Economic Update - 1st quarter 2017

 This report has been prepared from information available as at 31 January 2017. Further information from: Mark Berrisford-Smith, Head of Economics, UK Commercial Banking, HSBC Bank plc. Tel: 020 7991 8565. Email [email protected]

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Key points

• The inauguration of Donald Trump as President of the United States has ushered in a period of heightened economic and political uncertainty as his Administration embarks on a more nationalistic ‘America first’ approach to trade policy and international relations.
• The global economy ended 2016 on a brighter note, and we have made upward revisions to many of our growth forecasts. But many issues and potential hazards remain unresolved, so that the pace of expansion will remain distinctly anaemic compared with what passed for ‘normal’ before the global financial crisis.
• The most substantive of our upward revisions relate to the short-term forecasts for the USA, where the policies of the new Trump Administration look set to usher in a spell of ‘reflation’ as infrastructure spending is ramped up and taxes are cut. This reinforces our expectation that the Federal Reserve will quicken the pace of monetary tightening, with two increases in the benchmark policy rate expected this year, and another in the first half of 2018. These moves will tend to sustain the dollar’s recent strength at a time when no increases are anticipated from the central banks in the Euro Area, Japan, or the UK.
• The economy of the Eurozone is performing well by recent standards, with the way once again being led by Germany and Spain. But the boost from the plunge in oil prices during 2014-15 is now abating, while the outlook is also clouded by political uncertainties. Elections are due this year in the Netherlands, France, and Germany, and possibly in Italy as well. The Presidential elections in France, which will conclude on 7th May, will be perhaps the year’s biggest political moment.
• In the UK the government has confirmed that it will seek a 'hard', or 'clean' Brexit: leaving both the Single Market and the EU’s Customs Union. Article 50 will be triggered by the end of March, once the legislation, deemed necessary by the Supreme Court, has been passed.
• Britain's economy continues to display resilience, with full-year GDP growth for 2016 coming in at 2.0% (the fastest in the G7). Sterling has behaved much as expected since the EU referendum and is forecast to soften further during the course of this year. The profile of the anticipated slowdown has been altered, with stronger growth expected this year, but with a recovery taking longer to materialise.
• The Bank of England has declared its intention to 'look through' the spike in inflation. Provided that the pace of pay growth remains contained, the imminent economic slowdown and continuing Brexit uncertainties should ensure that Bank Rate is left unchanged.
• Further out, the prospect of a 'hard' Brexit poses more risks for 2019. The Government now appears to accept that a trade agreement with the EU will not be ready in time, so that interim arrangements will be required; if these cannot be agreed, British businesses face the prospect of delays and additional costs in trading with EU countries. Under such a scenario, the slowdown expected during the next two years would be prolonged, and could deepen.

Politics trumps economics

The past few months have seen a decided improvement in the tone of the economic newsflow relating to most of the world’s major economies. After five years of false dawns, HSBC’s Global Research team has finally been able to upgrade its assessments of the economic prospects for the coming two years. In particular, there have been upward revisions to the outlook for the USA and the UK, while commodity-exporting emerging economies will also derive some benefit from the recent firming of prices.

The upgrade is modest, with the result that the global economy is expected to expand by closer to 2.5% this year and next, as against more anaemic growth of closer to 2% in the past few years. Welcome as the recent improvement has been it’s also obvious that risks have become even more acute. In medical parlance, the patient has been patched up with a few sticking plasters, but is not cured, and faces a greater risk of a relapse.

These risks aren’t just the long-standing economic issues which have plagued the global economy these past few years. They have been added to by a growing list of present and potential threats emanating from the spheres of domestic politics and international relations.

Indeed, at this juncture, it is politics which is taking centre-stage, rather than economics. Last year will be remembered primarily as a tumultuous year of political upheaval. Although the headlines were dominated by the UK’s Brexit vote and the election of Donald Trump as US President, there was plenty of other evidence of a backlash against political establishments and the economic order which has prevailed since the fall of the Berlin Wall. In the economic sphere too, the tide of globalisation is ebbing: Donald Trump has vowed to kill off the Trans-Pacific Partnership (TPP), and negotiations on the Trans-Atlantic Trade and Investment Partnership (TTIP) between the US and the EU are in the deep freeze.

The anti-establishment backlash

Voters across the developed world have been hopping mad with their political representatives since the financial crisis. Non-mainstream parties have made gains at numerous elections, especially in the countries of southern Europe which have suffered the worst ravages of the Eurozone’s debt crisis since 2011.

