Looking ahead at the turn of the year is a favorite pastime for economists. Main scenarios, risks and black swan events are stables on the December festive menu. Does it matter? In some ways no, because the new year is a mere continuation of the old. In others ways it does, because the new year means fresh books are opened and accounts start from scratch.
Heading into 2016, things were looking ok from a macro-perspective, but markets tanked due to worries about a hard landing in China. The result was widespread panic as client accounts began the year in the red, which probably led to a larger market correction than what would have been the case, if events had taken place later in the year.
Heading into 2017, I worked with my amazing team in Washington on the top-10 risks for the year ahead, but at the same hotly debating what we had missed in the Trump reflation trade and what to make of 2016’s election results. A takeaway was that 2016 had been the year when experts finally realized that “something” was going on outside their ivory towers. The benefits from globalization – predicted by economic text books – did not reach all, and changes in social attitudes, celebrated in urban centers, increased the fault lines between the haves and the have nots. The rejection of London, Brussels and Washington was the defining message of 2016.
Looking back, 2017 sends almost the opposite message. The US tax reform disproportionally benefits the wealthiest and corporations with few efficiency gains to the economy as the tax code remains complicated and full of loopholes. The dismantling of regulation is a massive victory for corporate lobbyists. In China, President Xi solidified his control over party and state. In Europe, Macron won the French presidential and parliamentary elections, thus eliminating one of the most potent populist challenges. Stock markets soared even as Federal Reserve tightened monetary policy. According to Bloomberg, the 500 richest people in the world became USD1 trillion richer in 2017. The rest of us – holding financial and/or real estate assets – also saw good returns on investments.
Heading into 2018 the political fallout from increased inequality remains a worry. Although strong job creation across the developed world should strengthen the foundation underneath our civil societies, the focus on relative gains have probably become so ingrained that the political forces behind Brexit and Trump are not going away. Concerns about executive compensation and (legal) corporate tax evasion are no longer limited to the leftist parts of the populace. When the global elites meet in Davos in mid-January, they will probably collectively heave a sigh of relief for having avoided the pitchforks in 2017. But the support for the unquestioned globalized world view they represent is dwindling among the core constituencies.
The final Brexit countdown
The continued turmoil is most visible in two of the Anglo-Saxon countries, the UK and the US. The British Conservative election defeat in June was not due to a declining share of the vote (it went up from 37% to 42%), but a resurging Labour – not new and moderate, but a party whose leader embraces old-school socialist ideas.
The Conservatives have been unable to agree on what kind of Britain they want after Brexit. Brexiteers like Boris Johnson advocate a de-regulated Britain, which has little public support outside a narrow band of rightwing brothers. “If all this regulatory nonsense would just go away, the world would see that…” I am not sure what the Brexiteers expect, but I expect 2018 to be the year when their worlds view is finally challenged. In the Brexit referendum, Britons outside London voted for fewer Polish and Romanian workers, not more free trade and chlorine-washed chickens.
It is impossible to bridge the divide between what the EU can agree on internally, PM May’s red lines, a soft Irish border, and the regulatory divergence demanded by Brexiteers. I expect a meltdown within the Conservative party as Britain in 2018 moves towards a committed regulatory convergence regime with the EU. Bespoke indeed, but very much Norwegian in substance. Whether May can survive this politically is questionable. The alternative is a very hard Brexit, pushing the UK towards North America. There is no middle ground.
US mid-term election looming
The year 2017 has been quite a success for conservatives in Washington, despite the limited legislative victories. Courts, boards and agencies are now led by business-friendly Trump appointees, shifting the balance away from consumers, workers and the environment towards corporations. In the short run, this allows US businesses more freedom, but it also serves to increase the sense of disenfranchisement in the middle class, and carries the risk of an international backlash as the rest of the global business community (often spurred by social media outcries) moves in the opposite direction.
The US tax reform creates incentives for millions to leave the private health-insurance market when the individual mandate to hold insurance ends in 2019. This is likely to weaken the core of the current health-care system already in 2018 as insurance premiums are set to increase sharply, pushing millions onto government-run programs like Medicaid and the childrens’ program CHIP – or increasing premium subsidies. Republicans are now moving towards welfare reform aimed primarily at cutting Medicaid, the program most of the white lower middle class has become dependent on. I expect no major legislative action in Washington in 2018, but if Democrats are able to stay on message, they should make the 2018 and 2020 elections about redistribution; create a narrative of how Republicans take from the poor and give it to the rich.
