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The surge in bond yields and rally in the dollar since the US presidential election have sparked concern that financial conditions have tightened too much, too fast and that this may choke growth before the expected fiscal stimulus has even been passed. Our analysis shows that contrary to popular belief conditions remain very accommodative, but risks are likely to materialize if the bond rout continues.
The 10-year Treasury yield has risen about 50 basis points since the election, which has the equivalent impact on GDP growth of one 25-basis point rate hike by the Fed.
The trade-weighted dollar has appreciated roughly 3.5%, since Nov. 8th, which is the equivalence of a further 18 basis point rise in the fed funds rate.
That said, a number of factors have cushioned the impact from the stronger dollar and higher rates: rising US equity prices, the decline in equity market volatility, and a narrowing in corporate bond spreads have all helped to keep conditions supportive.
However, if bonds continue their sell-off over the coming weeks or months, it would destabilize equity markets, spur further gains in the dollar, and likely dampen business confidence – restricting financial conditions, constraining growth and likely side-lining the Fed.
Furthermore, an ongoing bond rout could unnerve the deficit hawks in the Republican congress and threaten passage of a large fiscal stimulus package. They may become concerned that the rise in yields also reflects the markets pricing in a widening budget deficit.
Healthcare services spending weaker than GDP second estimate. Little impact seen on intellectual property in Q3. Net, we see Q3 real GDP growth being unrevised at 3.2%.
At December’s ECB press conference, President Draghi turned the consensus view –that the ECBwould maintain monthly asset purchases of €80bn a month, but strike a more upbeat tone to appease hawks –on its head.
The decision to scale back monthly purchases to €60bn from March means that, in 2017, there will be less QE stimulus than widely assumed prior to the announcement. But some of the initial reaction in government bond yields was subsequently reversed in response to the more dovish tone struck by Draghi.
Based on the latest events, our view is that the ECB will taper purchases from the beginning of 2018 and thus end new purchases by the middle of that year.
Last night, Moody’s lowered its outlook on Italy’s Baa2 credit rating to ‘negative’, citing the prospect of both slowing reforms and lower economic growth following Sunday’s rejection of constitutional reforms.
The ECB is set to press the QE button one last time at today’s meeting, as concerns over persistently low core inflation and rising political uncertainty will convince hawkish members to remain accommodative.
Goods exports recovered in November, providing relief on global demand. But we remain cautious on the outlook. Meanwhile, solid import growth indicated steady domestic demand momentum and higher commodity prices.
Headline FX reserves fell by another US$70 bn in November. While this was in large part due to sizeable valuation effects, we expect the authorities to continue to make efforts to contain capital outflows in 2017.
Japanese Q3 GDP growth was revised down to 0.3% q/q versus the advance estimate of 0.5%. This was primarily driven by a smaller contribution from net exports, with investment also weaker than first estimated.
Today's final GDP estimate supports our view that while growth will pick-up over the next 12 months, the pace of acceleration is likely to be gradual. Against this backdrop, we expect the BoJ to defend the 10-year government bond yield target of "around" 0%.
A rebound in imports, which rose to AU$29.2bn, pushed the trade balance down to AU$1.5bn in October.
Goods and services imports grew strongly, by 2.4% and 2.1% m/m respectively. Within merchandise imports, capital goods led the way, increasing by 9.5% after two months of contraction.
Exports growth was steady at 1.4% m/m, with services slightly outperforming goods.
We believe Donald Trump’s election will not mark an immediate change in America’s foreign policy and we expect the US sanctions on Russia to remain intact in and beyond 2017.
In Europe, next year’s elections in France and Germany pose a bigger risk on sanctions than Donald Trump. Ultimately though, in our opinion the EU cannot afford to capitulate on Russian sanctions in the face of rising right-wing populism across Europe.
