An economic déjà-vu?
The answer to the question: “Where are we in the global economic cycle?” has almost become self-evident.
The world economy follows a classic economic cycle: it has now reached the expansion phase, after exiting a recovery mode, which was initiated by a credit-fueled stimulus in China in 2016 and the announcement of an ambitious tax cut program in the US in 2017.
The World economy is now expected to approach the peak of this current cycle, before slowing down from 2019 onward.
Yet timing till the peak differs across regions: we forecast one more year to go for the US, whose GDP growth should accelerate to +2.9% in 2018 as President Trump administration’s fiscal plan further stimulates the economy; the Eurozone is likely to register at least two more years of sound growth before decelerating more significantly (+2.3% in 2018 after +2.5% in 2017, and +2.0% in 2019), providing a unique window of opportunity to reform while surfing the ongoing momentum.
As for China, it is already handling its “soft landing”, with growth projected to decelerate from +6.9% in 2017 to +6.5% in 2018 and +6.2% in 2019.
What about companies?
They are reaping the benefits of this strong economic phase of the cycle.
Robust volume growth and better pricing power inflate turnovers. Companies are also able to continue strengthening their cash buffers.
Business insolvencies remain in check.They fall in Western Europe (-3%), Central and Eastern Europe (-3%) and North America (-2%), decelerate in Latin America (+2%).Asia Pacific significantly increases (+31%) due to forceful cleaning of ‘zombie’ companies in China.
Table 1 Key Euler Hermes/Allianz Research assumptions and forecasts for 2018 and 2019
How are politics factored into the equation? 2018 should not be short of political hurdles, with important milestones ahead: Brexit negotiations with the EU, NAFTA (North American Free Trade Agreement) renegotiation and mid-term elections in the US make the top of the list. Yet our baseline scenario does not consider a full-fledged crisis from the identified political obstacles, whether it could be the trade games between US and China, the tensions between US and Iran or a US withdrawal from NAFTA.
Table 2 Real GDP growth forecasts and revisions since last quarter
Getting tense in a late phase of the cycle increases risks
Late growth cycles coincide with increasing economic and financial tensions.
First, global liquidity is expected to progressively tighten, justifying the upcoming deceleration of growth forecasted in 2019. Monetary and financial conditions reflect the ease of getting credit and funding; after the 2008-2009 crisis, they significantly eased as a result of unconventional monetary policies. An announced global tapering – of the Federal Reserve (Fed), then European Central Bank (ECB) – would hence gradually tighten global financial conditions. We already see that the growth of money supply (M2) has significantly decelerated in the US, opening the way for other developed economies.
As a result of this, interest rates will increase steadily but slowly, in a context where inflation will be stable in the Eurozone (+1.5% in 2018) but accelerate in the US (+2.3%). Two more Fed hikes are expected in 2018 and two other in 2019. The ECB is expected to reduce the pace of its monthly asset purchases to EUR15bn between October 2018 and January 2019, and continue reinvesting the principals from the maturing bonds until at least 2020. A first rate hike by the ECB is not expected before Q3 2019. Alongside monetary policy normalizations, further bouts of market volatility are expected, similar to the ones witnessed late February.
Separately, tensions are arising from a trade war, or more precisely a trade game, between the US and China. In spite of the protectionist rhetoric, trade accelerated in 2017 (+9.3% in value terms, +4.8% in volume i.e. correcting for price and currency movements). We expect a scenario of mild protectionism in 2018. By the end of 2018, global trade will have recovered the USD2tn in value terms it had lost between 2015 and 2016. The slight deceleration of trade expected this year to +8.4% in value terms and +4.4% in volume terms, should prolong over 2019. Price effects should abate, with value and volume growth converging.
New types of risks make this cycle unique
Will economic history stutter? Not exactly. New risks have emerged; they have become distinctive features of our current economic cycle, the second longest since World War II.
First, fragmentation in financial markets has increased; blame it on a patchy financial architecture. Disintermediation did not spare the financial sector: new actors have taken excessive risks as they were not as regulated as traditional financial institutions.
New risks have also emerged in the real economy. Governments, companies and households have growingly and disproportionately relied on debt. Growth has become more credit intensive, hence more sensitive to interest rates fluctuations. We use a measure of credit intensity (units of additional credit needed to generate one additional unit ofnominal GDP, see Chart 1); compared to 2011, it has increased inFrance (4.8) Japan (4.3), China (3.1), and Brazil (2.0) and remains above 1 in the US (1.6). As a consequence, any shock on interest rates will spread to the real economy.
