Thursday, May 31, 2018/02:10 PM / Moody’s Investors Service
Overall, we expect 2018 to be a year of robust global growth, similar to 2017
However, global growth will likely moderate by the end of 2018 and in 2019 as a result of a number of advanced economies reaching full employment, and because of rising borrowing costs and tighter credit conditions in both advanced and emerging market countries that will hamper further acceleration. We expect the G-20 countries to grow 3.3% in 2018 and 3.2% in 2019. The advanced economies will grow at a moderate 2.3% in 2018 and 2.0% in 2019, while G-20 emerging markets will remain the growth drivers, at 5.2% in both 2018 and 2019.
Our outlook for global monetary policy is broadly unchanged
The US Federal Reserve is on a predictable path of gradually tightening monetary policy. We forecast three additional increases in the federal funds rate this year followed by three more rate hikes in 2019.
The European Central Bank will likely stop additional asset purchases by the end of this year and start increasing the deposit facility rate, which is currently held at -0.4%, in the first half of 2019. We believe that the Bank of Japan will maintain its current monetary policy over the next two years.
Global financial conditions have steadily tightened since February, when markets began to price in greater normalization in the US
Global conditions will tighten further when the pace of policy accommodation in Europe slows. The recent across-the board increase in market interest rates and depreciation of domestic currencies reinforce our view that central banks in emerging market countries will not be able to provide monetary policy accommodation for much longer.
Downside risks to growth stem from emerging markets turmoil, oil price increases and trade disputes
The ongoing financial market turbulence in emerging market countries poses risks of a broader negative spillover effect on growth for a range of countries beyond Argentina and Turkey, while there is a risk that high oil prices will be detrimental to consumption demand. A re-escalation of trade tensions between the US and China is another risk factor to growth. Political concerns add to downside risks in Brazil, Mexico and Italy.
Global economic outlook remains robust
We expect robust economic growth in 2018, although several key risks have begun to materialize and a further acceleration of growth is unlikely. Our outlook for the global economy is broadly similar to our previous assessment in February. We have maintained our growth outlook for most of the G-20 advanced economies for the next two years. (See Exhibit 1.) We expect growth in the US to outpace that of other advanced markets. Emerging market countries are on an upswing, in some cases through stronger commodity prices that are helping to strengthen recoveries.
As recent episodes of financial market stress unfold in emerging market countries, downside risks to some emerging market growth forecasts have risen. We expect emerging market countries to grow by 5.2% in both 2018 and 2019, down from 5.3% in 2017. The outlook for the emerging market countries differs considerably, based on our assessment of each country’s overall economic strength and the ability to withstand the rise in the volatility of capital flows. The growth outlook for South Africa has improved since our last assessment. In Argentina, however, a significantly tighter monetary policy to stabilize the currency has clouded near-term growth prospects. Turkey’s growth prospects have also worsened as a result of deteriorating external conditions, and we believe that there are further downside risks. We expect China, India and Indonesia to maintain average growth rates around 6.5%, 7.5% and 5.2%, respectively, in 2018 and 2019. We have also maintained our growth forecasts for Brazil of 2.5% in 2018 and 2.7% in 2019.
Overall, we expect 2018 to be a strong year for global growth, similar to 2017. However, global growth will likely moderate by the end of 2018 and in 2019. We expect the G-20 countries to grow 3.3% in 2018 and 3.2% in 2019. The growth differential between emerging and advanced economies will grow, with the advanced economies slowing from 2.3% in 2018 to 2.0% in 2019.
The slightly softer readings in March and April of high frequency data, such as global purchasing managers’ index (PMI) data and industrial production, compared with December and January, show that the global economy continues to hum along but is likely nearing peak growth if it has not passed the peak already. A further acceleration in global growth is unlikely for the following reasons:
1. We expect subdued productivity growth and a declining working age to drive down potential growth in a number of large economies. (See our recent report Demographics – Global: How demographics will shape labor markets and credit trends.)
A resurgence in productivity growth in advanced economies would be the single most important development necessary to decisively challenge the narrative of slower growth over the next two to three years.
2. A number of advanced economies, including the US, Canada, Germany and Japan, are at full employment and therefore likely to run up against capacity constraints. Spare capacity in the euro area is steadily diminishing. Furthermore, slow growth in the labor force, rising inequality, modest productivity growth and a general loss of economic dynamism as illustrated by slower business formation, for example in the US economy, point to permanently lower growth potential. China’s economic growth will continue to slow.