Although Greece is the only country where a radical party has taken power, Italy, Spain, and Portugal have all endured bouts of political instability. In the end though it was voters in Britain and America who kicked over the traces, with the UK voting to leave the EU and Donald Trump emerging as the victor in November’s US presidential election. Both results were unexpected, not least because these two countries had fared relatively well, economically, in recent years, and it should be remembered that in both cases the margins of victory were narrow. The USA and the UK both have unemployment rates at under 5%, and have enjoyed several years of modest-to-brisk economic growth. This suggests that it is no longer ‘the economy, stupid!’, as Bill Clinton put it back in 1992, which is the sole driver of voter behaviour. A raft of other issues, including national identity, sovereignty, control of borders and immigration, offshoring, inequality, and security have become more potent factors in shaping voter preferences.

Whatever the reasons for the political upsets of the past year, they have prompted an outpouring of angst among mainstream policymakers, pundits, and politicians. In the view of many people, recent developments are a sign that the neoliberal order has run its course, and that the process of globalisation, which has been a catalyst for massive changes to the world economy during the past 30 years, has lost the ‘buy-in’ of many people in western democracies. Economists generally believe that free trade is a good thing, enabling countries to specialise in what they’re best at and delivering lower prices for all. Consumers the world over have benefited enormously from falling prices for many goods, especially since China joined the World Trade Organization (WTO) in 2001. But cheaper clothes and televisions count for little, it seems, against a visceral distrust of the ‘establishment’, an amorphous concept which includes not just politicians, but also bankers, multinationals, and experts (including economists). It will live long in the memories of many ordinary people that most central bankers and economists failed to see the financial crisis coming. Mainstream political parties are now paying the price for what went wrong back then and for what has happened – especially the austerity – in the years since the crisis. The test of whether the anti-establishment bandwagon is here to stay or whether it will go down in history as an aberration, will come in the upcoming elections due in continental Europe during the course of this year: a key moment is shaping up to be the French Presidential elections which will conclude on the first Sunday in May.

Towards a multi-polar world

The election of Donald Trump poses particular risks in the geopolitical arena. Since the collapse of the Soviet Union, the United States has been the world’s sole superpower. But that position of hegemony is now being challenged by the military resurgence of both Russia and China. With America’s share of global economic output also in decline, some loss of influence is all but inevitable. Whether the Trump Administration accepts the new multi-polar reality or seeks to restore US power and influence will be the key factor shaping international relations in the next few years. Where the major powers rub up against each other, such as in the South China Sea, Syria, Ukraine, and perhaps even the Baltic States, could therefore see heightened tensions and conflict. But there are other potential flashpoints: North Korea has ratcheted up its sabre-rattling at a time when South Korea is rudderless in the wake of a vote in parliament to impeach the President; meanwhile, Turkey remains in a state of near-chaos following last summer’s attempted coup and the latest attempt by President Erdogan to wrest more power for himself.

There is a close nexus between geopolitics and economics, and nowhere is this clearer than in the field of trade. President Trump’s decision to ditch the Trans-Pacific Partnership (TPP) is signals a break with the approach which all American administrations have accepted since 1945: over the past sixty years, America has championed successive waves of trade liberalisation in the belief that economic openness went hand in hand with its core values of democracy and freedom, and that reducing barriers to the flow of goods and services would boost global economic growth and prosperity; moreover, America was often prepared to give more in terms of market access than it required from others in exchange.

If all this is now set to change, then the obvious question that arises is how the rest of the world will respond to a move in the direction of economic nationalism. Will others, especially China, want to take up the mantle of promoting global free trade? To what extent will the leadership in Beijing see it as being in China’s economic and geopolitical interests to open its markets, especially to other Asian countries, building on the existing Belt and Road initiative? With the demise of the TPP, attention will shift to the embryonic Regional Comprehensive Economic Partnership (RCEP), a Chinese-led initiative which is being negotiated among 16 Asian countries, including India, South Korea, and Japan, and extending to Australia and New Zealand. RCEP isn’t intended to be as deep an agreement as TPP, but it’s now the only game in town and could offer China a golden opportunity to cement its primacy in Asia and strengthen its status at the global top table.

The prospect of American reflation

It’s somewhat ironic that the tide of populism has swept across the democracies of the advanced economies just as the economic environment has shown tentative signs of improvement. Of course, there have been false dawns before, with many recent years being ushered in with a measure of optimism, only for a pall of gloom to descend by the summer. Yet across the world’s major economies 2017 will get off to a rather better start than did 2016.