This is also why the administrative powers of President Trump remain a worry. It takes time to get a US administration to get up and running, but the machinery is now in place to make some serious waves. The tax reform took some of the pressure off, but if opinion polls remain deeply negative for Republicans during winter (as I expect), more migration curbs and trade disputes are in the offing. Nafta is still a main target, but measures against friend and foe alike should be expected during the year. Not enough to derail the strong economic narrative (or change trade fundamentals), but enough to make a political splash. China will receive special attention as the trade deficit continues to widen.
In the 2016-election, 2.8 million fewer votes were cast than in 2012. The turnout rate of 60% (ranging from 43% in the 18-29 age group to 70% in the +70 age group) is way below that of other developed countries. In the mid-term elections, the voter turnout is generally lower and more skewed towards the older age groups. However, the proposed welfare cuts, a conservative social agenda as well as the rolling back of environmental and labor protections are likely to energize the younger age groups as has already been the case in Virginia and Alabama. The lasting legacy of President Trump (and the prevalence of social media) could well be a higher turnout among young voters, who overwhelmingly favor Democrats. Despite their best efforts, I except Republicans to lose control of at least one chamber of Congress in the mid-term elections.
The financial-market opioid addiction
The second half of 2017 saw the first global alignment of the economic cycle in a decade. There were no major weak spots, and the rising business cycle lifts all ships. After a decade of economic and political turbulence, the stars are finally aligned for good corporate performances, strong economic growth and more policy normalization.
For 2018 the usual caveats apply: geopolitical events in the Middle East, “Rocket Man” in North Korea, and Putin in Russia. The Italian election in March is likely to send a message of discontent. For financial markets, complacency could well be the most important risk.
Markets (and economists) remain focused on the next fiscal fix aimed at boosting economic growth and after-tax profits. Those are most likely not going to materialize. The US deficit is already set to explode from USD666 billion in fiscal-2016. In 2016, Federal interest expenditure for the first time eclipsed the previous peak in 2001 (USD223 billion versus USD216 billion). The debt has more than tripled during that period, and interest payments should reach USD300 billion annually towards end-2018. Much of Europe’s fiscal consolidation has been declining interest expenditure, and ECB is the sole net buyer of Italian government bonds. France has cut taxes, but cutting spending is going to be hugely unpopular. Not to mention welfare reforms. The UK has again postponed the timeline for reaching a balanced budget, and household debt is piling up as real incomes decline. An economy held together by increasing household indebtedness is not viable in the longer run.
Chair Yellen deserves enormous praise for having steered the Federal Reserve through the important turnaround in US monetary policy. But the US central bank also had significant leeway in designing monetary policy from 2012 to 2016 as the global economy was hurt by the European debt crisis and the emerging-market readjustment. The ECB has no such luck in 2018. A European upswing driven by domestic and global forces alike is sinking the ECB narrative supporting QE and negative interest rates. Nominal GDP growth in the euro area is likely to exceed 3% in 2018, while most government bonds carry a negative yield. It is simply unsustainable, and increasing divergence between monetary policy in Frankfurt and economic fundamentals is the biggest risk to financial markets in 2018. Look for an adjustment of the storyline after the Italian election.
The search for normal
“Normalization” is a term we often use, but without thinking deeper about what “normal” is. The period preceding the recession in 2008 was anything but normal. But the last decade’s massive monetary stimulus has also been as abnormal as can be. Central banks bemoan the lack of inflation – but there has been plenty of inflation over the past years, although not in goods, but rather in financial assets. The problem is not just the addiction in financial markets to an ever-increasing amount of free money, but also that attitudes towards debt are changing back to the irresponsible. When borrowing DKK1 million (USD150,000) costs the same as a Starbucks coffee per day, debt no longer serves as a limitation on behavior or expectations. This not only effects how housing markets work (bubbles already brewing), but also the fiscal narrative: if more debt is free, why do we need fiscal and structural reforms? Why do we need to prioritize and balance the books?
I expect 2018 to be a year of strong economic growth, but also a year where it becomes clear that we have learned little from the preceding two decades. Our ability to counter an economic downturn remains depleted as debt levels are already high and monetary policy lax. And no one seems to care. That scares me.