While an extension through mid-2017 is a given, we believe there is a 70% chance that sanctions will hold through end-2017. Further ahead, the risk of them being relaxed has increased, but we still see a 60% chance that sanctions remain intact well beyond 2017, as the Minsk accords remain unimplemented.
Bank of Canada leaves policy rate unchanged, but notes risks are titled to the downside. The Bank is likely to maintain a dovish stance through 2017 in order to foster stronger non-energy activity in a generally subdued inflation environment.
In a surprise decision the monetary policy committee left the repo rate unchanged at 6.25%. We, and most of the market, had expected the RBI to cut by 25bp in response to both the low level of CPI inflation in October and the deflationary pressures triggered by November's 'demonetization'. However, the MPC chose to pursue a more cautious policy, emphasising both external risks to inflation (global financial market volatility and higher oil prices) and taking a gloomier view of underlying domestic price developments than previously.
If the RBI sticks to this approach then the scope for further rate cuts will depend on the monthly inflation numbers and the markets' assessment of future US monetary policy.
After the approval of the budget law today by the Senate, PM Renzi will likely quit by the end of the week. President Mattarella will then start a round of consultations to see if there is political support to form a government under the current Parliament.
Meanwhile, the main risk in the short term comes from the banking sector. It is extremely likely that MPS will need some sort of public support and this is what markets have been pricing in over the last two days. This, however, is likely to require some burden-sharing by private investors.
Industrial production saw a surprise decline in October, dropping by 1.3% in the month, the biggest fall in over four years. But most of the contraction reflected disruption to North Sea production arising from ongoing maintenance.
That said, there was also a shrinkage in manufacturing output. But here too, erratic factors appear to have played a role. However, hopes that “the makers”will make a contribution to GDP growth in Q4 are looking more tenuous.
GDP growth come in well below expectations, with a 0.5% contraction in Q3. Investment, government consumption and net exports all subtracted from growth in the quarter. In contrast, growth in household spending was slightly stronger than expected, at 0.4%q/q.
With such a sharp contraction, we now expect the economy to grow by around 2.4% this year. Growth in 2017 will also be considerably weaker, at around 1.8%, as a result of base effects. The RBA signalled yesterday that it expects the economy to come out of the current soft patch in 2017. But continued weakness or an outright contraction in Q4 could prompt further monetary loosening.
The recent disinflation trend continued in November, with headline inflation falling below 6% for the first time in a year, down from 6.5% in October and a peak of 9.0% in July.
Looking forward, we expect monthly price rises to pick up in in the first quarter of 2017 as food prices stop falling and seasonal price adjustments due in February feed through. However, the annual inflation rate will likely fall within the target range of 2-4% by March due to sizeable base effects.
Trade deficit widens in October on lesser exports and greater imports. Net trade is expected to drag on real GDP growth in Q4.
OPEC led by Saudi Arabia surprised the markets and agreed to cut output by 1.2mbd to 32.5mbd at the Vienna meeting which has underpinned a rise in the oil price well above US$50pb. Although we remain sceptical of the deal's longer-term success, we do expect Saudi to implement its share of cuts in H1 next year and have revised down our forecast for oil GDP growth in 2017 to -0.9% as a result.
Meanwhile, however, there are signs that October’s US$17.5bn international bond issue has brought forth an easing in liquidity pressures already and increased economic optimism, with interbank rates having fallen, the government making substantial repayments to contractors and November’s PMI ticking up. But with oil prices low and fiscal consolidation continuing to be implemented, we still forecast non-oil GDP up a modest 1.5% next year after a small contraction in 2016. This will leave overall GDP growth at just 0.5% in 2017 versus 1.6% this year.
The CEE region appears to have shrugged off the ‘no’ vote in the Italian referendum. Meanwhile, the second Q3 GDP release for the four CEE economies confirmed growth at around 0.2%-0.3% q/q, underpinned mainly by consumption, while investment and external demand were both a drag on growth. Slovakia bucked the trend, however, growing by 0.7%, mainly driven by external demand as well as consumption.