In part this is because the financial markets appear to be on a more even keel than they were a year ago. Given the various bouts of turbulence which afflicted them at various times from 2013 to early last year, it’s surprising that the shock waves following the UK’s decision to leave the EU were so short-lived, and that there was barely a ripple following Donald Trump’s win in early November. On the contrary, the prospect of reflation in the United States has induced a near-frenzy of approbation in the equity markets, with benchmark indices in America and Britain (and elsewhere) reaching record highs since the turn of the year. Yet it would be a brave call to assert that financial markets are now inherently calmer and more stable. There are still plenty of causes for concern and potential flashpoints, and stock market valuations now look rich given the fundamental issues still faced by the global economy and the long list of things that could go wrong.

The commodities cycle has turned

Last year certainly ended on a much brighter note than it started. Apart from the calming of financial markets, matters were helped by the turning of the commodities cycle. Prices picked up from the spring, not as the result of strengthening demand, but in response to the gradual elimination of supply. In particular the authorities in China took measures to curb coal production, and OPEC and non-OPEC oil producers eventually concluded an agreement in November to reduce production. The Brent benchmark is now well established at $50-60 a barrel, having been in the $40-50 range before the agreement. The prospect of a gradual recovery in commodity prices has helped bring about a modest upturn in capital expenditure, especially in the United States, after a period of stagnation since prices collapsed in 2014.

By the close of the year the Purchasing Managers’ Index (PMI) surveys across the world were producing their strongest readings since back in 2015, with the upturn in capital spending driving a cyclical upswing in global manufacturing. For 2016 as a whole global GDP is likely to have expanded by 2.3%. While the USA managed growth of only 1.6%, the UK shrugged off the Brexit referendum and achieved a respectable expansion of around 2%. In the Euro Area meanwhile Germany and Spain continued to lead the way, so that the bloc as a whole is on course for growth of 1.6%, meaning that it could match the USA. In China the authorities have eventually succeeded in quelling the turbulence in financial markets, following the wobbles of 2015: coupled with a ramping-up of infrastructure spending and a general improvement in business and consumer confidence, this means that the economy registered annual growth of 6.7% for 2016.

Some upward revisions to our growth forecasts

Looking ahead, HSBC has made the first upward revisions to its forecasts in five years. The upgrades are fairly modest, and relate mostly to the advanced economies. The Trump reflation is expected to deliver faster growth in the United States, at least in the short term; and the post-Brexit downturn in the UK is now predicted to be shallower (albeit somewhat longer). For the Eurozone, the modest upward revision largely reflects the momentum carried over from the end of last year, and the pace of growth is expected to slow modestly as a pick-up of inflation squeezes real incomes. Taken as a whole, the advanced economies are expected to see GDP growth of 1.7% in 2017, a marginal increase from last year: within which the USA is projected to expand by 2.3%, while the UK, the Euro Area and Japan are all expected to grow by a more

Having finally plucked up the courage to deliver a second rate rise in December 2016, the US Federal Reserve is now expected to announce two further hikes (of a quarter-point each) in the target rate during 2017, with a further hike in the first half of 2018. But the Bank of England, the European Central Bank, and the Bank of Japan are all expected to sit on their hands until at least the end of 2018.

Across the world’s emerging economies, our growth projections have generally been nudged lower since the last update. Growth for these economies is still well above the rates achieved by advanced economies, but the gap has narrowed in recent years with their combined GDP growth for 2016 likely to come in at 3.6% once the figures have been totted up. One particular factor worth noting here is the hit to India’s GDP growth from the dislocation caused by the sudden withdrawal by the Reserve Bank of India (RBI) of high-denomination bank notes. India’s annual GDP data is produced according to fiscal years (running from April to March) rather than calendar years, and growth in the fiscal year ending this March is expected to come in at 6.3%: this sounds highly respectable, but represents a marked downgrade from the 7.5% which was anticipated before the RBI’s sudden move.

For emerging economies as a whole, the pace of growth is set to quicken this year to 4.1%, albeit that this is a little slower than the 4.3% envisaged in the previous update. Not only is China now on a more even keel, but growth looks set to resume in both Brazil and Russia this year after severe bouts of recession induced by 2014’s plunge in commodity prices.

The tightening of monetary policy by the Federal Reserve has the effect of also tightening conditions in many emerging economies. With investors now able to earn higher returns from placing their money into dollar assets, emerging-market alternatives look less attractive; for these emerging economies, matters are not helped by the fact that their currencies have fallen in the wake of Donald Trump’s victory, in particular the Mexican Peso and Turkish Lira. This means that their central banks now have less flexibility in setting their own monetary policy, since taking an opposite stance to the Fed would simply cause their currencies to depreciate even faster. Those countries which have especially high burdens of foreign-currency debt, in relation to GDP, are at risk of a sharp reversal of capital flows. For many emerging economies this ratio is around 30%, but is at 50-60% for both Chile and Turkey. Another factor to be borne in mind is where foreign investors hold a large share of locally-issued debt, such as in Malaysia and South Africa.