Another distinctive feature of the current cycle is the prominent role of China. An innovative policy toolbox makes China heterodox by European or US standards. As it carefully manages its “soft landing”, gradually opens its financial account and extends its influence, China could be the next stabilizer rather than the country from which the crisis originates. However, there are still persisting risks of a disorderly adjustment if the reining in policy targeting credit starts to impact domestic and global demand too severely.
One question then remains: where will the next crisis come from this time? Think data privacy and security; what if a confidence crisis arose from a massive data breach, and targeted Tech giants rather than actors in financial services? The likelihood of such an event rises every day.
Chart 1 Credit intensity (units of additional credit needed to generate 1 additional unit of nominal GDP)
Country risk in line with the economic cycle
Over the past years, country risk has broadly developed in line with the global business cycle. In 2015, the net change in our Country Ratings (upgrades minus downgrades) was -8, followed by -2 in 2016 (see Chart 2).
As global growth picked up to +3.2% in 2017, country risk reversed its trend and clearly improved, posting a net upgrade of +5. The uptrend continued in Q1 2018 with a net change of +2.
The cyclicality in the overall Country Ratings was mostly driven by changes in our Short-Term (ST) Rating – which shifted from net downgrades of -2 in 2016 to net upgrades of +2 in 2017 – and here in many cases reflecting changes in the CRI (Cyclical Risk Indicator) sub-component which is determined by trends in real GDP growth and insolvencies.
Our less volatile Medium-Term (MT) Rating was balanced in 2017, after net downgrades of -3 in 2016, and recorded one downgrade in Q1 2018. In a typical late phase of the cycle, some downgrades reflect a risk of overheating.
The early stage of the recovery in most of the emerging markets feed into further country rating upgrades
Advanced Economies (AE) have been ahead in the country risk cycle, with 2 upgrades in 2015 and 5 in 2016. It entirely reflects Eurozone’s recovery, embodied by a progressive decline of fiscal deficits among other improving fundamentals. Looking ahead, we expect a few more upgrades in 2018-2019. However, increasing protectionist tendencies pose a downside risk to our scenario.
Emerging Europe has followed the AE in the country risk cycle with a lag of one year or so. Following -1 net downgrade in 2015, the region registered +3 net upgrades in both 2016 and 2017, as robust domestic demand and rising exports resulted in strong regional growth. In Q1 2018, Eastern Europe registered one upgrade and one downgrade. Russia was upgraded from C4 to C3, thanks to the end of the recession in 2017, the stabilization of the RUB, which led to record low inflation, a narrowing of the fiscal deficit and an export’s recovery.
Concerns about continued and stepped-up Western sanctions are well reflected in the C3 rating. Romania was downgraded from B1 to B2 due to mounting overheating concerns. The +7% GDP growth achieved in 2017 was not healthy as it was fueled by strong pro-cyclical fiscal stimulus and high wage growth, that caused a significant rise in macroeconomic imbalances, notably widening twin deficits and rapidly rising inflation. Moreover, insolvencies rose by +9% in 2017 and are expected at +12% in 2018. Elsewhere in the region, Turkey is also overheating, with related risks already reflected in the current C3 rating. Going forward, we expect net rating changes to be neutral in 2018-2019, though complacency (postponement of necessary policy tightening) could lead to a deterioration of the risk environment.
Emerging Asia and Latin America followed next in the country risk cycle, with a reversal to net upgrades in 2017 (+3 and +2 respectively). In Asia, it reflected a strengthening of growth and better fundamentals in the ASEAN region.
Chart 2 Net changes in Country Ratings by region, from 2015 to Q1 2018
The reversal in Latin America was triggered by an exit from recession for both Argentina and Brazil amid recovering commodity prices. In Q1 2018, there was no rating change in Asia and one upgrade in Latin America. Chile improved from A2 to A1, thanks to a rebound of growth in H2 2017 and an improved growth outlook for 2018. Looking ahead, a few more upgrades are possible in these regions in 2018-2019 despite lingering risks related to US protectionist initiatives.
In the Middle East and Africa, country risk continued to deteriorate until the end of 2017, with -8 net downgrades in 2015-2017, reflecting mainly the adverse effects of persistently low commodity prices (notably oil), deteriorating public finances and external accounts, and in some cases also increased political risk (including hidden public debt). However, Q1 2018 saw 3 upgrades overtrumping 2 downgrades in the region. Algeria was downgraded from C2 to C3 due to ongoing lax fiscal policy and surging credit.
Tunisia was downgraded from B3 to C3 due to continued large external deficits and rising debt levels.
