The desynchronisation of the global cycle

5 min

The global economy is expected to continue to grow at a healthy pace in 2018 and 2019 albeit mirroring more diversity in an asymmetric reaction to a series of shocks on energy prices, political uncertainty and interest rates

The global economy has probably passed the peak of its current cycle

Global economic growth is set to accelerate further in 2018 to +3.3% y/y, after growing by +3.2% in 2017. The global economic landscape remains good, despite the emergence of cycle de-synchronization. Without a doubt, this phenomenon is crucial to both understand and anticipate the economic momentum. This de-synchronization will result in asymmetric answers from national economies to three global-scaled shocks.

First come commodity prices, in particular oil prices, which surged faster than expected. The Brent price reached the USD 79/bbl mark during May 2018. This general increase may favor exporting countries in the short term. It will also increase input prices and lead to a noticeable rise of global inflation in the upcoming months. However this hike should be temporary, and will not destabilize the global economy – we are forecasting stable oil prices around USD 69/bbl in 2019 – given that central banks are not likely to over-react to heightened inflation.

Then is the interest rate shock, following a faster than expected monetary policy tightening in the US. Indeed, the fiscal stimulus initiated in the US in 2017 appears to be more powerful than previously thought, while recent measures of financial deregulation will stimulate further the economy.

In this context increasingly resembling overheating, added to riskier behavior around corporate debt and financial activity at large, the Fed will toughen its line. We expect two more rate hikes in 2018 and two additional ones in 2019.

The normalization of the American monetary policy will inevitably result in unstable volatility and increased Dollar value – we are expecting a +5% appreciation in the Dollar index in the next six months. As a consequence, it will put most fragile economies under pressure , i.e. those characterized by persistent fiscal, commercial or price disequilibria. This will lead to a mounting discrepancy between weak economies – those showing high debt stocks or insufficient record of reducing imbalances in the last two years, despite a very favorable climate and stronger ones.

Finally, there is a global perturbation due to a shock of economic policy uncertainty, following protectionist moves and a historical overhaul of America’s foreign policy. The “America First” policy already had, and will continue to have deep consequences. One needs to analyze this new paradigm from a historical perspective, taking into account the traditional role played by the US as a supplier of public goods at the global level. It has long been a purveyor of security through NATO and the UN, of free trade through multilateral rules under the WTO and an economic power with a big influence within the G7 and G20. At every level, one can foresee a disengagement from the US, thus redefining international talks. The divide between economic and military rationales has blurred, with the Trump administration no longer hesitating to ask for commercial and financial compensation for its geostrategic contribution. Global multilateralism is clearly on the decline, triggering a negative shock of uncertainty around economic policy. The rise of populist regimes and their reaction to de-synchronized economic momenta will be the last source of asymmetries in the months to come.

 

Figure 1  Contribution to US GDP growth (%, y/y)

 

Source: IHS, Euler Hermes Allianz Research

The American economic policy will be a victim of its own success

The American economy should see an acceleration in growth in 2018, with production expected to increase by +2.9% y/y, after growing by +2.3% y/y in 2017. This can be explained by the ambitious fiscal reform which significantly reduced taxes for both companies and households. After this budgetary stimulus, American companies positively reacted with upward revision of both hiring and investment intentions. We estimate that Trump’s economic policy will contribute to further accelerate US GDP growth by +0.5pp in 2018.

This economic voluntarism, on which the mantra “America First” is based,  has hampered political discussions both in the US and abroad. Domestically, it led to an extreme political polarization of both parties’ stances and strategies in Congress. This is likely to lead to tensions around budgetary negotiations – the Congress is the final decision maker regarding American budgetary policy. In this context, Paul Rayan’s decision not to run for another term as President of the House of Representatives will contribute to weaken the American political debate – given his relentless efforts to bring around the table Trump, the GOP and the Democratic Party.  As the Republican Party is divided, November mid-term elections may rebalance the forces in Congress. The latest polls show an important turnout among Democrat voters, along with higher financial contributions to the campaign.  In such circumstances, combined with a rapid deterioration of the fiscal balance, the Trump administration may be forced to withdraw some of its most recent tax cuts if the House of Representatives, or even the Senate, became Democrat. This scenario would imply a less accommodating budgetary policy, accompanying a monetary policy tightening from the Fed.

These two factors are the main driver of an expected slowdown of US economic growth in 2019, to +2.4%  y/y. In this case, the American foreign policy - in particular its trade policy - could have its most polemical aspects tamed.

