Reflationistas vs Cautionistas

Debate continues around whether the better-than-expected signs of growth outside the US could lead to a genuine global reflation.

We put ourselves in the more cautious camp. A Trump fiscal stimulus package provides the potential for a pickup in the world’s largest economy. But global reflation likely depends more on emerging markets than advanced economies, even with the caveat that a newly empowered President Xi may turn his attention to debt rather than job creation in China. Indeed, we have long argued that the optimal scenario for China is not growth acceleration, which would only be possible at the expense of future stability. The better course would be well-managed deceleration that aligns with the economy’s diminishing growth potential and occurs in tandem with structural reforms and regulatory changes aimed at ensuring the sustainability of that growth.

This is what appears to be on the table in China. Of course, it helps if such difficult adjustments are pursued deliberately rather than being forced through in a disorderly manner. We are therefore reassured that concerns of an antagonistic US-China relationship haven’t materialized; although we feel that Commerce Secretary Wilbur Ross’ recent assertion that “US-China relationships are now hitting a new high especially in trade” is something of an exaggeration. However, the relationship has evolved more smoothly than it might, giving the Chinese leadership time to pursue needed reforms at a pace that does not threaten stability.

For other emerging markets, it is not the improvement in growth per se (minimal so far) that makes us more hopeful, but the noticeable qualitative improvement of macroeconomic policies. Admittedly, our more upbeat view on Russia partly reflects expectations of higher oil prices (despite recent volatility) and also the gradual healing in domestic demand as inflation retreats and monetary policy settings become more supportive for growth. There is no sign of genuine reform or move toward diversification that the economy desperately needs, making it the one BRIC where the upturn appears mostly cyclical in nature and hence vulnerable to erosion over time.

By contrast, a new bankruptcy law and recent agriculture reforms in India carry considerable potential for boosting productivity. While the demonetization move will have some negative consequences on growth in the shorter term, it stands to facilitate broader policy goals in the longer term, including broadening the tax base ahead of the upcoming GST implementation.

Brazil’s progress in the first half had been encouraging, before President Temer’s graft scandal put both the country’s ambitious reforms and the underlying economic improvement at risk. The Brazilian government has made considerable progress with fiscal management. While the most contentious reforms on pensions will probably end up being diluted, it would still represent the most comprehensive reform in decades and an important step towards long-term fiscal sustainability.

The Brazilian economy has shown signs of improvement over the last year and a half. Inflation has fallen from over 10.0% in early 2016 to just 4.1% in April, allowing the Central Bank to cut its policy rate from 14.50% to 11.25% over the same period. Moreover, GDP is projected to increase in the first quarter of this year following eight consecutive declines.

So while we see some small steps in the right direction for the global economy, we think it is too early to make a strong case for global reflation.

Christopher Probyn, Ph.D – Chief Economist, Investment Solutions Group – State Street Global Advisors