2017 Macroeconomic Outlook
FOR SOPHISTICATED INVESTORS ONLY
By Chris Rands, Portfolio Manager, Fixed Income - 7 February 2017
Global Outlook: A break from ultra-easy policy
The major theme influencing fixed income markets over the past two years has been perceived disinflationary forces leading to aggressive monetary policy in Europe and Japan. With the stabilisation of commodity prices, particularly oil, inflationary forces should be seen through the first half of 2017, which could potentially lead to a pause in easy policy around the globe.
Commodities performed strongly during 2016, with oil rising from around $35 a barrel to over $50 a barrel by year end. While this is still well below the $100 a barrel in 2014, this relatively strong price rise should be reflected in headline inflation over the first three months of the year. This has already begun in the United States, where headline inflation rose steadily through 2016 to peak at 2.1 per cent in December, while core inflation was consistently above 2 per cent. This means that US inflation is now above the US Federal Reserve’s 2 per cent target, marking the end of a 28-month stretch below it. This should give the Fed a greater chance of raising the cash rate in 2017, as the dual mandate of full employment and inflation becomes closer to being achieved.
Chart 1: Headline inflation is rising
Similarly in Europe, signs of inflation are beginning to show after two years of close to deflationary outcomes. In December, Eurozone inflation rose to 1.1 per cent y.o.y, after spending 38 months below 1 per cent. While the European Central Bank President Mario Draghi recently expressed that he thought these signs of inflation were transitory, the differential between German inflation and the rest of the Eurozone may begin to cause tensions, and raise serious questions on the viability of quantitative easing.
Chart 2: Inflation differential in Europe
At the end of 2016, German inflation rose to 1.7% y.o.y, with core inflation rising to 1.6%, which is above the inflation rates of France (0.6%), Italy (0.5%), Spain (1.6%) and Portugal (0.9%). Over the past 15 years, Germany has rarely had inflation above 2%, with its rate below the average of its peers. If Germany does not believe that inflation is transitory and requires tighter monetary policy, this could pose problems for quantitative easing in Europe. Evidence of Germany’s response to transitory prices previously can be seen in both 2011, when interest rates were increased, and also with the timing of the quantitative easing announced in January 2015, which happened to coincide with the low point of German inflation at -0.3%. Any rising inflation tensions between the European Central Bank and Germany could introduce questions over how appropriate a negative interest rate policy is, and how much support the ECB should provide through quantitative easing. This will come at a time when Germany’s economy is in stark contrast to that of Italy and Greece, which undoubtedly need easy monetary policy due to their weak economic growth. This is one issue that could continue to undermine the cohesion of the Eurozone.
Chart 3: Higher inflation in Germany
Rising inflation rates in Germany and the United States sets the stage for ultra-easy monetary policy to be either unwound or put on hold. In the short term, the positive price momentum and economic performance should continue into Q1 2017, as the Purchasing Managers’ Index (PMI) and Small Business Optimism Index improve. If the ECB reduces quantitative easing, the Eurozone and global economy will need to be closely monitored in the second half of the year, as tighter monetary policy and higher interest rates should slow the already fragile peripheral European economies. Over the past eight years, tighter monetary policy has typically resulted in slower economic performance much faster than central bankers expected, and there is a good chance that this could happen again.
Australian Outlook – Commodities drag to slow
The Australian macroeconomic outlook should see a change in two trends that have been in place for the past four years, culminating in a continued slow but robust growth environment. These trends include a slowdown of the residential construction sector, after being supported by lower interest rates, and an improvement in the commodity sector, given prices rebounded through 2016.
Over the past four years, the Australian economy has benefited from a residential construction boom that has been spurred on by continually lower interest rates. The recent concerns over the supply of apartments in state capital cities has coincided with a slowdown of building approvals from historically high levels, particularly for apartments. Since building approvals are a lagging indicator, this will set the stage for a slowdown in construction in the second half of 2017, removing one of the key tailwinds that has been behind the Australian economy since 2011.
Chart 4: Building approvals are slowing
On the flip side, commodities should provide some benefit to the Australian economy after falling during 2014 and 2015. Higher commodity prices will benefit the economy through improved corporate profits and higher wages, as Gross National Income rebounds.
This can be seen through the terms of trade, which has recovered very strongly through the end of 2016, after deteriorating over a number of years. Given the large amount of commodity production, the rise in iron ore should be a welcome respite at a time where residential construction should begin to slow.
Chart 5: A significant improvement in our terms of trade
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