The Global Economy Let Us Have Faith in This Expansion

Looking back at this passing year, we find reason to hold a favorable view on the global economy, with the following takeaways:

Global growth began to beat expectations. In 2017, the global economy was in its best shape since the financial crisis of 2008–2009. A consensus seems to be emerging that this positive momentum would be maintained in 2018 and possibly beyond.The International Monetary Fund (IMF) and several other analysts expect growth rates—both for 2017 and in the coming years—to be slightly above the historical average of around 3.5%. This is good news, but after years of disappointing growth and false starts (i.e., years that began well but ended in letdown), analysts remain cautious. Projections for economic growth often come with various caveats and lack confidence in the global economy’s sustained expansion.

We’d argue that the global economy turned another corner for the better over the past year and a half. Markets and forecasters may be underestimating the extent to which the global economy is strengthening. Exhibit 1 is telling in that respect: It shows how gross domestic product (GDP) projections for the Group of Seven (G7) economies have evolved over time. We had years of disappointing growth in which projections started high and were then repeatedly revised downward. But in the last two years, we see the opposite pattern: Projections have tended to be modest and are being revised upward. Perhaps the pendulum of sentiment swung too much toward pessimism and is now oscillating the other way, gradually.

Economic recoveries after financial crises are typically weaker and slower (or U-shaped) than after ordinary recessions, which are less acute and lend themselves to swifter (V-shaped) recoveries. Post-financial-crisis recoveries are akin to recovering from a severe flu rather than the common cold: It takes a long time to get back to normal levels of activity (and, in the case of economies, confidence and credit expansion). The early years immediately following the financial crisis of 2008–2009—the worst since the Great Depression—were years of recovery in an environment of weak balance sheets and low consumer confidence. The global economy required a great measure of healing to return to normal.

Its recovery is still underway and now nearly a decade in the making. Yet we believe this recovery is far from having run its course. In fact, in our view, it has only recently begun to look like a normal one. After years of economic adjustment, the world economy is now in better shape and resembles a normal business cycle in its expansion phase, as opposed to a recovery that is only tentative and fragile. What are the major signs of this normalization? We highlight five key developments:

1. Output gaps (the difference between economies’ actual and potential output) are closing in most major economies, according to the Organisation for Economic Co-operation and Development (OECD), a group of mostly rich countries that make up more than two-thirds of the world economy (Exhibit 2). The IMF also calculated the output gap for advanced economies. These are both reasonable estimates for the world economy and point to the same conclusion: that the global output gap that had opened after the financial crisis will likely close in 2018.

We believe that the output gap is one of the best measures of the state of the global economy. The world was operating below full capacity for many years after the crisis, and the recovery took longer than usual, but now, after about nine years, we are finally approaching full capacity.

2. Growth rates of emerging markets have stabilized (Exhibit 3). Emerging market growth had lost momentum after the financial crisis and steadily declined for a number of subsequent years. Global growth in 2010 seemed to break that trend, but it later proved a one-off rebound from a deep recession. The slowdown in emerging markets had multiple reasons, including the economic slowdown in developed economies as well as in China’s growth, sluggish global trade, and elevated uncertainty about prospects for a global economic recovery. Then came the Eurozone debt crisis, significant outflows from emerging markets (which began in 2013), and sharp declines in oil and other commodity prices. These trends have since stabilized or been reversed.

Growth stabilized in major advanced economies and China. Commodity prices also stabilized, and emerging markets responded to these shocks by adjusting their economic policies and addressing macroeconomic imbalances. Since roughly the middle of 2016, emerging market growth has stabilized and started to inch up. Capital flows to emerging markets resumed. Their growth momentum is a key factor in bringing global growth from beneath to above its long-term average in 2017—and we think this trend will continue.

3. Consumer and investor confidence worldwide (or “global confidence”) are back to pre-crisis levels.1 Exhibit 4 shows global household and business confidence, which are both at their cyclical highs and in line with pre-crisis expansion levels.This indicator, we believe, bodes well for global economic prospects in the foreseeable future.

* Standard deviation is a widely used measure of volatility.

4. In developed markets, the headwinds of deleveraging are largely behind us. The U.S. and European financial systems were at the epicenter of the global financial crisis. In the United States and parts of Europe, there was too much private-sector debt. The crisis led to a major deleveraging effort on the part of banks, households, and corporations to reduce their debt burdens instead of borrowing, consuming and investing. This was a necessary albeit painful adjustment. Fortunately, debt burdens in the private sector are now reduced on both sides of the Atlantic. Exhibit 5 shows the change in debt-to-GDP levels for non-financial corporates and households in the United States and the Eurozone. For both sectors, the more acute phase of deleveraging is over. While high levels of debt can be dangerous and hinder growth, a heathy dose of credit expansion is essential for a well-functioning economy. With the normalization of credit markets, lending and borrowing activity is turning from a headwind to a tailwind.

5. The expansion is tilting toward investments in addition to consumption. Investment during the recovery has been muted compared with past recoveries. This is a typical phenomenon after financial crises, which are followed by deeper and longer recessions, as well as protracted recoveries (as mentioned earlier). A deep recession creates excess capacity that is absorbed slowly, reducing firms’ incentives and need to invest. When confidence is weak and growth prospects repeatedly disappoint, firms delay investment decisions. But this story has lately begun to change. Both household and business confidence are strong, and as outputs gaps close, there is much less slack in major economies. Capacity utilization levels are back to normal expansion levels. Labor markets are increasingly tight, and in some countries, such as Japan and the United States, there are anecdotes about labor shortages. Uncertainty about global economic prospects are reduced compared with the earlier stages of the expansion. Financial conditions are very supportive, and corporate profits are in good shape. We believe all these factors create an environment that is conducive to expanding capacity through investment.

What We Expect Looking Forward

All the factors we’ve mentioned—and others—point to a virtuous cycle that is typical of business-cycle expansions. Strong household confidence, job creation, income growth, and a healthy dose of credit activity typically lead to strong consumption growth. Generally, when corporations have confidence that consumption is strong and likely to be sustained, they invest more. Investment is the key ingredient for sustained long-term growth, as historically, it has led to productivity growth, which is the only way for expanding output in the long-run. And at high levels of confidence, the economy and markets are more resilient to shocks or headwinds, such as Brexit, the U.S. Federal Reserve’s interest rate hiking cycle, and the European Central Bank’s (ECB’s) tapering of its monetary easing program.

Brexit was a significant political development, but so far has had no significant effect on the Eurozone and global economies. Similarly, the Fed has hiked interest rates three times last year and is on a path to hiking more. The ECB is tapering its asset purchases and is widely expected to end quantitative easing this year. A few years back, such developments would have led to market turbulence. In 2017, markets kept rallying.

In closing, we believe the period from 2009 to 2016 marked early stages of the recovery. But now we see the global economy as close to full health and able to resume its normal activity of growth. It goes without saying that there are long-term secular challenges to the world economy that we need to understand and adapt to, such as population aging. But in the near term, we see a cyclical upswing that is increasingly robust and sustainable. Let’s embrace it.

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  1. ^See J.P. Morgan Global Outlook 2018: The return of the business cycle. November 22, 2017.