2017 was the most positive environment for the global economy since the 07-08 financial crisis. Growth was above potential, but was also balanced and synchronised across developed and emerging markets. Importantly for financial markets, the strong growth was accompanied by a healthy but modest level of inflation.
Forward looking indicators remain encouraging and global real growth looks like it will maintain the current 3.5% to 3.7% pace. Growth is also now less reliant on household consumption as investments are increasing.
This is a relatively benign view so we are asking ourselves – what challenges this base case? We consider the following downside risks and potential upside surprises in 2018.
Downside risk! China:
In recent years China has been the master of recalibrating monetary and fiscal policies. But its task is becoming more challenging as authorities try to shift from an investment-driven economy to a consumer-led one, impose controls on the housing market, whilst achieving a level of economic growth that is more sustainable in its composition. Total debt has reached alarming levels (financial imbalances are a primary concern for the authorities) and geopolitics (including tensions with the US) are increasing.
The central case is a lower but still healthy level of growth: the risk is that the recalibration of policy does not produce the desired effect and growth drops below 6%.
Downside risk! Protectionism:
Protectionist policies became an obsession for the market in late 2016. These fears seem to have dissipated despite little progress in the NAFTA negotiations and ever more prevalent tensions between China and the US.
The need to avoid a conflict with North Korea makes a trade war unlikely. Nevertheless Mr D. Trump is arguably the most unpredictable US president in history; trade is an area where he has a degree of flexibility and where he could express his frustration. A disruption of global trade or the proliferation of protectionist policies represent a meaningful downside risk to growth, especially for open economies like China, Europe, Japan and some of the emerging market economies.
Upside surprise? Investment:
The improvement on the composition of growth and the noticeable pick-up in global capital goods orders and capital expenditure is encouraging. Looking beyond the very short term, investment is an essential ingredient to improve productivity. Debt-funded consumption simply brings future demand into the present and increases the debt burden of future generations. Investment increases potential GDP. This is particularly relevant in those economies that face challenging demographic dynamics.
Upside surprise? Europe:
Despite the recent strength, I see more room for positive surprises in Europe. Unlike the US, the economic cycle in Europe is very young. The deleveraging process has just concluded. A positive credit impulse will support activity as consumers and businesses (where confidence is at multi-year highs) increase their credit demand.
These dynamics are among those we will be keeping a close eye on into 2018.