Meanwhile, the 4.9% rise in German industrial orders, the sharpest rise since mid-2014, extended a positive run of news from the country, pointing to upside risks to our industrial production forecast of 1.3%, to be published tomorrow.
We do not see the outcome of this week’s Supreme Court case as being particularly significant given that the government is likely to be able to secure parliamentary approval to trigger Article 50 anyway. Thus it merely buys more time for the government to finalise its negotiation strategy. However, if the Supreme Court insists that the Scottish Parliament must also give its approval then this would represent a serious impediment.
Some form of interim arrangement – such as time-limited EEA membership – is looking increasingly likely. But the notion that the UK may pay for some preferential access to the single market does not look viable.
In terms of probabilities, once Article 50 has been triggered, we find two chains of events equally likely: (i) the UK reverting to WTO rules upon exit; and (ii) an interim arrangement leading eventually to a limited FTA.
An emergency hike by the central bank of Turkey (CBRT) is becoming increasingly likely following the lira’s 12% depreciation since November.
As expected the RBA held the cast rate at 1.5%. The monetary policy statement highlighted the recent softening of the economy. But this has broadly been in line with expectations, and the economy is expected to accelerate in 2017.
Recent activity data has been poor, with retail sales dipping 0.1% q/q in Q3. But we expect the economy to turn the corner in 2017, as the adjustment to the end of the mining boom comes to an end.
With the policy statement signalling that the RBA do not expect to ease further, we expect rates to remain on hold until 2018. Expansionary fiscal policy will be needed to maintain growth over the near term.
Non-manufacturing activity solid for a third month, at a 13-month high. Business activity and employment firm, new orders slightly slower, supplier deliveries slightly faster.
It would be a major surprise if the ECB failed to announce some form of extension to the duration of its asset purchase programme this month. We expect the QE termination date to be pushed back by another six months with monthly asset purchases maintained at €80bn.
A strengthening in services activity, combined with a solid new business pipeline and growing backlogs of work, keeps the economy on track to – at least – emulate the 0.5% GDP growth achieved in Q3.
But the CIPS survey offered a reminder that the outlook is more uncertain further out. Businesses remain nervous, while inflationary pressures continue to build. As such, we continue to expect activity to cool through 2017.
After the ‘no’vote in yesterday’s Italian referendum, Prime Minister Renzi said that he will resign.President Mattarella will probably respond by inviting attempts to form a new government under the current parliament rather than calling for fresh elections.
The new government, which could have a wider majority than the Renzi one, will probably focus on passing a new electoral law.
December payrolls were up 178,000, in line with expectations. Payroll gains for the two months prior were revised down a negligible net 2,000. The unemployment rate fell to 4.6% as the labor force shrunk and the participation rate slipped to 62.7%; the underemployment rate dropped to 9.3%. Hourly earnings were down 0.1% for the month, the first decline since December 2015 and wage growth slipped to 2.5% y/y. These data, combined with continued progress towards the inflation target, remain supportive of a tightening at the December FOMC meeting
Based on explicit baseline, downside and upside scenarios for Brazilian 10-year local currency bonds, we project probability-weighted returns of 15% (after adjusting for projected currency movements). The view is developed using a rigorous framework for assessing the medium-term outlook that takes domestic and global risks. This reinforces our view that the great Brazilian convergence trade has further to run.
In a recent note, we have flagged that risks to our central forecast are significant, but not sufficiently big to undermine our positive view. In this short follow-up piece, we provide two alternative scenarios – one downside and one upside – and attach weights to them in order to back out investors' total returns under each state of nature.
Our central view continues to be that the bond market is not pricing in enough rate cuts by the central bank (BCB) in the next 12-24 months. In our baseline scenario, to which we attach a 65% weight, 10-year yields fall to 10.7% and the Brazilian real rallies to 3.28 by the end of 2017, from 12.2% and 3.47 currently. Our baseline assumes the BCB will speed up the pace of rate cuts next year and cut the policy rate to single digits by 2018; an economy flirting with a third year in recession and with rapidly falling inflation only increase our conviction in our central scenario. The total return in hard currency exceeds 26% in one year in this scenario.
