More Turbulence On Tap, But Global Economy Getting Stronger

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The global economy and markets faced many shocks last year, yet emerged unscathed. We expect more challenges in 2017, but the good news is that growth is improving and the era of ultra-low inflation looks to be behind us.

Donald Trump's election as the next US president was probably the biggest surprise in a year full of them. But markets also had to navigate the UK's unexpected vote to quit the European Union and fears over a potential hard landing for a weakening Chinese economy.

There's still plenty of risk ahead. Potential flashpoints include a spate of elections in Europe, where anti-establishment parties are looking to replicate Trump's victory in the US. And there's uncertainty about what a Trump presidency will look like in practice. So far, markets are betting that Trump will deliver on his fiscal stimulus promises, but don't appear too concerned about potential changes to trade policy.

Somehow, the global economy has managed to shrug off all these concerns. It enters 2017 on an upswing, with the JPMorgan Global Manufacturing Purchasing Managers' Index currently at its highest level in more than five years. We still think structural headwinds, including the persistent debt overhang in many countries, will prevent a return to pre-crisis growth rates for some time yet. But the global cyclical backdrop certainly looks more encouraging.

Here are a few things to watch for in 2017:

Faster developed market growth. We expect the global economy to grow by 2.8% in 2017, compared to 2.4% last year. The reason? Developed market growth is shifting into higher gear. Much of this is due to the US, where we expect growth to hit 3.1%. In Japan, fiscal stimulus should help the economy grow by 1.5%, and we expect the same for the euro area. Compared with consensus, though, we're more cautious when it comes to China, where we think growth could slip below 6% this year.

The normalization of inflation. This could be the year's defining trend. Again, the focus is on developed economies: we see headline inflation, which strips out energy and food costs, averaging 2.1% this year. That's up from 0.8% in 2016. To keep the headline number near 2%, faster growth in core inflation will be needed. That seems most likely in countries where capacity use is high and aggressive fiscal policy is on the agenda (the US and Japan).

Central banks' next move. How the world's major central banks respond to these trends will be critically important. We expect the US Federal Reserve to raise interest rates further, though much more gradually than in previous cycles. By contrast, the Bank of Japan (BoJ) and European Central Bank (ECB) are still committed to large-scale asset purchases. Their resolve might be tested later in the year if current growth and inflation trends last.

It's not surprising that recent developments have put upward pressure on bond yields, with the US leading the way. We expect this trend to continue in the coming months, especially if BoJ or ECB asset purchase tapering comes onto the agenda.

When it comes to currencies, most fundamental factors point to a stronger US dollar, with one exception: valuation. In our view, a lot has been priced into the dollar already, and this could limit its upside - at least until we learn what the Trump administration plans to do on the fiscal front.

So another fascinating year awaits us. The good news for investors is that while there are still structural headwinds and political risks, the global economy looks poised to move out of a long period of ultra-low inflation and grow at least a bit more rapidly.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.