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Pleasant surprises of a slow-burn cycle

The growth cycle has proved to be disappointing. Indeed, growth has been picking up but there are a number of doubts about its strength and whether its duration will persist. There were concerns about its ability to be self-sustaining: investment was in the doldrums, job creation was only really strong in the United States and wages have not been keeping up. But in an environment that is supposed to be shot through with many risks, especially political ones, growth has surprised us on the upside. In 2017, it is now forecast to reach 2.25% in the United States – above its so-called equilibrium level of 2% – and 2% in the Eurozone, where potential growth stands at 1% according to the European Commission.

How do you best describe a cycle that ends up delivering pleasant surprises? Answer: by qualifying it, so to speak, as a slow-burn cycle. The classic sequence of events (production recovers, then investment, jobs, wages and, ultimately, prices follow) is falling into place, albeit very slowly. It is as if it were necessary – in addition to the obvious need to absorb excess capacity – to remove all doubts before taking any decisions. Household consumption is still the main driver of growth. But investment is finally beginning to show signs of life. The labour market has finally started to improve. And growth has finally started to become more job-rich. Meanwhile wages and prices are proving to be surprisingly well-behaved. This is a sign both of excess capacity, which is proving to be hard to absorb, and, without a doubt, structural change, what with the growth of the service economy and of ‘uberisation’ as drivers of competition, which are helping to keep wages down, especially in economies that are still convalescing after the crisis.

Moreover, while core inflation is still well-behaved, headline inflation is not under threat of becoming embalmed, and especially not as a result of oil price rises that are likely to be limited going forward. Although OPEC and its Russian ally have managed to cut their production in line with the 30 November 2016 agreement, they have not managed to reduce oil stockpiles. The resumption of production in Libya and the return of full export capacity in Nigeria, together with brazen US production that is managing to grow in a USD50/bl environment, have dashed OPEC’s ambitions. OPEC and the other signatories to the agreement have therefore extended their policy of cutting production until 31 March 2018. But the danger is that the reduction could contribute to driving strong, rising investment in some US states, thus limiting the scale of the much hoped-for price increases.

Against a backdrop of extreme wage restraint and with no significant pick-up in core inflation, the cycle is gaining momentum without degenerating. There are no signs of the excesses that traditionally herald a cyclical downturn and that are sometimes brutal and inherent in the cycle itself such as inflation, high levels of private debt and even external imbalances. The economic cycle is smooth, even monotonous, and it has been going on for some time now: could the devil be hidden in details that we might not have noticed? There are still risks mooted, including some still possible unpleasant surprises from the Trump Administration, as well as dangers linked to the growing imbalances in China’s financial sector. They must not be neglected, but they are external to the cycle itself.

While no endogenous imbalance currently seems likely to precipitate the end of the cycle, our ‘harmonious’ economic scenario nevertheless assumes that financial conditions do not brutally tighten. The monetary support mechanisms will be withdrawn very gradually. Any tightening has to be done ingeniously and with a light touch. The FOMC is likely to start its programme of slimming down its balance sheet from this autumn. The Fed should be cautious in its approach: it will avoid simultaneously hiking rates and shrinking its balance sheet, so that it can gauge the impact of those measures on the markets. The ECB seems likely to taper its quantitative easing (QE) in 2018. And while economic conditions (economic recovery and a receding risk of deflation) will allow it to taper, the scarcity of eligible securities will force it to. The very gradual (too gradual, in our view) rise in inflation should nevertheless encourage the ECB to remain accommodative over an extended period and prolong its tapering throughout 2018.

It is quite easy to hypothesise a gradual tightening of monetary conditions. But hypothesising that the tightening will not lead to monetary conditions brutally toughening up is a bolder idea. Yet, our scenario is based on a gradual, ‘orderly’ rise in long-term interest rates. It is in line with stronger, not very inflationary, growth, and above all with Central Banks that are keeping their eye on the ball as they try to subtly steer expectations and, as a result, long-term rates.

Lastly, US equities continue to rise even as hopes for pro-business reforms decline and as the Fed hikes its rates, raising the spectre of an equities market correction. In our view, such a strong performance from equities above all else reflects the low level of long-term rates and an improving global outlook. An economic shock triggered by a US market correction over the short term in the coming months seems fairly unlikely to us.

Growth is more robust in industrialised countries; political risk and protectionist threats have eased, and, most importantly, the gradual nature of US monetary tightening is not imposing ‘unsustainable’ financial conditions on emerging countries. As a result, emerging economies in general continue to benefit from a gradual, albeit limited, pick-up in their growth rates. Growth is proving resilient and it is spreading. It is being supported by favourable monetary and financial conditions. There seems to be no imminent risk of a perilous tightening of such conditions. It would be easy to draw up a dark economic scenario, where every latent risk raises its head, and to predict the end of the world as we know it. But we will refrain from that and posit a reasonably optimistic scenario.

Catherine LEBOUGRE catherine.lebougre@credit-agricole-sa.fr For further information, see World – Macroeconomic Scenario for 2017-2018: Pleasant surprises of a slow-burn cycle (publication and video)

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