3. Rising borrowing costs and tighter credit conditions in advanced and emerging market countries will serve as headwinds against further acceleration. The build-up of leverage on corporate balance sheets is of particular concern in the US as well as in some emerging market countries. High corporate sector leverage also exacerbates the impact of macroeconomic and financial shocks on the real economy. A worsening of macroeconomic conditions typically results in a deterioration in corporate earnings, making it harder to service and refinance debt, leading to an overall decline in investment spending. Furthermore, in the event of disorderly bankruptcies, shocks can be transmitted across sectors through direct and non-direct channels, as well as to thefinancial sector.
4. With economy-wide debt levels at an all-time high globally, the scope for additional and sustainable growth is also limited. Global economy-wide debt rose by $70 trillion over the last decade to $237.2 trillion (318% of global GDP) as of the fourth quarter of 2017.
Financial conditions will continue to tighten globally
Our outlook for global monetary policy is broadly unchanged. The US Federal Reserve is on a predictable path of gradually tightening monetary policy. We forecast three additional increases in the federal funds rate this year followed by three more hikes in 2019. The European Central Bank will likely stop additional asset purchases by the end of this year and start increasing the deposit facility rate, which is currently held at -0.4%, in the first half of 2019. We believe that the Bank of Japan will maintain its current monetary policy over the next two years.
Expectations of higher interest rates by global investors have had the expected impact on US and international asset markets. Consequently, US and global yields have gone up and the US dollar has strengthened. Global financial conditions have steadily tightened since February when markets began to price in greater normalization in the US.
They will tighten further when normalization in Europe begins. We believe that ongoing US monetary policy normalization will entail a gradual rise in interest rates as well as spreads widening across asset classes and globally. The recent across-the-board rise in market interest rates and depreciations of domestic currencies and increases in market interest rates reinforce our view that central banks in emerging market countries will not be able to provide monetary policy accommodation for much longer.
Downside risks are playing out
Since the publication of our last Global Macroeconomic Outlook in February, there have been three major developments that could have global macro implications: (1) institutional investors are pulling out of emerging economy financial markets, causing a sharp drop in local currencies and exposing countries such as Argentina and Turkey to changes in investor sentiment, as a result of the continued upbeat assessment on the US economy and firming expectations of continuing monetary tightening in the US; (2) oil prices have risen sharply and are likely to remain elevated because of, among other things, a rise in geopolitical risks; and (3) trade tensions between the US and China have ratcheted up.
Recent reversals in capital flows to emerging markets highlight downside risks
As we noted in February, a rise in global financial market volatility is consistent with the ongoing normalization of the global financial environment after the “risk-on” period associated with quantitative easing. Since the start of this year, financial markets have adjusted to the prospects of higher US interest rates in sporadic episodes. These risk-off episodes have involved declines in equity and bond prices in the US and globally, a rise in US interest rates, reversals of capital flows away from emerging market countries and a strengthening of the US dollar in trade-weighted terms.
Most recently, emerging market currencies have depreciated against the US dollar since April as a result of renewed bouts of capital outflows triggered by a steady stream of solid US economic data and an upbeat assessment from the US Federal Reserve. (See Exhibits 2-3.) Argentina and Turkey have so far fared worse than other emerging market countries. The sell-off has been fairly broad-based but there are no signs of a broader contagion event just yet.
Academic literature points to a number of factors that make some countries more vulnerable than others to the risk of reversals of international capital flows. The susceptibility of countries with fiscal and current account imbalances and disappointing growth performance to sudden-stop episodes that have been known to cause financial and economic crises is well documented (Calvo (1998), Edwards (2007), Forbes and Warnock (2012)).
In a paper by Eichengreen and Gupta (2014) that focuses on the 2013 “taper tantrum” episode, the authors find that better fundamentals in terms of economic growth, level of reserves, budget deficits and public debt do not necessarily provide insulation from a reversal of capital flows. Instead, the countries that experienced the sharpest depreciations were those that experienced the largest appreciation of their real exchange rate, regardless of differences in fundamentals.
Importantly, countries with larger and more liquid financial markets experienced a greater stock market downturn, reserve loss and exchange rate depreciation when flows reversed.
