Geopolitical article

Geopolitical Uncertainty Shadows Improving Economic Growth


Story Highlights

  • We forecast U.S. GDP growth at 2.5% in 2017.
  • We still expect a total of three rate hikes from the Fed this year.
  • We are increasingly worried about risks from the geopolitical environment worldwide.

Despite some early political setbacks for the Trump Administration, we believe global economic growth is set to improve this year as higher commodity prices, reasonable inventory levels and an increasing appetite for capital spending are likely to drive the continued recovery. At the same time, political uncertainty could be rising across the globe.

Better economic growth

The U.S. economy was weaker than expected in the first quarter of 2017. However, we believe the weakness is due to some factors that will likely reverse in the second quarter. After growing at more than 3% during the last year, consumer spending looks to have increased by less than 2% in the first quarter. But income growth accelerated, which we think will lead to a recovery in consumer spending going forward. In addition, companies have recently indicated that capital spending plans are improving. Based on these and other factors, we continue to forecast U.S. gross domestic product (GDP) growth will average 2.5% in 2017.

The Federal Reserve (Fed) hiked the federal funds rate by 0.25 percentage point in March. While we think the potential for four hikes has increased, we still believe the Fed will hike interest rates three times this year with a pause at the December meeting. At that point, we think the Fed is likely to cease its reinvestment of maturing securities and allow its balance sheet to gradually shrink over time.

Economic data in the eurozone has been relatively robust to start the year, driven by improving global trade coupled with very accommodative monetary policy. We think this backdrop is likely to continue over the course of this year, with the European Central Bank (ECB) leaving policy unchanged until 2018. We forecast eurozone GDP growth will average just less than 2% in 2017. In the U.K., Prime Minister Theresa May recently invoked Article 50 and officially started the two-year negotiation process to leave the European Union (EU). In an attempt to extend her party’s parliamentary majority, May also has called for new elections to take place in June. While we were wrong about the Brexit vote leading to a recession in the U.K., we continue to believe that economic growth will slow going forward. With a lack of clarity on the final relationship between the U.K. and the EU, companies there have no incentive to dramatically increase capital spending or employment. In addition, the weakness in the British pound after the Brexit vote is likely to result in higher inflation over the course of 2017, putting pressure on the spending power of households.

Similar to the eurozone, economic data in Japan has improved on the back of better global growth and easy monetary policy, accompanied by an increase in fiscal spending. We believe the Bank of Japan is likely to stay extremely accommodative this year as inflation continues to underwhelm.

With the improvement in global trade and higher commodity prices, we project that economic growth in emerging markets should continue to improve. Countries that experienced deep recessions last year, such as Brazil and Russia, seem to be bottoming. India appears to be recovering from the shock of demonetization, which temporarily reduced the amount of currency in circulation. In China, we believe better exports coupled with continued government spending and improving corporate profits is likely to result in sustained economic growth in the 6.5 – 7.0% range.

Political uncertainty rising

Much has been made recently about the failure of healthcare reform legislation in the U.S. that was intended to repeal and replace the Affordable Care Act (“Obamacare”). Despite holding a majority in both the House of Representatives and the Senate, the Republican Party was unable to garner enough votes, which we found disappointing. We think the Republican leadership will continue to work on healthcare, but the path to success remains challenging.

President Donald Trump and other leaders have indicated that tax reform will come next. While we believe the healthcare outcome makes tax reform less likely, Republicans must realize that failure on two major initiatives would be devastating to their mid-term election chances in 2018. Thus, we expect tax reform will happen in some form. We also expect an increase in infrastructure spending in 2018, but we would not rule out some progress on this initiative in 2017 in a bid to “get something done.”

Elections in Europe have been a focus during the last few months. In the Netherlands, the nationalist party failed to win enough votes in March to gain control of the government. Elections are scheduled later this year in Germany and possibly Italy.

However, the main focus has been on presidential elections in France, where candidate Marine Le Pen has continued to campaign on a platform based around a referendum to leave the EU. The first-round vote in France took place on April 23. Centrist candidate Emmanual Macron and Le Pen advanced to the second round of voting, which is scheduled for May 7. The latest polls show Macron as the likely winner by a comfortable margin. Given Macron’s reformist agenda, such a result is likely to be seen as market friendly, especially if follow-up elections in June produce a reform-minded parliament.

We also are increasingly worried about the geopolitical environment. Trump has recently become outspoken about North Korea’s pursuit of its nuclear weapons program, and has said the U.S. could act unilaterally if that country continues its development. Any military action would be a significant concern for financial markets.

In addition, the recent action in Syria has resulted in an increased probability of further problems between the U.S. and Russia. The growing “lone wolf” terrorist attacks in Europe also could put a dent in confidence and economic growth.

Finally, trade and immigration policy will be watched carefully going forward, as Trump has sounded hawkish on these issues in the past. Any move toward trade barriers or restrictions on immigration flows could be harmful to U.S. and global economic growth.

While we are optimistic on the direction of global economic growth in general, we will be watching these issues closely.

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Associated Tags: Global Growth, Economy

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