Central in forecasting 2017 and beyond is whether a new economic order is taking shape. Before the U.S. elections, economists were inclined to advise investors “to expect more of the same in the months to come,” as Lazard Asset Management did in October. After Donald Trump’s win, the paradigms that shaped the U.S. and European economies and policies over the past decade suddenly seem to have abruptly shifted or collapsed. Cheap oil. A stock market crash, the worst since the Depression. Investment banks on life support. Negative interest rates. Bull market for bonds. Deflation. Weak dollar. All were the decade’s recurring headlines, but these are less frequent now. These days, it is: Record stock indices. Reflation. Strong dollar. Higher gas prices. Bear market for fixed income.
“Old” problems remain for Europe. Greece’s debt crisis is again at a breaking point, and Eurozone governments’ borrowing (combined) is at 90 percent of GDP, near an all-time high. The weight of European banks’ non-performing loans continues to limit credit access and squeeze profits, which may lead some institutions to receive “bailouts” and “bail-ins” to survive (as may happen soon with Banca Monte dei Paschi if private financing doesn’t materialize Deutsche Bank, for example, is weak and is facing a lawsuit alleging anticompetitive behavior while being under the cloud of an investigation revealing that it allegedly rigged proprietary indexes. Unemployment is stubbornly high, the economy is idling, an aging population is hampering growth, gains in productivity are tepid, and inflation can’t take root.
The United States has a new president, a resurgent economy, and a just-built political hearth forging the right, raucous populists, and business into a policy-driving consensus. The Federal Reserve yesterday (December 14) raised the target range for its federal-funds rate by a quarter-point to between 0.5-0.75 percent and indicated there will be a 0.75-percentage-point rise in 2017—likely in three, separate quarter-point moves.) (The move was widely expected, with fixed-income markets having “priced in” the Fed move for current rates, the 10-year Treasury up to 2.478 percent at market close Monday [December 12], the yield’s highest in 17 months.)Continuing the country’s third-longest expansion, growth is projected at 2.3 percent in 2017, according to the OECD’s latest forecast; the labor market is tightening and wages are rising. Growth next year may be even higher than that forecast, as suggested by the GDP increase for the recent third quarter; it rose 3.2 percent, the fastest in two years, according to the U.S. Commerce Department. If Washington enacts a massive stimulus package, including cuts in corporate and personal income taxes, in early 2017, some economists see even more robust growth ahead, with the Fed rate hikes unlikely to rein in the expansion.
CHART: U.S. GROWTH ON TRACK TO BE ONE OF THE LONGEST
Source: Wall Street Journal, January 2016.
Europe equally is seeing populism strengthen as elections approach for leadership contests in the Eurozone’s three largest countries – Germany, France, Italy – and the Netherlands (the eleventh largest) next year (2017). Greece, too, may be heading to the polls. Appealing to anger and disenchantment, the movement is yet “unable to transform people’s anger and mistrust into a new political vision.” The fallout from the unprecedented wave of migrants is likely to drive voters’ choices, as is the economy’s seemingly intractable lethargy and governments’ inability to do something about it. If inflation rises and unemployment falls, quantitative easing (QE) by the European Central Bank (ECB) looks likely to “taper” further, despite the maestro’s cautions. One consequence of QE is the euro’s low value, a boon for export growth in products with price-sensitive demand. Start-ups are flourishing in Dublin, London, Stockholm, Paris, Amsterdam, and Berlin, although the pool of capital and private investors is much smaller than that available in the United States. Brexit’s impact remains an imponderable; muddling through the complicated policy decisions is likely to be the scenario. Temporarily, investors are complacent, shrugging off concerns of Brexit’s consequences for Britain’s economy and Europe’s unity.
CHART: MODEST GROWTH, WEAK INFLATION, AND BELOW-TARGET INFLATION IN EUROPE
Source: OECD, Euro Area - Economic forecast summary. November 2016. http://www.oecd.org/eco/outlook/euro-area-economic-forecast-summary.htm .
CHART: EU GDP GROWTH RATE, 2011 – 2016
Source: TradingEconomics.com. http://www.tradingeconomics.com/euro-area/gdp-growth .
If a new order is taking shape, the recent decisions by the U.S. and European central banks may be the starting points. The Fed made its first move yesterday (December 14) with three more rate hikes indicated for next year. In Frankfurt in early December, the ECB announced four changes in its unprecedented and unconventional program: scaling back from April onward its monthly purchase of bonds, from $85.29 billion (€80 billion) to $63.96 billion (€60 billion); continuing its buy-back program through December next year and longer if warranted; increasing the maturity range to 1-30 years from 2-30 years; and, buying assets yielding below the deposit rate (‑0.4%) for the first time.