This time too, countries with exchange rate overvaluation and weaker fundamentals (Argentina and Turkey) have seen intense financial market pressures. (See Exhibit 3.) But investors’ need for portfolio rebalancing has led to increased exchange market pressure in other countries as well. This doesn't mean, however, that economic fundamentals do not matter. The ability of countries to weather external pressures is strongly related to the strength of their economic fundamentals. (See Exhibits 4-13.)
It is not surprising that Argentina and Turkey have come under greater pressure than other emerging market countries. Turkey’s economic policies in particular have contributed to a worsening of its credit fundamentals, making its economy uniquely vulnerable. Similar to Turkey, Argentina has seen its borrowing costs go up significantly in the latest episode.
In both countries, inflation rates are in the double digits and have been rising. (See Exhibit 4.) Even though both Argentina and Turkey officially adopted inflation targets, de facto monetary policy has not tightened fast enough to contain rising price pressures. In comparison, Mexico’s central bank, faced with above-target inflation, followed a fairly tight policy stance at the cost of short-term growth. Other central banks have also made considerable progress in implementing inflation-targeting frameworks, establishing a degree of policy credibility. Indeed, with the exception of Argentina and Turkey, inflation rates in all major emerging market countries, including Mexico, are now well within their respective inflation target range.
On the external front, Argentina and Turkey also stand out. (See Exhibits 6-7.) Both countries are overly reliant on hot money inflows, exposing them to external liquidity risks. Short-term external debt stands at 100% of foreign currency reserves in Argentina, and at 143% of reserves in Turkey. These metrics have worsened considerably over the last few years in the case of Turkey, with total external debt increasing by over $100 billion since the “taper tantrum.” Moreover, the risk has built up on the balance sheets of Turkish nonfinancial corporates and in the financial sector. According to International Institute of Finance data, foreign currency-denominated debt on the balance sheets of Turkish non-financial corporates has risen by 22.6 percentage points as a share of GDP since 2007, of which half is denominated in US dollars and the other half in euros. The Turkish financial sector has also increased its foreign currency liabilities over this period. US dollar-denominated liabilities as a share of GDP have risen by 10.8 percentage points.
Foreign currency denominated liabilities of the Turkish non-financial sector stand at 36% of GDP and those of the financial sector stand at 22.5% of GDP, the highest among major emerging market countries. (See Exhibits 12-13.) Current account deficits in both countries are also unsustainably high, at around 5% of GDP. In contrast, overall macroeconomic imbalances, particularly inflation dynamics and current accounts, have improved in Brazil, India, Indonesia and South Africa since the taper tantrum episode.
Looking beyond macroeconomic indicators, many emerging market countries have also adopted macroprudential measures to strengthen their domestic banking sectors since the global financial crisis. (See Exhibit 8.)
Risks that relate to private-sector debt have risen for a number of other economies as well. On the one hand, an increase in corporate debt can be interpreted in a positive light as a reflection of deepening credit markets. However, the increase in foreign participation in emerging market debt and the growth in foreign currency-denominated debt on corporate balance sheets increase vulnerability to external shocks. Tightening global financial conditions create additional headwinds to growth through the corporate balance sheet channel.
Near-term inflation from higher oil prices to weigh on purchasing power
Our growth forecasts are based on our baseline view that oil prices at the current level – Brent is hovering above $75 and WTI is above $70 – are unlikely to be sustained, with US shale production continuing to ramp up. Oil prices have moved up with the near elimination of the excess supply of a few years ago. Global inventories have fallen as a result of the combination of rising demand and OPEC supply cuts in place at least until the end of 2018. Production cuts in Venezuela and the re-imposition of US sanctions on Iran have provided further support for prices.
However, we recognize a downside risk to consumption spending and growth and upside risk to inflation if the higher prices are sustained. While geopolitical risks in the Middle East have been ever present, the US withdrawal from the Iran nuclear deal and the decreased predictability of US foreign policy with regard to the Middle East increase our assessment of this risk.
Risks of a flare-up in tensions between the US and China remain
Risks of a renewed flare-up in US-China trade tensions remain high, even as the US administration on May 20 announced that proposed tariffs on $150 billion in imports had been put on hold while negotiations proceed. There are two main reasons for the continued risks: (1) it is difficult to achieve the stated objective of reducing the bilateral and overall trade deficit, and (2) the US
Senate is considering a bill that would give the US Committee on Foreign Investment more powers and increase scrutiny of Chinese investments. Reducing the bilateral trade deficit appears to be only one of the objectives motivating the negotiations. Another objective is maintaining technological distance from China. The Chinese government’s Made in China 2025 initiative is perceived in some quarters as a threat to the prevailing dominance of the US in the technology sector.