With this in mind most of the interest rate cuts which we’d previously pencilled in for emerging economies have now been taken out of the forecasts. This applies especially to China, where we’d previously forecast four cuts but now expect none. And in those countries, such as Brazil, where we still expect some loosening of policy, the easing cycle is likely to proceed at a more cautious pace.

United States – the Trump experiment

Since Donald Trump's shock win in the US presidential election on 8th November, most of the high-frequency official and survey data has been strong, suggesting that the final quarter of 2016 saw growth similar to the 0.9% registered in the preceding quarter. The acceleration may have more to do with the revival of oil and commodity prices than to Mr Trump’s victory, but is nonetheless welcome after three soft quarters. Even with another brisk read-out for the final quarter, growth for the whole of 2016 is came in at a modest 1.6%, meaning that the UK has again been the fastest-growing of the major G7 advanced economies.

Once Mr Trump takes over as President, it is clear that there will be major shifts in economic policy. Mr Trump has committed to a programme of sizeable tax cuts, both on businesses and individuals, and also to an increase in spending on defence and infrastructure. It remains highly questionable whether he can pull this off without precipitating a substantial widening of the budget deficit. Things could go badly awry a few years down the line, but this bold effort to reflate the economy will cause both growth and inflation to be higher in the next two years. HSBC has therefore raised its expectations for economic growth in 2017 to 2.3% from the 2.1% anticipated in our previous forecast, while 2018 is now forecast to see growth accelerating further to 2.7% against a previous expectation of 2.2%.

The strong dollar won’t help US manufacturers …

There are, nonetheless, a few factors which will tend to drag on the US economy during the coming year. The first is the strength of the dollar. The greenback has continued to strengthen since the Presidential election, and has now appreciated by about a fifth in the past three years. Irrespective of what President Trump decides to do about what he regards as unfair competition from the likes of China and Mexico, the strength of the dollar will make life tougher for US exporters, while imports will become more competitive. Imports are therefore expected to expand at about twice the pace of exports, thereby dampening the contribution to economic growth made by net trade (which is the difference between the growth of exports and imports).

Americans are also starting to face higher prices for gasoline: in aggregate they have received a windfall of around $140 billion in the past two years, but some $40 billion of that is likely to be clawed back this year, which will tend to have a modest dampening effect on other aspects of consumer spending. Finally, the prospect of reflation has caused long term interest rates to increase, with an increase of around 0.7 percentage points in the 30-year rates which determine the mortgage cost for American homebuyers. The obvious consequence is that activity in the housing market is likely to soften, with slower growth of residential construction.

… but won’t deter the Fed from further rate rises

The Federal Reserve duly delivered its second interest rate hike of the present cycle on 14th December. With Mr Trump (no fan of the Fed) in the White House and with government taking a more activist approach to economic management, we now expect two further increases in 2017 and one more in the first half of 2018. That would take the cumulative increase in the fed funds’ target rate to 125 basis points.

While the closely-watched core PCE (personal consumption expenditure) measure of inflation is likely to remain stable, averaging around 1.7% during 2017, the members of the Federal Open Markets Committee will be mindful of President Trump’s hostility to ultra-low rates and also of the tightening labour market. At 4.8%, as at December, the rate of unemployment is now in the range that the Fed judges to be consistent with full employment. That being the case, it will need to find some very strong reasons not to start returning the stance of monetary policy to a more normal setting.

The Eurozone – a crowded political calendar

Five years on from the eruption of the Eurozone debt crisis, those events are still casting a long political and economic shadow, including in some countries which weren’t in the eye of the storm. While Spain finally has a government after two general elections and a long period of stalemate, the region is still facing considerable political instability as radical parties challenge established players. Although the economy is enjoying modest growth, unemployment remains at elevated levels in several countries, including in three of the region’s four biggest economies. Across the Eurozone as a whole the unemployment rate has now fallen back to under 10%, and fell by 0.7 percentage points in the year to November 2016. But it’s still some two percentage points above where it was at the outbreak of the global financial crisis. Meanwhile, inflation remains stuck fast at sub-par rates, with the ECB rapidly running out of tools and ideas about what to do next.

