After a year of political surprises, 2017 could see 'tectonic shifts' in economic policy, suggests Hermes Investment Management group chief economist Neil Williams.
Looking to the year ahead, Williams sees scope for reflation, inflation and political contagion but suggests it is still too soon to bet on any ‘great rotation' of an en masse shift out of bonds as that would mean taking on the central banks
"Speculation, rightly, that major economies will open their fiscal box is currently causing ‘reflation trades' to puff up growth assets, raise inflation expectations, and make the 30-year bull-run in government bonds look even staler," he says.
Yet, while this should be better for growth, he warns, financial markets may be ignoring the new global risk emerging. He adds: "Rather than the financial distrust of 2008/09, we may need to brace for political distrust, with the threat of beggar-thy-neighbour policies - from the US to Europe - rising."
Amid these conflicting growth forces, says Williams, Hermes' macro outlook is based on six core beliefs.
1. Fiscal solutions
In picking up the policy ‘baton' from central banks, Williams predicts governments will offer fiscal solutions in 2017 to add stimulus and to try to appease electorates.
"President-elect Donald Trump is set to reflate the US, and austerity in the UK is being deferred again," he explains. "It makes sense too for slower-growth Japan and the eurozone to loosen fiscally using the aggressive QE they're doing anyway to cap any rise in bond yields.
"Already halfway down the Japan route, the eurozone can open the fiscal box."
2. Monetary expansion
That said, Williams continues, fiscal policy will occur on top of, not instead of, this monetary expansion. "We are nine years since the first traces of crisis, yet central banks still daren't lift the tide of liquidity hiding the sharp rocks beneath," he warns.
"Real policy rates will stay negative, with peak rates lower than before, and central banks unable to turn off their liquidity taps without unintended consequences."
3. Trade Trump-card
President-elect Trump could invoke the all-encompassing trade clause ‘Super 301', which would allow him to impose tariffs without congressional approval, Williams points out.
"Such a protectionist policy would spur on a re-emergence of inflation," he adds. "However, it will be the ‘wrong' sort - 'cost push', led by tariffs, goods and labour shortages, rather than 'demand-pull'. In which case, central banks will turn a blind eye as their economies stagflate - meaning the inflationary flame may snuff itself out without policy action."
4. Cushioning the blow
While China has the tools to cushion the indirect blow of a ‘trade war' with the Peoples Bank of China's $3.1tn in reserves, argues Williams, it also has internal macro issues to consider.
"Its main macro dilemma is supporting growth, yet minimising a boost to the housing market," he explains. "There, affordability in the main cities has deteriorated faster than in other world financial centres. The deflationary and leveraging risks need watching."
5. Dollar debt exposure
The outlook is, on the other hand, less rosy for non-commodity-exporting emerging markets with high exposure to short-term US dollar debt and/or foreign saving needs, believes Williams.
"For these countries, clear vulnerabilities exist," he continues. "But, for others, external debt-ratios are lower, with fewer currency pegs to have to protect. And, where domestic debt climbs, they too can run QE."
6. Political not financial contagion
Unlike 2008, says Williams, the threat of contagion could this time be political not financial, with the Italian referendum result setting up 2017 to be a highly charged political year for the euro-zone.
"With upcoming elections in France, Germany, The Netherlands, and maybe now Italy and Spain, there may be little sympathy for a quick, ‘no-strings' UK Brexit deal once Article 50 is triggered," he explains. "Our exit negotiations could thus take much longer than the three years needed in 1982/85 by Greenland."
If this is the case, Williams predicts ‘lower for longer' and 'grab for yield' themes will continue thanks to political disruption, protectionism, cost inflation, and dissipating growth, even if governments opt for reflation trades in the short term.
"With the liquidity taps still on, chasing the ‘great rotation' of an en masse shift out of bonds means taking on the central banks," he concludes. "Because, for more fiscally-active governments, to initiate also the end of QE would be like a turkey voting for Christmas."
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