It is possible that labor-saving new digital technologies, such as big data, machine learning and artificial intelligence, that are currently in the development phase will yield enormous gains in terms of efficiency and productivity once they are utilized in industrial manufacturing processes. One of the explicit goals laid down by the Chinese government under the Made in China 2025 initiative is to become a “manufacturing superpower” in less than 10 years. Thus, the insistence of the US administration for reciprocal treatment is not just about bilateral trade but a much longer-term concern with regard to preserving a certain amount of technological advantage.
(See Cross-Sector - US and China: China is focused on developing its tech sectors despite risk of US restrictions.)
Whether or not they are justified, trade barriers are bad for growth and productivity. History shows that once tariffs are imposed, they tend to remain for two to three years. In our previous publications, we have said that a significant escalation of trade tensions will pose downside risks to sentiment and global growth. (See Trade - US and China: Rising uncertainty will magnify credit effects of weaker trade relations.)
Financial markets by and large have so far shrugged off the risk of a prolonged US confrontation with China on economic issues. However, otherwise positive investor sentiment could be significantly dented if tariffs were to go into effect, with the impact of the tariffs likely to be particularly acute in other parts of Asia. Quantifying the first round “direct” trade-related effects of an escalation of the US-China trade dispute is difficult because of the complexities of the supply chains in various sectors. Trade elasticities – the response of imports and exports to changes in prices – vary widely based on the estimation methods used. A seminal study by Imbs and Mejean (2010) suggests that when sectoral specialization is taken into consideration, import elasticities can be quite large.
Moreover, given that trade tariffs would affect goods representing a significant share of sector imports for both the US and China, we would expect a material impact on domestic prices. Further, over time, a continuation of high tariffs could alter the location of global supply chains, adding a dynamic impact of tariffs. Finally, any second-round “indirect” effects through the impact on sentiment and financial markets would amplify the impact. Our current baseline assumes that trade talks will continue, just as NAFTA negotiations have. However, there are downside risks to our growth forecasts as a result of a resurgence in trade tensions. Ultimately the impact on the global economy will depend on the strength of business and consumer sentiment under such a scenario. One reason for optimism is the backdrop of synchronous global growth and limited excess capacity in some advanced economies.
Select forecast revisions
We have maintained our previous forecasts for most of the G20 countries in contrast to our February publication when we raised the growth forecasts for a large number of countries. We have reduced the 2018 growth forecasts for Argentina, Turkey, Canada and India. We have raised the growth forecasts for South Africa and Australia. Our current forecasts assume that the recent financial market selloff in equity, bond and currency markets in emerging market countries will have a limited impact on most emerging market economies.
We have revised real GDP growth forecasts for Turkey to 2.5% in 2018 and 2.0% in 2019 from our previous forecasts of 4% and 3.5%, respectively, after 7.4% growth in 2017. We were previously expecting the economy to slow as a result of cyclical factors and the easing of fiscal and monetary stimulus. Although new stimulus measures have been announced, including a reduction in foreign reserve requirements for commercial banks, financial conditions have tightened considerably. Turkey’s lira came under greater pressure than other emerging market currencies over the last few weeks, with the delayed policy response from the central bank exacerbating the fall. Even after the 3 percentage point increase in the late-liquidity rate to 16.5%, market concerns about Turkey's economy and monetary policy remain. As of 24 May, the currency had depreciated 24% against the US dollar, while the benchmark 10-year government bond yield increased by 300 bps from the beginning of the year. The inflation rate started to rise again in April, reaching 10.9%, and will increase further as a result of currency depreciation and higher oil prices. All of these factors will weigh on private consumption, business investment and ultimately, overall growth in the second half of this year.
Since the attempted coup to overthrow President Recep Tayyip Erdoğan in July 2016, after which the economy slowed considerably, a combination of low real interest rates and fiscal and credit stimulus supported well-above-potential economic growth last year.