Despite the political uncertainty, Europe will continue to grow above potential

After strong growth in 2017 (+ 2.6%, the highest in 10 years), the Eurozone economy should slow down in 2018 and 2019 to + 2.1% and + 1.9% respectively. However, growth will remain above potential. Intra-zone trade and more generally domestic demand will offset the external slowdown. In 2019, domestic demand will contribute more to GDP growth (+1.8pp after +1.4pp in 2017). But the resurgence of protectionism, even if it is currently under control (expected export losses of EUR12bn if import tariffs are expanded to the car industry in addition to steel and aluminum products), weighs on business confidence. Internally, the political uncertainties (Italy, Brexit, German coalition, rise in populism) announce a high volatility regime.

Indeed, over the past few years global liquidity and the broad-based cyclical upswing in the Eurozone helped drown out concerns about the underlying structural weaknesses in the economy as well as political discontents.

Going forward, with the economic upswing in Europe likely to have passed its peak and global central banks gradually normalizing their policy stance, markets are bound to become increasingly more sensitive to political risks – and this is visible in the higher Italian-German 10-year bond spreads – which we expect around 180 to 250bp for the remaining of the year.

Figure 3  Eurozone GDP growth and components

 

Source: IHS, Euler Hermes Allianz Research

The ECB will start to progressively normalize its monetary policy but we expect the tone to remain rather dovish, keeping the rise in long-term interest rates rather contained. The Quantitative Easing program should end in December 2018 as recently announced, while a first increase in the deposit rate should not come before September 2019.

We estimate that a rise of + 50bp in the key interest rate will increase the interest charge by EUR60bn for companies in the Eurozone.

Hence, the acceleration of European institutional reforms will be key to reassure on Europe's capacity to integrate further, especially in the current context of a decreasing multilateralism led by the America First policy and supported by a certain surge of growing European populism – we estimate the first parties to win the European elections in 2019 to be anti-establishment.

The balance on the European reform agenda looks delicate despite the Macron pivot.

However, the region benefits from important safety mattresses, which protect growth from the negative impact on business confidence: (1) fiscal policy that will become expansionary in 2019, particularly in Germany, Italy and to a lesser extent in Spain; (2) private consumption, supported by the acceleration of wages (to +2.3% in 2018 from +1.6% in 2017) coupled with contained inflation (1.7%), means greater real purchasing power, notably in the second half of 2018; (3) companies’ margins remain high, notably in Italy and Spain; (4) turnover growth around +6% on an annual basis and above pre-crisis levels; and (5) companies enjoy high cash holdings (above EUR890bn).

Eastern European countries benefitted from the Eurozone recovery and a rebound in investment activity thanks to better absorption of EU funds, reaching GDP growth above +4% in 2017. However, over the past two years, this has favored the accumulation of imbalances and increased the risk of overheating.

This has been the case for Turkey and Romania, and more recently for Hungary.

Turkey and Romania will experience a sharp slowdown which will reduce growth in the Eastern European region to +3% in 2018 and +2.7% in 2019. In Russia, higher oil prices will more than offset any impact from the new US sanctions that were implemented in April. Still, growth will pick up only moderately from +1.5% in 2017 to +1.8% in both 2018 and 2019 as structural rigidities persist.

In Asia, resilience will stem from China

Asia-Pacific economic growth will depend on China’s ability to respond to the US and to keep domestic demand growth in check.

We expect a gradual and measured response to the US protectionist measures (see regional outlook for Asia) consisting in many small policy moves ranging from tighter regulation against US companies, strategic partnerships with key allies to pressure the Trump administration and currency depreciation.

On the domestic side, we expect private expenditures to stay firm, supported by rising income and solid profitability.

The policy mix is expected to be relatively balanced, supporting growth on the one hand (e.g. through fiscal stimulus and targeted liquidity support) and keeping risks in check on the other (with stricter regulation to maintain deleveraging efforts).

This supportive policy mix will be associated with a gradual opening of the economy with (i) tariff cuts for consumer related sectors and (ii) continued progress on financial liberalization. Against this background, China’s economic growth is expected to stand at +6.6%.

This resilience of China will act as a buffer for the region. Regional economic growth is expected at around +5% in 2018 and 2019. India is expected to pick up speed as proactive policies (capital injections for banks, pre-emptive rate hikes) improve confidence, reforms (bankruptcy law, GST, e.g.) start to bear fruit and the adverse effects of demonetization fade away.

In Japan, economic growth is expected to slow as the impact of the previous fiscal stimulus recedes. Yet growth would remain above potential supported by a still accommodative monetary policy, and a resilience of private demand. 

