What to expect for the global economy in 2018

In 2017, the global economy recorded its best performance in six years. Persistent fears of "secular stagnation" were finally put to rest. The stage is now set for sustained solid growth in the world economy in 2018. IHS Markit expects global growth of 3.2%, matching 2017's growth rate, and well above 2016’s 2.5%.

The US economy will see a further pickup in growth, with or without a tax cut. However, growth in the Eurozone is predicted to have peaked in 2017. Similarly, the recent Japanese growth spurt looks set to fade. The Chinese economy’s gradual deceleration is expected to continue. Fortunately, the emerging world's recovery will likely be sustained and pick up a little steam.

Unfortunately, there is no shortage of risks facing the world economy. But most are low-level threats. The most worrisome are policy mistakes either in the United States (such as a fiscal shock or a trade war) or in China (such as a mismanaged deleveraging).

1. The US economy will sustain above-trend growth. IHS Markit expects growth in calendar year 2018 to be 2.6%, above the 2.3% in 2017, and well above the 1.5% in 2016. Financial conditions remain supportive, household balance sheets are improving, the US dollar is off its peak, and capacity utilization rates are high. These are strong tailwinds for consumer spending, capital expenditures, and housing.

Last, but by no means least, if the Republican Tax Cuts and Jobs Act is passed by the full Congress, it would raise growth by 0.3 of a percentage point a year from 2018 to 2020, push down the unemployment rate even further and push up interest rates and the dollar.

2. Europe’s expansion will slow a little, but remain solid. The relatively tame outlook for oil prices will limit the upside for inflation, which bodes well for real income growth. Labour markets will continue to improve. A still competitive euro and strong global growth should help exports. Perhaps, most importantly of all, the policy backdrop continues to be growth-supportive. In particular, the ECB is expected to proceed gradually with its tapering of bond purchases through the end of 2018.

However, political uncertainty in both the Eurozone (elections in Italy, coalition challenges in Germany, and separatist pressures in Spain) and the United Kingdom (the risk of a "hard" Brexit) could undermine growth. As a result, we expect Eurozone growth to ease to 2.2% in 2018, while UK growth will drop to 1.1%.

3. Japan’s growth spurt will fade. While the economy will continue to grow in 2018, momentum will ease relative to 2017. We forecast growth will soften to 1.2% in 2018, from 1.8% in 2017. The weak yen is likely to support exports and tourism, but this could be offset by softer growth in Japan’s major trade partners, especially China.

On the other hand, domestic demand will stay resilient as consumer spending growth is likely to remain moderate but steady. Additionally, infrastructure projects ahead of the 2020 Olympic Games will support capital expenditures.

4. China’s momentum will weaken. China’s fundamental problems of excess industrial capacity, debt overhang, and a housing glut have remained unresolved. The government will continue to address these problems through the “Supply Side Structural Reform” program in the near-to-medium term. These structural problems and the government’s policy response will be a drag on the economy, in general, and investment demand, in particular. This will result in growth diminishing to 6.5% in 2018. A wildcard in the 2018 outlook is whether the Chinese government will go to the stimulus well once again, when growth slows.

5. The performance of the emerging world will improve gradually. IHS Markit predicts a further modest rise in growth to 4.9% in 2018 as the global environment continues to be growth-supportive. While some countries will see stronger growth in 2018, other countries and regions will face challenges. Growing debt burdens could become a risk for many economies. In Asia, India will recover from its twin policy shocks of demonetization and the imposition of the goods and services tax. At the same time, Indonesia, Malaysia, the Philippines and Vietnam will sustain 5-6% growth.

Most Latin American economies will also see better growth in 2018. On the other hand, Emerging Europe will see slower growth, due to overheating and labour shortages. In the Middle East, the recovery from the oil slump will be slow. In Sub-Saharan Africa, the big economies (Angola, Nigeria, and South Africa) will struggle to expand by more than 1%.

6. With the rally over, commodity prices will be range-bound and volatile. While oil prices rose at the end of 2017, and OPEC and Russia agreed to extend production limits for another year, continuing growth in non-OPEC liquids will keep a lid on prices. Slower growth in China, the winding down of loose monetary policies in the developed world, deleveraging in China’s economy, and a still strong and mildly appreciating US dollar will all act as constraints to commodities prices. That said, geopolitical risks could be a source of upside pressures.

7. Upward pressures on inflation will remain muted. Structural factors such as technology and globalization will probably prevent any sharp rise in inflation. Moreover, it will be a few years before inflation reaches or exceeds the 2% target of central banks. In the US economy, there are growing indications that a very tight labour market is translating into a modest uptrend in wage inflation. In the emerging world, inflation rates have fallen and will continue to decline, thanks to more stable commodity prices and currencies. All told, inflation will slowly drift up in the next couple of years in the developed world and keep falling in the emerging world.

8. The Fed will keep raising interest rates, and some other central banks may follow. The Federal Reserve is on track to hike interest rates another three times in 2018 in March, September, and December. However, there is a chance that the Fed may raise interest rates more on concerns about overheating, given strong growth, a falling unemployment rate, and potential inflation impact of a tax cut.

The European Central Bank and the Bank of England are unlikely to raise interest rates until 2019, and the Bank of Japan will wait even longer. The only other major central bank expected to tighten in 2018 is the Bank of Canada. Outside the G7, countries with currencies pegged to the US dollar (Hong Kong, Singapore, and the Gulf States) will have little choice but to follow the Fed. Also, given strong growth rates, a number of Asian economies can be expected to tighten further in 2018, including India, Indonesia, the Philippines, and South Korea.

9. The US dollar is likely to get nudged higher, though volatility could also remain high. There are at least three reasons why the pressure on the dollar over the next year will be mostly upward. Firstly, the Fed is well ahead of most other central banks in its tightening cycle, meaning that for the most part, interest rate differentials will widen in 2018. Secondly, as US growth picks up, and as growth rates of the Eurozone, Japanese, and UK economies slip, investors will refocus on US assets.

Finally, the enactment of the US tax bill will further boost investor confidence and will probably result in higher growth and interest rates. Limiting the rise of the dollar will be the large US current-account deficit and large current-account surpluses in other parts of the world, including Europe. We predict that, on a trade-weighted basis, the dollar will rise by 2-3% over 2018, with the euro-dollar rate at around $1.15 at the end of the year.

10. The risk of a recession remains low, with global growth momentum strengthening, and assuming no policy mistakes or "black swans". Derailing the global economy would require a large shock. While the list of such shocks is long, the probability of any of them doing serious damage is low. The Fed - or for that matter any other major central bank - is unlikely to raise interest rates high enough in the next year to kill growth.

Deleveraging in China is fraught with risk, but the prospect that the Chinese government would do anything serious to harm growth is remote. An oil shock is always possible, but with US and other non-OPEC oil production rising, it would take a major geopolitical event in the Middle East to disrupt oil markets in a big way. And while the risk of trade friction is uncomfortably high, the chances of an out-and-out trade war are low.