Economic Normalization vs. Political Polarization

Still low interest rates, stable commodity prices, as well as a generally stronger US dollar should provide further tailwind for many economies in the coming months. That said, economic policies of the new US administration remain uncertain and while some aspects (such as the fiscal stimulus plans) have the potential to improve the global outlook further, others – for example, the protectionist inclinations – raise downside risks for global growth.

Global Growth Supported by a Number of Positives

• In the USA, where the economy is already very close to full employment, consumer spending looks well supported by high consumer confidence, solid labor markets and the prospect of tax cuts in the coming quarters. In addition, business investment spending is likely to pick up.
• In the Eurozone, the acceleration in economic activity seen in late 2016 is likely to hold as low interest rates, a weak euro and slowly declining unemployment provide the foundation for the recovery to become increasingly broad-based and self-sustained across countries.
• The UK economy faces a more difficult outlook as some negative effects of the decision to leave the EU seem to be slowly reaching the labor market, which should with some delay also affect private consumption.
• Japan appears to benefit from the weaker yen and the stabilization in China, among other things, and we expect growth to remain above potential and largely similar to last year.

Fading Energy Price Drags to Lift Inflation

Base effects from crude oil prices have already turned positive but appear likely to top out during Q1 2017. The chart also indicates that even after peaking during Q1, base effects from energy prices are likely to remain positive for most of the year. Headline inflation in most advanced economies will thus likely peak early in 2017, overshooting core inflation rates, before declining back closer to the core rates later in the year.

Core inflation on the other hand will likely edge up only very slowly in Japan and the Eurozone. This means that the headline inflation targets of both the Bank of Japan (BoJ) and the European Central Bank (ECB) will remain out of reach for the foreseeable future.

In the USA, core inflation is already above two percent and is likely to edge higher as the labor market tightens further. In the UK, the sharp depreciation of the British pound following the Brexit referendum will likely drive core inflation higher. Given these core inflation trends, headline inflation is also likely to shift back to a gradual upward trend in both economies following the topping out process in Q1.

Monetary Policy: Mostly on Hold as the US Fed Tightens

The differences in the outlook for inflation are also reflected in differences in the monetary policy outlook. The US Federal Reserve (Fed) has already indicated at the December 2016 meeting that it expects 75 basis points of policy tightening until year-end 2017 to be an appropriate course of action. This view was also repeated by Fed Chair Janet Yellen in recent speeches, where she also sounded more upbeat on the labor market. We share the assessment that a tightening labor market, inflation close to the target and the prospect of significant fiscal stimulus warrant rising policy rates. However, we remain cautious given the uncertainties surrounding the US economic policy outlook, with protectionist stance posing downside risks to the economy.

• Rising US rates are generally good news for most other major central banks, as they tend to weaken their respective currencies vis-a-vis the US dollar without them having to become even more expansive to achieve a similar goal.
• We expect the ECB and the BoJ to leave monetary policy largely unchanged throughout the year.
• Uncertainty seems fairly high regarding the stance of the Bank of England (BoE). For now, economic data remains robust and inflation is going to overshoot the BoE target. The question is whether these trends can remain in place.

Among emerging markets (EMs), most central banks will likely be forced to put currency trends at the center of their attention. This is particularly true for countries with weaker fundamentals such as Mexico, Turkey or South Africa. Other central banks may continue to ease their monetary policy stance, such as in Brazil or Russia. In China, the focus will rather remain on keeping the renminbi stable.

Emerging Markets: Between USD Strength, Better Global Growth and Protectionist Risks

The outlook for major EMs is generally relatively positive, but given the heterogeneity within that group, there are exceptions to this picture.

• China appears likely to continue its managed slowdown, with Q4 2016 data showing another quarter with successful GDP growth stabilization. As this stabilization was mainly brought about by a significant expansion of public investment spending, the risk remains that growth may slow down more meaningfully over the year.
• In India, the economy was significantly affected by the November 2016 demonetization. However, this negative impact will most likely prove temporary and we expect the economy to recover quickly.
• Russia has apparently emerged from recession at the end of 2016, with the stabilization of commodity prices a main contributor. The new US President Donald Trump has already hinted at the possibility of lifting Western sanctions on the country, which would provide another short-term tailwind for the Russian economy.
• Brazil's recession appears more persistent than expected. Growth estimates for 2017 have already fallen a lot over the past months (our forecast stands at just 0.5 percent YoY), but risks are still tilted to the downside. As inflation is coming down rather quickly while the government is on track to implement important reforms, the Brazilian central bank looks very likely to cut policy rates rather aggressively during this year.
• Mexico is severely affected by the shift in US policies and the risk of a much more protectionist stance of its northern neighbor. While the sharp depreciation of the Mexican peso has already contributed to an increase in inflation, the significant increase in energy prices at the beginning of the year will likely push inflation even higher. The Mexican central bank will thus have no alternative to raising policy rates further, in our view.