In ASEAN, a still firm rise of global trade and an increase in foreign direct investment will help keep growth in a solid range: Vietnam could grow by +7%, Philippines by +6.8% and Indonesia by +5.2% especially.

In the short run, we see currency turbulences as the main risk especially for countries with twin deficits (India, Indonesia), in countries where investors could perceive a risk of policy mistakes (Malaysia on fiscal consolidation, Philippines on credit management).

In the medium term, we do not expect this risk to derail economic growth.

The first reason stems from the proactivity of the central banks that have raised policy rate pre-emptively to reduce pressures on the currency.

Secondly, most of the large economies of the region have sufficient buffers to keep growth in-check.

Latin America: the BAM (Brazil, Argentina and Mexico) under political and financial pressure

In Latin America, the takeoff expected at the end of last year is delayed. We have revised downwards growth prospects of the region (+2.0% in 2018 after +1.2% in 2017, and +2.4% in 2019) mainly due to revisions in Brazil and Argentina.

Why? Because the late cycle market stress has exposed regional vulnerabilities. Argentina, with its twin deficits and high inflation (+25%) was sanctioned by markets (-45% depreciation of the ARS peso ytd).

The situation is now under control with the IMF support until 2020; yet the tight fiscal adjustment will cut growth (+ 1.4% in 2018 and + 1.7% in 2019 down from + 2.9% in 2017).

In Mexico, despite a resilient economy (+ 2.5% growth in 2018 after + 2% in 2017), financial pressures will continue. The overhaul of NAFTA probably delayed to 2019 and the future of the energy sector - a possible target of the new Mexican president - will be a source of prolonged volatility.

Although we don’t expect a major fiscal slippage, public spending could also increase going forward.

In Brazil, the recovery will be slower than expected, but the country should resist volatility thanks to a favorable external position, with growth expected at + 1.9% in 2018 (+1% in 2017) and +2.5% next year.

The medium-term outlook remains degraded due to drifting public finances, especially as the outcome of the presidential election remains uncertain.

Middle East: recover and rebalance

In the Middle East, annual growth will pick up from just +0.8% in 2017 to over +2% in 2018-2019 as the GCC region recovers at last from the recession, thanks to higher oil prices and the fading impact of OPEC-agreed oil production cuts at the end of 2016.

Higher oil prices will also support the rebalancing of large fiscal and current account deficits in the GCC economies that evolved in 2014-2017.

However, Oman and Bahrain remain the weaker spots in the region as they have fiscal breakeven oil prices of more than 80 USD/bbl.

 

Figure 8  Trend in insolvencies in the first months of 2018

(*) Figures for China: +64% YTD and +90% for the latest 12 months Sources: National statistics, Euler Hermes, Allianz Research

Africa: a growth driven by commodities

In Africa, the recent rise in commodity prices should have a stabilizing influence for the entire region; specifically a consolidation is awaited in Nigeria (+2.5% in 2018).

Euler Hermes expects an acceleration of the African growth at +3.9% and +4.3% in 2018 and 2019 (after +3.4% in 2017).

The question is not the growth in itself. The infrastructural projects are still numerous, in particular in Eastern Africa (Ethiopia, Kenya) or in Western Africa (Côte d’Ivoire, Senegal).

But the way those projects are funded can be an issue and lead to situations of excessive debts.

Accordingly, the examples of Mozambique and of the Republic of Congo could become more than isolated incidents.

Insolvencies in 2018 and 2019 to mirror de-synchronized cycles

The diversity of trajectories in this adjustment to the threefold series of shocks will require skills of discrimination for investors and risk managers. The significant complexification of the global political environment coupled with a historical phase of monetary policy normalization is likely to generate some decoupling in the pattern of global insolvencies. To this regard, the first half of 2018 has been illustrative of this idea of a transition between a synchronized global economic cycle and more heterogeneity to come:

  • In the first months of 2018, corporate insolvencies increased in more than half of the countries monitored compare to the same period of 2017
  • The surge in insolvencies continues in China, notably re ‘zombie companies’, and insolvencies rebounded in Hong-Kong and Singapore. 
  • The downside trend remains on track in the US, but paused in Canada.
  • The downside trend also remains on track in Germany and in most Southern Europe countries, notably France.
  • Yet, many other European countries posted a rebound in insolvencies the first months of 2018: Belgium, Switzerland, Poland, Romania and the Nordics
  • The improvement in Brazil marked a (temporary) pause.
  • We expect our Global Insolvency Index to remain on the upside for a second consecutive year in a row in 2018 (to +8% from +6% in 2017) and to keep on increasing in 2019 (+4%). However, this global trend will reflect different trends by regions and countries.

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