CHART: FEDERAL RESERVE INTEREST-RATE TARGET, 2004-2016
While some saw the ECB announcements as the start of “QExit,” Draghi tried to dismiss assessments that a “taper” is underway. “The natural way to look at a word like that is to have a policy whereby purchasers would gradually go to zero, and that’s not been discussed or, as a matter of fact, it’s not even been on the table,” he said at the press conference (December 8). Underneath his defense was a fear that bond markets would have a “taper tantrum” (panicking investors fearing higher risks in bonds dump them and thereby force rates up), as happened in May 2013 when the Fed scaled back its roughly $70 billion-a-month purchases of bond and mortgage-backed securities. Already, the ECB has invested $1.05 trillion (€1 trillion) to stimulate the Eurozone economy. On its balance sheets, securities of euro-area residents (denominated in euros) $1,223,230 (in millions) (€1,161,004) and lending to euro-area credit institutions related to monetary policy operations (denominated in euro) $588,951 (in millions) (€558,989) are the largest holdings.
CHART: ECB ASSETS, 1999 - 2015
Against this backdrop, here are some areas that promise to influence Europe’s economy next year and beyond:
U.S. economy: The pace of U.S. growth is key for Europe, since the two form the world’s largest bilateral trade relationship (a third of the trade between both comes from intra-company transfers), with each investing more in the other than their foreign direct investments in any other region. Looked at another way, U.S.-EU trade accounts for more than 50 percent of world GDP in terms of value and 40 percent in terms of purchasing power, according to the Center for Transatlantic Relations.
CHART: TRANSATLANTIC ECONOMY VS. THE WORLD – SHARE OF WORLD TOTAL
Source: The Center for Transatlantic Relations, Transatlantic Economy. October 2016. https://transatlanticrelations.org/wp-content/uploads/2016/10/Transatlantic-Economy-Chapter-2.pdf
Robust growth in the United States will benefit Europe. When and how it will do so, and by how much, are the questions shaping Europe’s outlook. A strong U.S. economy will help emerging markets, too, which, in turn, will be better markets for Europe’s goods and services.
Investment: Attracting investment in Europe, and allocating it more effectively, is an essential foundation in rebuilding Europe’s economy, according to economists Elisa Gamberoni, Claire Giordano, and Paloma Lopez-Garcia. “An efficient allocation of inputs across firms is a necessary condition to boost… growth,” they write. They present “evidence that in large Eurozone economies, capital misallocation trended upwards in the period 2002-2012 while labor misallocation dynamics were flatter. Uncertainty and credit market frictions were strongly associated with the observed developments in capital misallocation, whereas the overall deregulation in the product and labor markets contributed to dampening input misallocation dynamics.” 
Key to Europe’s economic strength ahead is the region’s ability to use capital more efficiently and effectively. A corollary to this challenge is the need to deepen financing for start-ups, since Europe’s venture capital infrastructure is less sophisticated and extensive than the U.S. system, particularly in late-stage funding, when large amounts of capital are needed to grow exponentially to secure dominate market-share early. How access to capital expands and addresses start-up needs will have an influence on Europe’s economy.
BREXIT: Immediately after the vote, numerous analysts cut forecasts for Europe’s economic outlook, citing, as the rating agency S&P did, “numerous downside risks” over the next two years. Its forecast saw Brexit dragging the UK’s GDP down by 1.2 percent in 2017 and 1 percent in 2018 while costing the Eurozone 0.8 % in GDP output over 2017 and 2018. More recent forecasts are less dire, with the pound rallying against the euro and the dollar in early December as U.K. government officials hinted that a “soft” Brexit being a possible outcome. The U.K.’s divorce proceedings will continue to be a factor in Europe’s outlook, but more and more at the margins as a “two speed” Europe gains momentum.
Fiscal support: European nations’ governments spending.
Europe can’t expand unless fiscal austerity is reduced. But with debt-to-GDP ratios high and governments unable to grow revenues in a slow-growth economy, their ability to run higher deficits to boost economy growth is constrained by many factors, including the EU’s debt and deficit targets established when the euro came into use in 1999. While yet to be imposed, the penalties could cost a country 0.2 percent of its GDP in fines. EU observers generally think the era of austerity is over, however, and that Brussels will be more tolerate of deficit increases to free up government funds for initiatives that cut taxes and create jobs. The success of the move to end austerity approaches will have an influence of economic growth.
Source: Caroline Gray, “Set to breach targets again? Debt and deficit outlooks for Southern European Eurozone countries in 2016 & 2017.” November 28, 2016. Focus-economics.com. http://www.focus-economics.com/sites/default/files/wysiwyg_images/focuseconomics_eurozone_publicdebt_fiscaldeficit-01.png .
Ahead, then, there are many reasons to be optimistic for Europe’s growth outlook, but the unanticipated events, the constraints on fiscal spending, the inertia of policymakers, and U.S. growth factors are to be watched.