The output gap already turned positive in the second half of last year and the current account deficit widened significantly further in the first quarter of 2018 after reaching 5.7% of GDP last year. The country is especially reliant on foreign capital inflows, given these large deficits on top of refinancing requirements in excess of 20% of GDP. We believe that further efforts to fuel economic growth through expansionary policy measures will come at the cost of rising risks to economic and financial stability. Investor sentiment has already soured toward Turkey, as reflected in widening sovereign bond yields, the shortfall of financing for the current account deficit and recently low rollover ratios for Turkish banks’ maturing debt.
President Erdoğan’s recent statements about gaining control over monetary policy after the presidential and parliamentary elections on 24 June further damaged the credibility of the Turkish central bank’s inflation-targeting framework. The statements also weakened the central bank’s independence, another blow to the rule of law.
In addition to the reliance of Turkey’s economy on foreign funding discussed in the previous section, currency mismatches are another concern. In particular, we are concerned about currency mismatches at the corporate level, where activities such as construction have been funded with foreign currency loans from domestic banks. (See Exhibits 14-15.) We recently published a report on the downside risks to Turkey’s banking system that drive our negative outlook on the sector. (See Banking System Outlook - Turkey, Downside risks for funding and asset quality drive our negative outlook.)
In sum, downside risks to growth are considerable. Turkey remains heavily reliant on short-term external funding. A worsening of internal and external imbalances, along with a reliance on short-term funding, has increased susceptibility to rising global interest rates and currency depreciation. Foreign currency exposure of the banking sector as well as corporate sectors present additional financial stability risks.
Argentina has been hit the hardest in the latest financial market selloff in emerging markets. A heavy reliance on external borrowing in foreign currency, with external debt around 36.5% of GDP, a growing current account deficit and a double-digit inflation rate close to 25% make Argentina acutely vulnerable to changes in international investor sentiment. The peso has depreciated by 15% in real effective terms since April 25. To stem capital outflows, the central bank increased the interest rate to 40% on 5 May from 27.25% at the end of March. The government has responded with measures to reduce public investment spending and has opened discussions with the IMF for a standby arrangement. Together, these measures will weigh on economic growth. We have revised our growth forecast for Argentina to 1.5% in 2018 and 2.5% in 2019, down from our previous forecasts of 3.0% and 3.5%, respectively. Risks to the forecast are further to the downside given persistent internal and external imbalances. In particular, the pressure of further nominal depreciation will remain as long as the inflation rate remains elevated. Depreciation will in turn increase the burden of foreign currency debt.
Our revision to Canada’s growth forecast to 2.1% from 2.3% for 2018 reflects somewhat lower economic momentum in the first quarter. Inflation has picked up with the economy operating close to capacity. We have maintained our growth forecast of 1.9% for 2019. We expect the Canadian central bank to raise rates two to three times this year, while closely monitoring potential financial risks stemming from vulnerability of the indebted household sector to rising interest rates. Housing demand and consumption growth should cool somewhat as borrowing costs increase, resulting in faster convergence to medium-term trend growth.
We have raised our forecasts for South Africa for 2018 and 2019 by 0.2 percentage point to 1.6% and 2.1%, respectively. The marked improvements in business and consumer sentiment since Cyril Ramaphosa took over as president in February support the upward revisions. Risks to the growth forecasts are to the upside. Inflation increased to 4.5% as of April from 3.8% in March, but it remains squarely inside the central bank’s target range of 3%-6%. The inflation rate has moved lower since the beginning of 2017, allowing the central bank to bring the policy rate down from 7% to 6.5% currently.
The Indian economy is in cyclical recovery led by both investment and consumption. However, higher oil prices and tighter financial conditions will weigh on the pace of acceleration. We expect GDP growth of about 7.3% in 2018, down from our previous forecast of 7.5%. Our growth expectation for 2019 remains unchanged at 7.5%.
On the domestic front, growth should benefit from an acceleration in rural consumption, supported by higher minimum support prices and a normal monsoon. The private investment cycle will continue to make a gradual recovery, as twin balance-sheet issues – impaired assets at banks and corporates - slowly get addressed through deleveraging and the application of the Insolvency and Bankruptcy Code.
Ongoing transition to the new Goods and Service Tax regime could also weigh on growth somewhat over the next few quarters, which poses some downside risk to our forecast. However, we expect these issues to moderate over the course of the year.
China's economic growth will moderate
We have maintained our growth forecast for China. After growing 6.9% in 2017, the economy will decelerate to 6.6% in 2018 and 6.4% in 2019. As we have mentioned previously, we believe that the authorities may be willing to accept growth slightly below 6.5%, given the need for deleveraging. The effects of the deleveraging measures are evident in the increasing number of defaults. The access of weaker borrowers to financial markets has also tightened.
