From Morgan Stanley's Elga Baartsch, Chief European Economist
The Lessons of 2016
As we are entering the finishing stretch towards the festive season, financial market activity and economic newsflow are likely to slow this coming week. Away from procuring last-minute presents for loved ones and posting belated holiday greetings to far away ones, these calmer days offer a good time to reflect on the year that is about to end and think about what the next year might bring. This reflection about the accuracy of our key calls and the major surprises we encountered form an essential part of the forecasting process, for we aim to constantly improve by learning from our mistakes, reviewing our priors and engaging in a robust debate with our colleagues and clients.
So, here is how our forecasts fared over the last 12 months and what this implies for 2017.
In our 2016 outlook, where we pegged global GDP growth at 3.3%Y, the MS macro team was too optimistic about growth. At about a quarter of a percent, the forecast miss was relatively small though and almost equally due to misses in DM and EM. Our inflation forecasts, by contrast, did less well, in particular in DM, where headline inflation, at 0.8%Y on average, ended up half as high as we projected in November 2015. Our EM teams did a much better job collectively, projecting headline inflation a touch below 4%Y. A considerable part of the inflation forecast error can be attributed to an unexpected fall in commodity prices in early 2016, which the oil futures we base our forecasts on did not reflect. But in some countries, e.g., Japan and the UK, we also had material misses on core inflation.
As a result of the downward revisions to the growth and inflation outlook in the course of 2016, we also had to amend our monetary policy forecasts, taking out two Fed rate hikes, pushing the ECB depo rate deeper into negative territory and adding to the ECB’s QE programme. Like the market, we did not see the BoJ’s U-turn on negative interest rates coming in early 2016. However, our Tokyo team had given the idea of yield curve control some thought already in 2015. In the UK, Brexit caught us and the BoE wrong-footed and forced a prospective tightening cycle to be replaced by additional monetary policy easing. The key EM central banks, on average, kept policy tighter than we had thought, especially the PBOC and the CBR. At the same time, the RBI and the BCB reduced rates more than expected.
In the middle of the year, we got too cautious on growth in the wake of Brexit, which, contrary to our and most other forecasters’ expectations, did not push the UK into recession or dent euro area growth. The other big political surprise of the year, the election of Donald Trump in the US, caused us to revise up our growth forecast on the expectation of a material fiscal stimulus. The US equity market did better than we had expected in 2016, while European and Japanese equities were trailing behind. We would expect this relative performance to reverse in 2017 and currently prefer Japanese and European equities over the US. EURUSD did not hit parity in 2016, but is expected to break below this key level in the course of 2017. JPY strengthened more than expected in 2016, but is now likely to weaken materially in 2017. Bond yields experienced much more of a rollercoaster ride than we had anticipated in 2016, first falling further and then bouncing back faster. While UST yields are likely to end 2016 not that far away from our original target of 2.70%, yields on Bunds, JGBs and gilts are far lower than we had anticipated a year ago in our 2016 outlook.
The biggest surprises in 2016 were clearly political – notably Brexit and the US presidential election. As a result, we will be keeping a close eye on political developments in 2017, notably in Europe, where not just Germany, France and Italy are heading to the polls in 2017, but also the Netherlands and possibly also Greece. Political discontent in Europe could once again cause investors to question the long-term viability of the euro. One major pivot for financial markets in early 2016 was investor concern about capital outflows from China. We expect this issue to remain in focus in 2017 and acknowledge that it – together with the vibrant credit dynamics – could call into question our call for a PBOC rate cut. Ongoing pressures on the capital account could also reignite the debate about the benefits of a large, one-off RMB devaluation – something that our China team does not deem to be likely though. In 2016, the Fed was much more dovish than we and the market projected initially – a development that our US economists took on board much faster than the consensus. In 2017, barring a complete U-turn on the part of the Trump camp on the desirable monetary stance, there seems to be to a risk of a hawkish tilt at the Fed.
While we don’t exactly know what 2017 will bring, we believe that 2017 will be another year of interesting and intense macro debates where reflation has further to run before the sparkle in risk assets will start to fade. We are already very much looking forward to actively engaging in the debates on the fatter tails of the distribution of the likely macro outcomes next year.