Asymmetric challenges

The global economy is still fractured. While some countries and regions are moving ahead steadily, others are falling behind. This is perhaps most apparent when comparing the US with the eurozone, but there are deep divisions within the customary country groupings as well. China is powering ahead, while countries such as Brazil and Russia appear to have reached a dead end. Germany remains strong, while France, Italy and Spain seem unable to shake off recessionary tendencies. The prospects for global growth as well as developments in financial markets should be viewed against this backdrop.

The US economy is gradually moving into a more mature phase of the recovery from the global financial crisis half a decade ago. The recovery has been weaker than many would have liked. The economy has not performed as strongly as it did during upswings in the past. Nevertheless, looking at a broad set of indicators, it is clear that the cyclical recovery is well advanced. Indeed, unemployment has fallen steadily, while the economy is approaching what would be viewed as full capacity utilisation. Meanwhile, households have repaired their balance sheets. The huge deficit in the federal budget is also long gone and public finances no longer pose threats to the economy’s overall wellbeing.

Real GDP is expanding at a pace that is likely to induce further declines in the unemployment rate. The Federal Reserve may be complacent towards financial exuberance, but is still likely to deliver a first hike when the unemployment rate declines to the perceived level of “the natural unemployment rate”, which we expect in December or January. Many analysts expect a first hike in the second quarter of next year, while Fed funds futures are not pricing in a first hike until July of next year. In our view, these assumptions are likely to change in the direction of earlier Fed tightening.

The eurozone picture is quite different. This was of course the case all along. However, instead of catching up with the US, the eurozone now appears to be at risk of stalling. We see two main negative scenarios being played out. First, rising geopolitical tensions have cast a dark cloud over the economy. The deterioration in the West’s relations with Russia, triggered in particular by events in Ukraine, has significant negative effects on the eurozone economy. The effects are asymmetric: Europe is hit much harder than other regions, while the US is much less exposed. The Middle East no doubt poses huge challenges globally and for the US. Nevertheless, the economic fallout is likely less significant than for Europe.

The troublesome geopolitical events of late come at a very critical juncture. Growth in the eurozone is fragile and many countries are dependent on exports, as domestic demand is still stalling. This is no longer the case in countries such as the US, the UK or Sweden. More is at risk in the eurozone, both because it is closer to the global hotspots and because the economy is less self-sustaining in the first place. In this context, it is of course important to note the big gaps within the common currency area. Germany, with its strong export sector and robust domestic credentials, should still be able to shake off these headwinds. For the other large eurozone economies, this will not be as easy.

The second theme is the slow speed at which the eurozone addresses its internal problems. While the ECB may have managed to restore confidence in the government bond market, banks and corporates in the most troubled countries are still subjected to rising borrowing costs. This situation is made even worse by the fact that the ECB has not kept sufficient distance from deflation. During the spring, we hoped that the Central Bank would do more, launching a programme of asset purchases. Although our hopes so far have been dashed, we expect more action to address the problems ahead, in which case the euro should weaken as a result.

In the UK, growth has surprised on the upside. The labour market has gradually improved, while wage developments have been unexpectedly sluggish. The Bank of England has seen this as indication of continued slack and we expect it to maintain its expansionary policy stance throughout this year. Japan decelerated in the second quarter, mostly due to sluggish consumption associated with the indirect tax hike in spring. Exports have also been weak. We think that the authorities will have to spell out their structural agenda more clearly, and we expect continued monetary stimulation from the Bank of Japan.

Emerging economies are also impacting the global outlook in a quite asymmetric fashion. In China, selective stimulation measures have so far succeeded in stabilising growth. However, given the slow pace of structural reform, we anticipate China’s growth rate to abate gradually over the next couple of years. The rest of Asia, including India, is also developing positively. By contrast, we are very negative to Russia, where we see sub-par growth well beyond our forecast horizon. Brazil is also likely to disappoint. Apart from the fact that global commodity markets have run out of steam, both countries’ structural policies leave a lot to be desired.

The Nordic countries are also travelling at different speeds. Signals from Denmark were quite positive in the beginning of the year but the upswing has since stalled, mirroring the eurozone. Finland is already affected by developments in Russia. Looking ahead, fiscal policy is likely to add further headwinds for the economy. The outlook for Norway is more upbeat, despite the fact that industries such as fish farming are subject to sanctions by Russia. Sweden, finally, is likely to deliver solid growth over the next couple of years. While Sweden is subject to the same external environments as its neighbours, it is less vulnerable in the sense that it is more reliant on domestic demand.

Beyond the downtrend in inflation below the Riksbank target, we do not find convincing arguments to support the commonly held belief that the current extremely soft monetary stance will last very long. Given our outlook for Swedish inflation and the expected rate hikes by the Fed, the Riksbank is likely to change its tune sooner than both it and the market expect. In combination with our views on the ECB, we find it reasonable to expect the krona to trade stronger against the euro.

For further information, please contact:
Jan Häggström, Chief economist, +46-8 701 10 97, +46 70 761 43 66

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