The first test for the established order will come on 15th March with the general election in the Netherlands. The anti-EU Freedom Party, led by Geert Wilders, is currently ahead in the polls, and could be the biggest party in the 175-seat lower house of the legislature. The Netherlands has a very proportional electoral system, so that no party has governed on its own since the end of the Second World War. It therefore remains open to question whether the Freedom Party could find enough allies to form a government. But in the event of a period of messy coalition-building, it is possible that other parties may be prepared to work with the Freedom Party in exchange for a referendum on EU membership. Opinion polls suggest that the Dutch are narrowly in favour of remaining in the EU, though it should be noted that similar polls in the UK also showed the ‘Remain’ camp narrowly ahead until the last few weeks of the campaign.

Elections in France and Germany …

A strong showing for the Freedom Party in the Netherlands could well unsettle financial markets ahead of the year’s big political event: the Presidential election in France. This will be conducted over two rounds of voting, which will take place on 23rd April and 7th May, Marine Le Pen, the candidate of the far-right National Front (FN), is trailing well behind Francois Fillon, the candidate of the centre-right UMP, but after last year’s upsets in Britain and America, nobody is taking the result for granted. In particular, with the Socialist Party having been in some disarray recently, it’s quite possible that Mme Le Pen will make it to the second round in a run-off against M. Fillon. Admittedly, the cause of the Socialist Party may be helped by the decision of the incumbent President, Francois Hollande, not to run.

A victory for Marine Le Pen will cast serious doubt on the continuation of the ‘European Project’ as we have known it for the past 60 years. Mme Le Pen has always wanted to hold a referendum on France’s membership of the euro, but now also seems likely to campaign for a vote on membership of the EU. Of course, there is no guarantee that she would win either vote, with support for the EU and the single currency holding up relatively well in France. But at the very least, a Le Pen Presidency would usher in a period of heightened uncertainty until these votes had been held.

There is much less likelihood of an upset being caused when the Germans go to the polls in September to elect the members of the Bundestag (the federal parliament). Although Angela Merkel has faced considerable criticism, including from within her own CDU party, for her ‘open door’ policy toward refugees from the war in Syria, the polls still give her a clear lead over her likely rivals for the post of Chancellor. Her main opposition will be a centre-left campaign led by Martin Schulz, who is expected to be confirmed as leader of the socialist SPD party in March after the incumbent Sigmar Gabriel unexpectedly stood down in January.

The SPD will obviously hope to gain sufficient votes for it to form a coalition government with one or more of the smaller parties, rather than entering into another ‘grand coalition, with the CDU/CSU parties. At the moment, however, another left/right coalition led by Mrs Merkel looks to be the most likely outcome. The key focus of interest will be on the performance of the far-right Alternative for Germany (AfD) party, which has done well in regional elections, but which so far has no representation in the Bundestag. That will almost certainly change in September’s election, the only question being how many seats it can win.

… and perhaps in Italy

There is also a strong chance that Italy will also go to the polls at some point during the course of this year. Following the resignation of Matteo Renzi, whose proposals for constitutional reform were rejected in a referendum in early December, a coalition administration led by the Democratic Party (PD) is limping on with Paolo Gentiloni as Prime Minister. But few observers believe that it can make it through to the scheduled date for fresh parliamentary elections in May 2018. The priority will be to pass a new law governing elections to the Senate of the Republic, with the aim of bringing this into line with the arrangements which now apply to the Chamber of Deputies. The radical Five Star Movement (M5S) came very close to being the largest party in the 2013 general election, and continues to poll strongly. Assuming that the electoral reforms can be passed swiftly, the most likely date for a general election is the second quarter.

In this febrile political climate the economy of the Eurozone has performed relatively well by recent standards. Last year ended with something of a flourish, with growth for the year as a whole expected to come in at 1.6%. But the positive effects of exchange rate depreciation and falling energy prices have run their course, so that the going is likely to get a little tougher in 2017, with GDP forecast to expand by only 1.2%.

With budget deficits having gradually reduced since the worst of the debt crisis, there is potentially scope for some modest fiscal stimulus. Indeed, the EU Commission has suggested that the region deliver a fiscal stimulus of roughly 0.5% of GDP during 2017. Of course, it doesn’t want the countries that still have large deficits to start loosening the purse strings, preferring instead that those with the strongest fiscal positions do most of the heavy lifting. Germany is the only country which could deliver a stimulus which would make a meaningful difference; but the reality is that there is little prospect of a meaningful fiscal boost from that quarter, with Angela Merkel’s CDU party committing itself to maintaining a balanced budget.

