This is our last economic report for 2016 and we look back at the surprises this year and try and assess what may lie in store in 2017. One surprise in 2016 was a pleasant one, global growth improved as the year progressed and the world’s two biggest economies, the US and China, look like finishing 2016 with economic growth rates higher than widely forecast at the beginning of the year. Indeed for a year that started so badly – widespread views that global economic growth may be failing; large falls in the early months of the year in share markets and commodity prices; government bond yields plumbing record lows and concern about potential deflation – the rebound from around mid-year has been quite stunning.
The positive swing in perceptions in the second half of 2016 about global economic growth prospects plus the sharp improvement in sentiment towards risk assets, especially resource stocks was also surprising given that the change in perceptions occurred coincidentally with two factors that are normally harmful to economic growth and risk assets, rising interest rates and a sharp lift in geo-political uncertainty. Government bond yields have risen sharply everywhere over the past few months and several factors point to further increases over the next few months. In terms of geo-political risk the revolt against the political establishments was highlighted in Britain’s Brexit vote, the US Presidential election and the Italian political reform referendum. Just from these three election results, the European Union looks much closer to disintegration and the political relationship between the US and China is souring fast.
Looking towards 2017, the first point to make is that there still appears to be some positive momentum in the economic data out of the US and China. Leading economic indicators of US economic activity are looking strong or very strong. The December National Association of Homebuilders’ index jumped to 70 from 63 in November. Readings above 60 are strong and around 70 are very rare. Barring weather-related events US housing activity is likely to stay very strong early in 2017. Recent consumer sentiment and confidence readings are also elevated, a jump of 4.2 points to 98.0 for consumer sentiment in early December and a 6.3 point lift to 107.1 in November consumer confidence. Manufacturing and non-manufacturing purchasing manager surveys are also pointing to expansion. Annualised US GDP growth, barring severe winter weather disruption, looks set around 3% in Q4 2016 and possibly Q1 2017 too.
In China too, recent monthly economic data and purchasing manager reports point to annual GDP growth holding around 6.7% y-o-y in Q4 2016, the same growth rate reported all through 2016. China’s stable and relatively strong growth rate comes with risks to the sustainability of growth later in 2017. House prices have been rising too fast and have fostered too much residential construction building activity risking a destabilising collapse in property construction. The authorities are trying to temper the boom in property by imposing various restrictions on loans for speculative property purchases. One way or another, the outlook is that residential property construction takes a weaker turn at some point in 2017.
Returning to the US, stronger economic growth coming on top of seven years of modest expansion is cutting in to what is left of underutilized US economic resources increasing the likelihood that inflation in the US starts to lift. The Federal Reserve’s policy meeting last week lifted the funds rate by 25bps as widely expected to 0.75%. Where the Fed surprised was in the Chairman’s comments following the policy move, providing strong indication of three rate hikes in 2017 and a blunt warning that the economy was growing well and needed no help from fiscal expansion. The implicit warning was clear, if President-Elect pursues his plans for cutting taxes and spending more (fiscal expansion) the economy could overheat necessitating a lot more than three rate hikes in 2017.
The news that the Fed is changing its spots from acting cautiously lifting rates and falling behind upward movements in bond yields to potentially acting more aggressively going forward reinforces various factors driving bond yields higher.
How much the Fed will raise interest rates in 2017 and the nature of the potential clash brewing between the Fed Chairman and President-Elect Trump is one area of great uncertainty in 2017. It seems to us very unlikely that risk assets can continue to rally strongly mostly because the growth and policy outlook beyond the next month or two is highly uncertain. Also, rising interest rates and their growth-crimping impact cannot be ignored for much longer.
Apart from the uncertainties that are likely to be generated overseas in 2017, Australia has one significant home-grown one, at what point does record household indebtedness peak and turn potentially to a period of household deleveraging? A long period of low and falling interest rates has caused households to borrow more relative to their income, but low borrowing interest rates are starting to turn higher. The asset that households prefer to borrow on and buy, housing, is offering patchier and some cases deteriorating returns. More likely than not Australian households will borrow and spend less confidently in 2017 than they did through 2016. Less robust growth in household spending implies that Australia’s annual economic growth rate fades through 2017.
All told, 2017 looks capable of throwing up at least as many surprises as occurred in 2016. One surprise we fear is that interest rates internationally rise more than expected and even if the RBA is inclined at some point to try and offset the rise in Australian interest rates by cutting its cash rate, the impact may be entirely offset as bond yields continue to rise internationally. 2017 looks like being a year where borrowers pay more, possibly much more than they have been accustomed to paying over recent years.