For the first time in seven years, developed and emerging markets are both showing signs of economic strength. What does that mean and is it sustainable?
For the first time in seven years, the global economy is getting in sync—meaning both developed and emerging market economies are recovering at the same time.
In our view, developed markets pose the likeliest risk to this global cycle.
In developed markets, aggregate demand is recovering, helped by a private sector that is now willing to take on debt and more spending, shifting away from the previous focus on balance-sheet repair. At the same time, emerging markets, which have been adjusting for the past four years amid slack commodity prices and weak global demand, are also in recovery mode.
This synchronous recovery could create a positive feedback loop. Indeed, with developed markets accounting for 60% of emerging-market exports, as real import growth accelerates in the former, exports are on the rebound for the latter. Meanwhile, the improved outlook for emerging markets helps reduce disinflationary pressures on developed markets.
U.S. Business Cycle
How sustainable is this recovery? Business cycles typically end when macro-risks, such as runaway inflation, financial bubbles, or external threats prompt policymakers to tighten monetary and/or fiscal policy aggressively. In this cycle, emerging markets have just begun their recovery phase, with inflation and current account balances moving toward central-bank comfort zones; macro stability risks are unlikely to resurface anytime soon. Moreover, emerging markets have now built high levels of real-interest-rate differentials vis-à-vis the U.S., providing adequate buffers against expected moves by the Federal Reserve to raise U.S. rates back to normalized levels.
In our view, developed markets pose the likeliest risk to this global cycle. The U.S., which is in the most advanced stage of the business cycle, may be the critical link, in part, because it tends to have an outsized influence on the global cycle, particularly for emerging markets. While price stability features very prominently in debating any central bank’s monetary policy stance, financial stability is clearly emerging as an equally important factor.
To that end, private sector leverage has picked up modestly in the U.S.* In fact, the household-sector balance sheet, which was the epicenter of the 2008 credit crisis, had been deleveraging until the third quarter of 2016. Moreover, the regulatory environment so far has remained relatively credit-restrictive. Hence, we see the current risks to financial stability as moderate. However, financial stability risks could rise, considering that monetary policy is still accommodative (real rates are below neutral rates), and particularly so if the Trump administration relaxes the financial sector’s regulatory measures.
Price stability would be a more critical risk to watch in the near term. U.S. core inflation has been moving closer to the Fed’s target, while the U.S. unemployment rate now around the rate below which inflation could accelerate. Therefore, we expect the Fed to raise key interest rates six more times (vs. the 3.2 times that markets currently price) from now until the end of 2018, and expect the other major developed-market central banks to tilt toward a less dovish/more hawkish stance.
The synchronous recovery raises the near-term risks for higher prices. The emerging-market recovery could reduce further disinflationary pressures on economies such as the U.S., even as domestic demand ramps up, with the private sector borrowing and spending more. That said, we still see low risks of a major inflation “surge.” Fed Chair Janet Yellen herself has weighed in on this topic recently, highlighting how, during the past two cycles, inflation failed to surge, even with unemployment rates falling below levels that should trigger higher inflation.**
Against this backdrop, the global cycle expansion remains intact in our base case—although we are mindful of the potential risks. Developed-market central banks, while moving to normalize monetary policy, are unlikely to be provoked into an aggressive tightening, and this environment will provide emerging markets with the breathing space they need to stay on a recovery path.
However, if the recovery in the global private-investment cycle, particularly in the U.S., proves stronger than we currently expect, it would support productivity growth, lift neutral real rates and encourage the Fed to take up an even faster pace of rate hikes than we currently pencil into our base case.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Mar 26, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest macro and strategy coverage and reports. Plus, more Ideas.