The ECB is running out of ammunition

There is also very little that monetary policy can now do to lift economic growth. The European Central Bank has been injecting quantitative easing for the best part of two years while operating a negative deposit interest rate, with no evidence of a boost to core inflation or to inflation expectations. The ECB mandarins will be loath to admit that their approach has failed, but in reality they now have little choice but to gradually withdraw the stimulus before they exhaust their ammunition completely, and put the onus back onto governments to deliver structural reforms. In this context, we expect that they will announce a further tapering of QE in the autumn of this year, with the monthly level of asset purchases falling to €40 billion from the start of 2018. Interest rates are likely to be left where they are until at least the end of 2018.

The aftershocks from the debt crisis are still being felt, especially in Greece and Italy. The Greek government’s decision in early December to implement a modest fiscal stimulus has soured relations with creditor institutions, and will probably lead to a delay in completing the Second Review under Greece’s third Economic Adjustment Programme. It’s hard to get excited about another stalled review process, as these have been the norm over recent years, but it does make it less likely that the IMF will be willing to participate in the programme.

In Italy meanwhile the long-running saga of Banca Monte dei Paschi di Siena has finally come to a resolution. Attempts to engineer a complicated private sector recapitalisation, accompanied by a sale of impaired assets, ended in failure just before Christmas. The Italian government will therefore rescue the bank, having gained approval from parliament for a rescue fund of €20 billion, some of which will also be deployed to assist other struggling financial institutions. The size of this and previous rescues in Italy is meagre, compared with the sums which the British and American governments threw at their banks at the height of the financial crisis. The issue for Italian banks isn’t that they took especially excessive risks before the financial crisis, but that they have been ground down by some questionable management actions, and especially by many years of negligible economic growth. The lack of growth and the persistence of high unemployment, which currently stands at around 12% of the workforce, is the root cause of much of Italy’s political and financial instability.

China – another reflation story

It’s not just in the USA that a measure of reflation is underway. Indeed, it is arguably a more appropriate term to describe China’s recent experience, where four years of ‘factory gate’ price deflation has finally come to an end. Given the importance of the manufacturing sector, the return to positive inflation has fed through to an acceleration of nominal GDP growth and an improvement in corporate profitability. This, in turn, has helped to boost confidence among Chinese businesses.

So while the headline figures for real growth of GDP have barely budged, and are in any case expected to slow very slightly in the course of 2017, the economic and business climate in China now looks to be a good deal more settled than was the case from 2014 until the second half of last year.

Stabilisation has been achieved largely thanks to a renewed spending spree by the government on infrastructure projects. During the first ten months of last year infrastructure spending was up by a sixth compared with the same months of 2015. The authorities have also stepped up efforts to rid the country of over-capacity in heavy industrial sectors, which has not only blighted the domestic profitability and prevented the local market from functioning properly, but has also proved to be a thorny issue in international trade relations, with China facing accusations of dumping.

The election of Donald Trump as President of the United States is likely to cause headaches for the authorities in China on a number of fronts. The prospect of a reflation of the American economy and the resulting faster pace of Fed tightening will narrow the room for manoeuvre of the Peoples’ Bank of China (PBOC) in setting its own monetary policy. Before Mr Trump arrived on the scene we had anticipated several more interest rate cuts in China, but we now believe that the PBOC will leave both its benchmark interest rate (currently at 4.35%) and the commercial banks’ reserve requirements on hold through this year and next. Should the authorities wish to loosen the stance of policy they will therefore have to resort to other tools including macro-prudential measures to encourage or inhibit the provision of credit, especially to the residential and commercial property markets.

During the Presidential election campaign Mr Trump was vociferous in his condemnation of China as a ‘currency manipulator’ and for what he considered to be its unfair trading practices, and promised to impose tariffs of 45% on imports of goods from China to the US. Even if this turns out to be just campaigning rhetoric, it is clear that the tone of Sino-US trade relations is going to be very different from here on, with a clear risk of the two countries becoming embroiled in a tit-for-tat trade war.

Britain: the Brexit process starts in earnest

A common thread running through much of the economic commentary during recent weeks and months has been the surprisingly resilient – robust, even – performance of Britain’s economy in the second half of last year.

In the immediate aftermath of June’s referendum vote to leave the EU, it was widely expected that growth would slow sharply as the heightened uncertainty started to weigh on activity and spending. Those predictions have proved wide of the mark – at least, as far as 2016 was concerned. The Office for National Statistics reported that GDP expanded by a respectable 0.6% in both the third and fourth quarters, matching the pace set in the second quarter while the campaign was underway. The figure for the final three months is only a preliminary estimate at this stage, and so could yet be changed, but it would appear that the UK’s economy expanded by a perfectly respectable 2.0% during 2016, only marginally slower than in 2015.