Egypt (from C3 to C2), Ghana (from B2 to B1) and Côte d’Ivoire (from C3 to C2) were upgraded thanks to low levels of inflation and improved fiscal as well as external imbalances. Yet, against the backdrop of high political risk and weak economic fundamentals in many countries, it remains to be seen if Q1 may have heralded a tentative reversal in country risk profiles of the region.
Companies are reaping the benefits of an extended phase of expansion
The improvement of macro fundamentals continued to translate into a reduction of risk at sector level. In line with the previous quarters, a large number of industries reported a stronger demand in Q1 2018 and presented a positive outlook (76). This by far exceeded the number of industries with a worsening demand outlook (32).
A positive momentum has prevailed throughout the past 4 quarters (276 industries with stronger demand as opposed to 157 with weaker under lying top line fundamentals). Moreover, positive reports on profitability (69) and liquidity (52) outnumbered negative ones.
In this context, our sector risk ratings show a net positive change for the third consecutive quarter with twice as many grades upwards (21) than downwards (10). Even though there is still disparity amongst region and sectors, this is confirmation of the turnaround that began mid-2017.
The sector outlook remains strong in the developed world ex UK, while improving in Asia and Latin America.
Sector risk ratings in Western Europe continued improving albeit at a slower pace, with a net balance of 3 upgrades in Q1 and 23 over the last 4 quarters. The momentum persisted in Q1 2018 with 6 new upgrades after 14 in Q4 2017 and 32 upgrades over the last 4 quarters. Yet, there is one important exception: UK retail sector’s downgrade from ‘Medium risk’ to ‘Sensitive’. It marks our first downgrade for the UK since the Brexit vote. A strong deceleration of private consumption, intensifying price competition and some disruption from e-sales all contributed to this downgrade.
Chart 3 Regional fiscal balances
We observed a trend reversal in Latin America, after waves of downgrades from 2015 onward. Argentina’s and Brazil’s exit of recession is now feeding through into sector upgrades, notably on the consumer side.
There were 7 net upgrades in the region in Q1 2018, out of which 5 in Brazil (including Retail and Household equipment). The vast majority of upgrades, though, are from ‘High risk’ to ‘Sensitive’, which still indicates an elevated level of risk.
Separately, we observed that (i) there were no additional upgrades in North America – the region being in advance in the economic cycle; (ii) there were more upgrades than downgrades for the second quarter in a row in Asia, confirming a continuing improvement in the region; and (iii) Concerns over overheating in Eastern Europe have no impact on sector risk ratings at this stage.
A broad-based and well balanced improvement in the sector outlook
The distribution of our upgrades, was very balanced (7 from high to sensitive, 7 from sensitive to medium and 7 from medium to low risk), with some concentration on cyclically sensitive sectors (Metals, Automotive and Household equipment). Rising commodity prices have led us to upgrade the Metals sector in 3 countries (Australia, Poland, and Spain) as global demand is strong. While we see a clear and sustainable recovery in base metals and mining, we continue to have concerns with regards to Steel. In a number of countries, stronger earnings are driven by protectionist measures, while global overcapacity persists - about 25-30% overcapacity globally, most of which concentrated in Asia (China). US tariffs will have a limited direct impact on the sector, as numerous exemptions were granted. Nevertheless, Japan remains largely exposed to tariffs and protectionist measures might accelerate capacity closures in Asia.
Downgrades appeared notably at the safer end of the risk range, with 3 out of 4 downgrades from ‘Low’ to ‘Medium risk’ in the Retail sector in the Baltics. This sector, with 8 downgrades over the last 4 quarters including the UK case, remains on the watch list as challenged by structural change. Downgrades in the Construction sector to ‘High risk’ were isolated and in our view represent idiosyncratic factors in Russia and South Africa.
Metals, Construction and Textiles remain the riskiest sectors, all rated ‘Sensitive’ on average. We consider Pharmaceuticals and Agrifood as the safest sectors. Note that both of the latter are entirely deprived of ‘High risk’ ratings. Also, Chemicals, Automotive manufacturers and IT services, on average rated ‘Medium risk’, contain a significant share of countries at ‘Low risk’ grades (respectively 38%, 34% and 33%). Conversely, there are pockets of higher risk within Energy and Transportation, where we rate 31% of countries as ‘Sensitive’ or ‘High risk’.
Chart 4 Summary of Q1 2018 rating changes (new grades)
Chart 5 Q1 ratings by sector (global average) and risk distribution of sectors (number of countries in %)