Wealth Insights (March 2017)

Faster Growth, Fading Deflation

Richard Jerram
Chief Economist
Bank of Singapore
Member of OCBC Wealth Panel

The pickup in global growth seen in late 2016 has extended into the new year. This should pull the world further away from the risk of deflation and means we can look for turning points in monetary policy outside the U.S.

The purchasing managers’ index (PMI) offers a simple and timely guide to the state of the economic cycle, where 50 is the line between expansion and contraction. The global PMI pushed comfortably into positive territory in 2H 2016 and the January reading was the best since early 2014.

The improvement is broad-based. The United States, the Eurozone and Japan have all seen a striking improvement. This is in line with other measures, such as trade flows, or economic surprise indicators.

In the United States, the gains started well before the election, but there are signs that small business confidence has surged over the past couple of months, perhaps on hopes of less regulation (such as lower healthcare costs) and tax cuts. Consumer confidence has also pushed higher, suggesting that President Trump’s supporters believe that he can “make America great again”.

Most emerging markets hit bottom some time in 2015 and a combination of weaker exchange rates, better domestic policy settings and a rebound in commodity prices have driven an improvement in business conditions. The chart below compares the most recent PMI with the low of 2015, where readings to the right of the diagonal indicate improvement.

Emerging markets seem particularly exposed to policy uncertainty in the United States, through the risk of protectionism or of faster Fed rate hikes if Trump pursues a much looser fiscal policy. They are more resilient than during the 2013 taper tantrum, but could still struggle.

Stability in China has contributed to the broader emerging market rebound, with policy support again boosting growth. The recent squeeze on housing and tighter monetary policy means that PMIs are likely to slip in coming months – this appears to have started in the January readings. However, the immediate threat to China is from U.S. trade policy rather than domestic imbalances. Key officials in the Trump administration have a history of being very critical of trade relations with China.

If we put a renewed appetite for fiscal stimulus in the developed economies on top of this mid-cycle growth acceleration and rebound in commodity prices, it means that reflation replaces deflation as a market theme. This is a big swing from as recently as 2015 when around 60 per cent of the global economy faced inflation below 1 per cent, so had a real danger of falling into deflation. This year is set to be more regular, with only about 10 per cent of the world experiencing uncomfortably low inflation.

Reflation brings monetary policy consequences. By now we are accustomed to discussion of the timing of U.S. rate hikes although there is too little focus on quantitative tightening, which is set to start in 2018. However, reflation implies that the next move in monetary policy in the Eurozone and Japan is likely to be towards tightening. This will take the form of tapering bond purchases in Europe and a higher target for 10-year bond yields in Japan.

This challenges the primacy of U.S. monetary policy tightening and undermines the idea that the U.S. dollar should be exceptionally strong. We still believe U.S. dollar will remain firm but do not see huge upside from these elevated levels.