With the economy having sailed through the Brexit vote last year with barely a ripple, some commentators have likened Britain’s current situation to a ‘phoney war’. But it should be remembered that the original ‘Phoney war’ turned into the genuine article within a matter of months. 2017 is set to be the year in which the Brexit process gets under way in earnest, the first significant development being the Prime Minister’s speech on 17 January.

Mrs May signals that a ‘hard’ Brexit looks more likely

After much speculation concerning the Government’s intentions, in terms of aiming for a ‘hard’ or ‘soft’ Brexit, Mrs May’s speech made it very clear that the primary aims are to exercise control over immigration and to withdraw from the jurisdiction of the European Court of Justice. Her speech, while setting out twelve specific objectives, also acknowledged that these primary aims are incompatible with retaining membership of the EU’s Single Market and full membership of the Customs Union. Although the Government will aim to reach agreement on a mutually-advantageous trading relationship with the EU, Mrs May also made it clear that ‘no deal is better than a bad deal’, raising the prospect that post-Brexit trade with the EU could be conducted under the rules of the World Trade Organization (WTO), with no preferential access to EU markets for UK exporters.

Clearly, much work remains to be done before we reach that stage, but a practical start has at last been made. On 24 January the Supreme Court, as had been widely expected, ruled that Parliament approval will be needed before the Prime Minister can write the letter which will begin the process of withdrawal from the EU. Crucially, however, the Court also ruled that a vote was not required from the devolved assemblies. In response, the Government has published a short bill – comprising just five paragraphs – which authorizes the Prime Minister to invoke Article 50 of the Lisbon Treaty. The Government intends to write the letter by the end of March which, given the two year negotiation period specified by the Lisbon Treaty, implies that Britain is on track to leave the EU in 2019.

Some key dates in the Brexit process

31 Jan – 1 Feb 2017: Parliamentary debate on triggering Article 50.

31 March 2017: Deadline set by Mrs May for notifying the European Council of Britain’s intention to leave the EU and formally starting the Brexit negotiations.

30 September 2018: Date by which the EU’s chief Brexit negotiator, Michel Barnier, wants to conclude the terms of Britain’s exit from the EU.

31 March 2019: Date by which Theresa May wants to conclude negotiations over Brexit.

April/May 2019 ?? Britain formally leaves the EU following ratification of Brexit deal by a majority of other member states.

Risk of further sterling weakness

Brexit developments are therefore set to dominate the headlines, and will be a key driver of market movements, especially in the currency markets, during 2017. HSBC expects some further weakening of sterling this year, with the pound falling to $1.10 against the dollar at year-end. Against the euro, the pound has recently recovered some ground, reflecting among other things the prospect of further political uncertainty in Europe. A key moment in this respect will be the French Presidential elections, a two-round process which takes place in April and May. The big uncertainty is how well the ‘populist’ Marine Le Pen will perform: assuming that she does not succeed in eventually winning, HSBC expects that the pound will also weaken against the euro, perhaps falling to parity by the end of the year.

Coming back to the domestic economic outlook, the resilience of Britain’s post-referendum economy owes much to the buoyancy of the consumer sector, which in turn reflects a sustained period of benign conditions in the labour market. Unemployment has fallen to an eleven-year low of 4.8%, while the employment rate (the proportion of the working-age population that is in work) is close to its all-time high. Meanwhile, wage growth has crept steadily higher, with average earnings up by 2.7% compared to a year earlier. This isn’t a particularly impressive growth rate by historic standards, but the very low levels of inflation during the past couple of years means that it has been enough to provide meaningful increases in most households’ real incomes and spending power.

Gone shopping

British consumers have responded to these conditions in the time-honoured fashion – by hitting the shops. Official figures show that, despite a disappointing setback during the month of December, the volume of retail sales in the final quarter of 2016 was up by over 6% compared to a year earlier.

It’s possible (though the published figures aren’t sufficiently detailed to confirm this) that retail sales have been boosted in the past few months by foreign buyers taking advantage of the more favourable (for them) exchange rate – not only in the form of shopping by tourist visitors but also through higher volumes of online shopping by foreign buyers. But it’s probably also fair to say that British consumers have taken advantage of the recent spell of ultra-low inflation to resume their free-spending ways. Meanwhile it’s been another bumper year for the motor trade, with car registrations posting a new annual record of 2.69 million vehicles sold in 2016.