We expect the government to continue its push to contain leverage through structural reform and to contain financial risk. So far, the deleveraging measures have not had a detrimental impact on economic growth. However, the pace at which deleveraging is permitted to proceed will depend on the tolerance level of the authorities for lower growth.
Q1 deceleration in the US is likely temporary
We have maintained our growth expectation for the US economy. We project real GDP growth of 2.7% in 2018 and 2.3% in 2019. The near-term growth outlook for the US economy remains robust despite a slightly weaker advanced estimate of first-quarter GDP growth of 2.3% (quarterly annualized) compared with 2.9% in the fourth quarter of 2017. Compared with the first quarter of 2017, however, real GDP grew by a robust rate of 2.9%. Solid gains in business fixed investment and exports helped support growth in the first quarter.
Real nonresidential investment grew by 6.1% (12.3% growth in structures and 4.7% growth in equipment) in the first quarter. Higher oil prices will continue to support nonresidential investment in structures.
A pullback in real personal consumption expenditure, which only added 0.73 percentage point to growth in the first quarter, appears to be temporary. After declining by around 0.15% in January and February, real personal consumption rebounded by around 0.4% in March. The Conference Board’s measure of consumer confidence increased in April to close to 18-year highs despite stock market volatility and worries about rising trade tensions with China, with most of the improvement in confidence among households earning below $25,000 annually.
We believe that developing nominal wage pressures as a result of a strong jobs market will continue to support private consumption in the near term. However, rising underlying inflation and oil prices will partially offset the impact on households’ purchasing power.
The economy has continued to add jobs at a healthy pace of roughly 200,000 per month this year, with the unemployment rate now below 4%. By all measures, the US economy is above full employment and the output gap is now positive, and inflation measures, particularly the Federal Reserve’s preferred core-PCE inflation, stands nearly at the central bank’s 2% inflation target. The rise in the pace of wage growth and inflation has so far turned out to be gradual and contained despite the steady rise in labor scarcity, allowing for steady but measured normalization of monetary policy.The headline inflation rate will likely rise further in the coming months on account of the recent rise in oil prices.
We are maintaining our expectation that the Federal Reserve will raise the federal funds rate three more times this year, and an additional three times in 2019. While it is likely that inflation will rise slightly higher than the Federal Reserve’s target in the short run, we believe that the members of the FOMC will tolerate some overshooting in the short run after several years of undershooting the inflation target to ensure an orderly normalization process.
A more rapid pace of tightening would likely precipitate a slowing of the
economy and would raise financial stability concerns regarding the ability of highly leveraged entities in the US corporate sector to adjust.
Euro area growth at peak
We expect real GDP growth for the euro area to decelerate from 2.5% in 2017 to 2.1% in 2018 and 1.8% in 2019. In particular, we expect the German economy to grow by 2.2% this year, down from 2.5% last year. In our view, this above-trend growth rate at this late stage in the business cycle is still quite strong.
We expect the Italian economy to grow by 1.5% in 2018, similar to 2017, followed by slightly lower growth of 1.2% in 2018. While we have maintained our growth forecasts for Italy from February, there is a great deal of uncertainty around our forecasts arising from political developments. Italy’s current internal struggles to form a government are likely to result in another election being held, most likely sometime in September.
The political instability and policy uncertainty have led to higher sovereign spreads over the bund not only for Italy, but also for other periphery countries. Our baseline forecasts incorporate the view that the spread widening will remain contained. However, there are clear downside risks to the economic outlook. Higher interest rates, if sustained, could weigh on investment and growth.
The euro area economy grew by 0.4% in the first three months of 2018 over the fourth quarter of 2017 (2.5% year-over-year). This reflects strong economic momentum in the euro area, albeit slower than the 0.6% quarterly growth of the last three quarters of 2017.
First-quarter growth was muted in the three largest economies – Germany, France and Italy. Germany grew by 0.3% in the first quarter after expanding by 0.6% in the fourth quarter of 2017. The quarterly growth rate of France decelerated to 0.3% in the first quarter from 0.7% in the fourth quarter of 2017. The Italian economy grew by 0.3% in the first quarter, the same pace as in the previous quarter.
