This is the last weekly of 2016, so we wish you well for the holidays and look forward to catching up with you again 2017.
2017 is going to be an interesting year with plenty of things to think about. Trump’s fiscal policies are the obvious talking point as is the strength of the dollar. But is the US economy strong enough to handle two or three rates hikes? Will the housing market start to stall now that mortgage costs have risen significantly in recent months? What about the effect of ageing populations dragging down growth and inflation, the opposite of what many people think will happen to global growth next year? These are the topics we will be discussing in next year’s weeklies.
Last week the FOMC decided to raise the fed funds rate to 0.75% and have pencilled in an extra rate hike in 2017. The media would have us believe that the faster pace of normalising the policy rate to its long term norm now estimated at about 3% reflects both a stronger US economy and expectations of outsized fiscal stimulus under a Trump presidency. An upward revision to Q4 GDP also tends to have some carry-forward into the Q1 level of GDP in the staff’s forecast exercise, thereby explaining the small 2017 revision. That leaves the tiny revision to 2019, which is hardly worth mentioning. At 1.9% that forecast remains at or below the US long term potential growth of about 2%, which in itself is at the high end of the staff’s latest estimate of 1.5% to 2%.
By contrast, the ‘dot plot’ of FOMC participants’ assessment of the appropriate monetary policy has captured the headlines. While it is true that the average level of the policy rate in December calls for three rate hikes of 25 basis points in 2017, instead of the two hikes envisioned at the September meeting, the new outlook still remains less aggressive than what participants envisioned in June, and in the interim most participants seem to have signed on to the latest staff research showing strong evidence that demographics can explain all of the decline in the long term neutral rate of interest rate to less than 1% in real terms (3% in nominal terms if inflation is stable at its target of 2%). A few members remain outliers in calling for the fed funds rate to rise to 3.5% to 4% but that dissenting view is increasingly out of sync with the majority.
If Congress does approve an outsized fiscal package, the staff forecast will be revised upward commensurately with the inescapable consequence of having to raise the inflation forecast for 2018 and beyond. In short, upward surprises in either economic growth or in the nation’s fiscal policy setting are likely to translate into a more aggressive Fed. The December FOMC decision is not yet the clarion call for higher rates at a faster pace, but it is a red flag for things to come if politicians think fiscal policy is a free lunch.
Turning to the topic of aging populations, a couple of recent papers from the IMF have detailed the palpable problem of aging populations and specifically aging workforces across Europe and Japan; highlighting the current and expected accelerating impact these will have on productivity and economic growth. Whereas an increase in the dependency ratio is an obvious drag to economic growth - the effects of an aging workforce itself is not obviously a hindrance to productivity. For an older workforce may make up for in experience what they may have lost in vigour and entrepreneurialism associated with youth; particularly in technologically advanced economies where the considered elderly may easily be just as effective in many fields of employment. Studies of this effect on advanced economies are scarce and ones accounting for the further potential advance of technology are fewer but these two papers, “The Impact of Demographics on Productivity and Inflation in Japan” and “The Impact of Workforce Aging on European Productivity” go some way to showing that these ‘headwinds can have a non-trivial impact on total factor productivity (TFP) and deflationary pressures.’
The age distribution of the workforce in Europe has shifted upwards over the past few decades but will accelerate in the years ahead to the extent that it ‘could reduce TFP growth by an average of 0.2 percentage points every year over the next two decades’. ‘But in countries where aging will be most pronounced—Greece, Hungary, Ireland, Italy, Portugal, Slovakia, Slovenia, and Spain—annual total factor productivity growth could be reduced by as much as 0.6 percentage points.’ Japan faces the same problem along with an overall declining population and few major economies are exempt from the predicament. Across the 24 European countries projected by 2030 all except Luxembourg will have between 15-25% of the workforce aged 55-64.
Countries that have already ridden the demographic growth boom and failed to invest those gains preparing for when these population pyramids become top heavy will face an increasingly uphill battle. Those with already unsustainable net foreign debts will have shrinking productivity with which to service these hefty debts whilst spending on increasing welfare costs. This problem is only exacerbated every time such necessary global deleveraging is pushed down the road and it will remain a long term risk to global growth and inflation prospects well beyond the next few election cycles and perhaps well into all of our retirements (or geriatric careers). We continue to believe that high quality investment grade debt from net foreign creditor regions represents a sensible investment in the face of such growth headwinds.
Changing demographics provided the idea for the Next Generation Global Bond Fund which we launched as a Guernsey based fund back in July. This fund is proving very popular with a UCITS version of this fund being launched today.
Wishing you a prosperous 2017.