and will add to headline prices. While core inflation trends are a bit softer, our positive outlook on growth in 2018 means that we see the risks of inflation lifting higher than currently expected – particularly in the US.
Risks – more political risks this year?
Political risks will be more prominent in 2018 compared to 2017, particularly in the Eurozone. Italian elections in March could cause a messy outcome because of a highly fragmented electoral backdrop that increases the risk of an ineffective minority government. The Italian Euroskeptic parties have not recently been campaigning for an Italian exit from the Eurozone, which has significantly diminished this risk. But a fragmented government is not positive for the Italian economy or for integrated Eurozone reform. More can be done to improve Eurozone growth. In 2018, the focus from policymakers will be on strengthening the banking union in the Eurozone.
2017 did not see a more protectionist US economy, but this risk still looms. President Trump could adopt a more protectionist rhetoric to relations and dealings with China. There will also be ongoing uncertainty about North Korean and US relations.
Implications for investors
Our positive view on global growth and earnings means that growth assets should perform well in 2018. We favour European and Japanese equities, relative to the US. While the medium-term outlook is positive for risk assets, the odds of a near-term market correction are high given the run-up in markets.
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