Spain registered the best growth performance of the four largest economies, growing by 0.7% in the first quarter, the same as the previous quarter.
A moderation following an unusually strong growth streak in 2017 does not necessarily signal an impending material slowdown, nor is it that surprising. This is because PMI, industrial production, trade and capital spending indicators remain elevated, indicating that the investment cycle remains intact, at least for now. (See Exhibits 16-17.) Strong employment, rising incomes and strong consumer confidence bode well for continued growth in household consumption.
Some of the first-quarter weakness in France and Germany can be attributed to temporary factors such as the cold weather spell across the continent, the flu outbreak in Germany and the German labor strike. But the moderation in some of the high frequency PMI data as well as the IFO Business Climate Index from multi-decade highs may also mean that economic growth in the region has likely peaked. Another possible reason for the slowdown is that the trade uncertainty is finally starting to have an effect on investor sentiment and export orders. Unfortunately, it is too early to be sure of the causes of the latest slowing in momentum.
Inflation gauges in the euro area, particularly core inflation, remain stubbornly muted. The weaker euro combined with higher oil prices should push headline inflation up over the coming months. In our view, core inflation is unlikely to weaken significantly as the economy continues to grow. We are therefore maintaining our baseline assumption that the European Central Bank will end asset purchases by the end of this year and start to raise interest rates around mid-2019. However, if growth and inflation continue to miss expectations, the European Central Bank will likely continue quantitative easing beyond 2018 and maintain policy interest rates at the current level well into 2019.
Wages in Japan on the rise
Japan’s economy contracted in the first quarter to 0.2% over the fourth quarter (0.9% year-over-year). Most of the weakness is attributable to muted domestic demand. However, we believe this to be a temporary pause in growth. There are positive signs elsewhere. Most importantly, wages are finally rising, according to the March wage report.
Average monthly earnings increased by a solid 2.0% in March from February (2.5% over March 2017), much higher than the average of 0.4% for 2017. The Final Report of Monthly Labour Survey indicates that real wages increased by 0.7% in March overall and by 2.2% in the manufacturing sector. The slow-but-sustained wage growth for both full-time and part-time workers indicates that the impact of the tight Japanese labor market may finally be yielding much-awaited results. With steady wage gains, inflation is also rising, with core inflation at 1% as of April.
The strengthening of the US dollar bodes well for Japan in this context. Although we do not expect the Japanese central bank to tighten monetary policy until sometime after the inflation rate reaches the target 2%, gradually firming inflation could allow for some flexibility in yield-curve management.
UK economy continues to slow
The UK economy has continued to decelerate in line with our forecasts. We expect the economy to decelerate to 1.3% in 2018 after 1.8% growth in 2017. We forecast a cyclical recovery of the real GDP growth rate of 1.7% in 2019. This forecast incorporates our baseline assumption of gradual progress toward a final deal between the UK and the EU. However, there are downside risks.
In the first quarter, GDP growth fell to only 0.1% from 0.4% in the fourth quarter, owing to a slump in construction, which tends to be a weather-sensitive sector. However, it is unclear as to how much of this weakness can be attributed to weather conditions. Leading indicators of second-quarter activity so far do not point to a rebound.
On the positive side, with the unemployment rate steady at 4.2%, weekly earnings including bonuses increased in the first quarter by an annual average growth rate of 2.6% and earnings excluding bonuses increased by 2.9%. The inflation rate, which has decelerated steadily since November, stood at 2.5% as of March. Thus, the combination of steady wage growth and falling inflation should support real incomes of households. On the downside, if the euro-area economy were to slow further, it would weigh on economic growth in the UK.
As per the 21-month transitional agreement that will come into effect after the UK’s formal withdrawal from the EU on 29 March 2019, the UK will retain full access to the EU internal market and remain aligned with its customs framework until the end of 2020. The agreement extends the time frame that is available to shape and implement a new trade agreement and regulatory regimes with the EU until existing common rules cease to apply.
However, the agreement remains conditional on the UK and the EU overcoming other challenges, such as the need to find a solution that prevents the creation of a hard border between Ireland and Northern Ireland, as well as legal enforcement of the withdrawal. The negotiating guidelines issued by the European Council appear to enhance the UK’s chances of securing a free trade agreement that retains many features of current trading and regulatory arrangements, particularly in the trade of goods. Thus the transition agreement is a positive development; however, significant downside risks remain if the UK and the EU do not reach a final deal.