Looking beyond the consumer sector, other areas of the economy by and large also showed surprising resilience during the second half of 2016. Business surveys posted some very weak readings in the immediate aftermath of the referendum result, reflecting the general sense of shock and bewilderment, but have since bounced back strongly. By December, the headline readings from the monthly PMI surveys of manufacturing and service sector activity were at their highest since June 2014 and July 2015 respectively. And official figures showed that business investment, which had been widely expected to be an early casualty of the vote on 23 June, grew by 0.4% during the three months to September.

Out of the woods?

These positive developments are of course very welcome as we go into 2017, and provide some reassurance about the short-term outlook. But equally it would be premature to say that Britain’s economy has successfully weathered the storm of the Brexit vote. Rather than being ‘out of the woods’, a better assessment arguably is that the UK has not as yet really entered the woods. The third quarter’s unexpected increase in business investment, for instance, could be the result of decisions taken much earlier; and business surveys, in particular the regular reports from the Bank of England’s regional agents, have been pretty consistent in pointing to a marked reduction in firms’ appetite to invest.

The other concern as we go into 2017 relates to the consumer sector, which has provided most of the momentum for the UK’s recent spell of robust growth. The dramatic political events of last year have, unsurprisingly, resulted in something of a rollercoaster ride for consumer confidence. In contrast to the strong rebound in business surveys, for instance, the closely-watched GfK index ended 2016 on a somewhat more subdued note than it had started. Given all that’s happened, it’s no surprise that consumers have become less confident about economic prospects, although they remain sanguine about their own personal circumstances, with December’s survey suggesting that the appetite to make ‘big ticket’ purchases is undiminished. The current retailing frenzy may not yet have run its course, with people perhaps thinking that the next few months will be a good opportunity to make major purchases before prices are pushed higher by the weaker pound.

Inflation

Indeed it is rising inflation that is likely to eventually bear down on consumer spending as we move through 2017. The most immediate consequence of the vote to leave the EU has been a sharp fall in the pound, which ended last year at $1.24, a decline of 17% from its value before the referendum. All else being equal, a weaker pound pushes up the cost of imports, and as this feeds through supply chains it eventually pushes up inflation.

This is now starting to happen in a meaningful way. Having been at or close to zero for most of 2015, inflation has climbed to 1.6% (as at December); the process is expected to accelerate this year, with HSBC forecasting that the headline rate will peak at between 3.5% and 4% by the end of 2017. This may seem a relatively innocuous figure, certainly compared to some of the UK’s past inflationary episodes, but at a time when pay growth remains relatively subdued by historic standards (and could fall back if conditions in the labour market deteriorate), it nevertheless means that by this summer inflation will be running ahead of pay. In other words household incomes will be falling in real terms, taking us back to the situation that we experienced from 2010 to 2014, when negative real wage growth was a major factor in depressing overall economic growth.

The outlook for growth and interest rates

Be that as it may, Britain is starting 2017 in a much stronger position than had been anticipated, and economists – including ourselves – have therefore been scrambling to update their forecasts. HSBC now expects the UK economy to expand by 1.2% in 2017. This will, of course, still represent something of a slowdown from last year’s annual growth of 2.0%, but it will be less severe, compared to our previous forecast of sub-1% growth. Our revisions are not entirely a good news story though: sluggish growth is expected to persist into 2018, with GDP expanding next year by just 1.3%.

Against this background, the prospects for monetary policy are a little less clear than was the case a few months ago. In normal times the current conjunction of strong growth, near-full employment, and rising inflation might point to a rate rise. Indeed, financial markets are pricing a 50% possibility that by the end of this year the Bank of England will have reversed last August’s quarter-point cut in interest rates, which with the benefit of hindsight now looks over-hasty.

On the other hand … The Bank of England might argue that last August’s rate cut was a key factor in keeping Britain’s economy on an even keel after the referendum result. And the MPC has in the past shown itself very willing to ‘look through’ (= ignore) an inflation spike which it deems to be a temporary phenomenon caused by external factors. And last but not least these are, clearly, not ‘normal times’, with Brexit-related uncertainty adding an extra dimension to the usual concerns about inflation and growth rates. Accordingly, our judgement is that the MPC is likely to leave Bank Rate unchanged at 0.25% throughout this year and indeed to the end of 2018.

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This economic briefing is issued by HSBC Bank plc (“HSBC Bank”) for information purposes only. It is not intended to constitute investment advice, and no liability can be accepted by HSBC for recipients acting independently on its contents.

The information presented here is based on sources believed to be reliable, but HSBC Bank accepts no liability for any errors or omissions. Unless otherwise stated, any views, forecasts, or estimates are those of HSBC Bank, which are subject to change without notice.

Issued by HSBC Bank plc

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