US is back on path to normal growth

By Invesco’s chief economist, John Greenwood

Summary
With the US Federal Reserve (Fed) starting on a series of fed fund rate hikes from 16 December 2015, US money and credit markets will be on the path towards normalisation after seven years of abnormally low rates. This is a sign that, despite the weakness in other developed and emerging economies, the US is back on the road to normal growth.

However, the key indicator to watch will be the rate of growth of bank credit. The US is the only major economy where bank credit growth has returned to normal (6-8% p.a.) and it is critical that, in the aftermath of interest rate hikes, credit continues to grow at roughly the same rate. If this happens, then equity and property markets can shrug off the early phase of interest rate hikes in my view.

Assuming no tightening of credit conditions, I expect US real GDP growth in 2016 of 2.6%, and CPI inflation of 1.4%.

By contrast, the eurozone and Japan are still in the midst of extended programmes of quantitative easing (QE) intended mainly to keep interest rates low along the length of the yield curve (rather than directly to boost the rates of growth of money and credit), and hence to stimulate the two economies.

With the Euro-area likely to grow at only 1.5% in 2016 and Japan at 1.3% and with inflation in both economies well below 2%, the European Central Bank (ECB) and the Bank of Japan (BoJ) are at least a year, if not more, from hiking interest rates in my opinion. In both cases there are faults in the design of their QE programmes that need to be rectified in order to make them more effective.

The upswing in both the economies of the eurozone and Japan have slowed somewhat in recent months, demonstrating that the underlying recoveries in the US and the UK are inherently more sustainable than the – as yet – fragile upturns in the eurozone and Japan.

The divergent monetary policies of the Fed and possibly the Bank of England (BoE) on the one hand and the ECB and BoJ on the other implies some further volatility in the currency, fixed income and equity markets.

In particular, the US dollar will probably appreciate further while the euro and the yen might depreciate more. This may weaken the earnings of large US companies with substantial overseas sales, but medium and smaller-size US companies should benefit from the broadening domestic recovery.

The overall picture globally is one in which both growth and inflation will remain subdued against a background of several years of very low money and credit growth.

The UK is faced with a similar situation to that in the US – reasonably buoyant economic activity (I forecast 2.4% growth in 2016), but accompanied by inflation well below target. This implies that the BoE are unlikely to follow the Fed in raising interest rates until February or May 2016 at the earliest.

In the emerging economies the slowdowns in China, Brazil and Russia are continuing to impact commodity markets, numerous basic industries and global trade volumes. Beyond that, the struggle among emerging market (EM) producers more generally to regain competitiveness threatens several EM currencies with the need for further currency depreciation.

The emerging economies face three key problems. First, many of them allowed excessive rates of growth of money and credit in 2009-13; second, most are still overly dependent on an export-led growth model; and third many of them are very dependent on commodity exports at a time when commodity prices have slumped.

Following the temporary recovery in the price of oil between March and May 2015 to US$60- 65 per barrel, prices fell again in Q3 2015 and Q4 2015, with the West Texas Intermediate oil price falling below US$40 per barrel in December. I believe that oil prices will remain weak (below US$60) in 2016.

Inflation rates have continued to remain very low in most developed economies. The widespread inflation undershoot reflects not only the direct effect of weak commodity prices but also the persistent background of slow money and credit growth that has characterised the post-crisis period. Only in the US have money and credit growth rates returned to normal rates.

In spite of these short to medium term setbacks in the recovery process my long-standing view has been that the current global business cycle expansion will be an extended one. The main reason is that sub-par growth and low inflation would avoid the need for the kind of tightening policies that would bring an early end to the expansion.

It is also the case that recessions or growth weakness in the EM economies are unlikely to derail the modest-paced recovery in the developed economies. While some companies or sectors cannot avoid being affected by the problems of the EM, the transmission of key fundamental forces – like monetary policy and balance sheet repair – still goes primarily from developed markets to EM, not vice versa.

In addition, the recovery in the US, although already six and a half years old, is only now starting to take on the typical characteristics of a normal recovery: banks have started to provide credit instead of the Fed, business investment is recovering and consumer spending is regaining its normal momentum.