For the sake of simplicity and transparency, we framed our downside scenario as a return to the panic days of January 2016 by stressing yields and the exchange rate to 16.8% and 4.15/$. In this 'worst case scenario' investors lose 27% over 12 months. In order to reflect current skewness towards negative risks, we attached a considerable 25% weight to this scenario.
In the upside scenario, to which we attach a 10% weight, we assume the BRL rallies all the way to the psychological barrier of 3/$ and yields fall to single digits by the end of 2017. Should this scenario materialise, investors would be thrilled with returns in excess of 45% in 12 months, meaning 2017 could turn out to be as good as 2016 for those who get in early on the second leg of Brazilian convergence trade.
The latest Global Scenarios Service report contains analysis of such risks.
Politics takes centre-stage once again this Sunday, as Austria and Italy face key elections on Sunday. Given the significance of immigration as an issue in both countries, these votes are seen as a measure of the likely success of other anti-establishment parties in upcoming elections in 2017.
Meanwhile, a Reuters article yesterday quoted senior ECB officials as saying that the ECB is likely to extend its QE programme beyond the original expiry date of March 2017, but may also use its forward guidance to signal an eventual end to these asset purchases.
As expected, the BCB cut the policy rate by 25bp to 13.75% this week.
Falling inflation and inflation expectations tied with a disappointing recovery means the BCB is likely to speed up the pace of easing to 50bps from January.
Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis-related effects that dragged wage growth down are fading – though Japan may be an exception.
Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017-18, with the pace of growth rising by 0.5-1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
Few countries have maintained their pre-crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: wage growth has run as much as 0.5-1% per year lower in the US and Japan than conventional models would suggest.
The link with productivity seems to have weakened since 2007 and Philips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
The forecast rise in inflation over the next year as energy price base effects turn negative is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010-11 when oil prices spiked and real wages fell.
Construction spending increased in October, and spending for August and September was revised higher. The October construction spending data are consistent with solid increases in residential investment and government spending in Q4 GDP.
The OPEC meeting in Vienna caught the oil market by surprise with an agreement to cut output by 1.2mb/day to 32.5mb/day. This was in-line with the previous announcement in September, but this time supply cuts were allocated by country and there was also a promise from Russia to join in with its own 0.3mb/day cut. Certainly, this is progress. But we remain sceptical about whether many of these cuts will be fully implemented and discussions are still ongoing with non-OPEC members.
For now, we have not changed our oil price forecasts. While the OPEC agreement is mildly bullish, downside risks for demand have been building. To a large extent these two factors are offsetting each other for now. The prospect of prices falling much below US$40pb have lessened due to OPEC’s agreement, but cutting supply in a weak demand environment is probably not going to be enough to drive prices back above US$60pb in the near future, especially given the threat of higher US output. We still forecast Brent crude averaging US$50pb in 2017 and US$52pb in 2018, although will monitor compliance with the agreement closely in the months ahead.
Manufacturing activity picked up in November, but expansion remained modest. New orders and production both improved while delivery times slowed. Inventories remained in contraction, but only narrowly. Employment dipped slightly.
The Prudential Regulation Authority yesterday told RBS and two other UK banks to strengthen capital again. This says as much about the Bank of England’s preference for extremely stressed scenarios as it does about RBS’s buffers. It could be a further drag on UK lending growth.
The final manufacturing PMI for November suggests that Eurozone quarterly GDP growth may have edged up in Q4, with our forecast now at 0.4-0.5% after 0.3% in Q3.
The unemployment rate, at 9.8% in October, is falling and confirms the relative health of the labour market. Finally, Italian GDP growth was confirmed at 0.3% in Q3, with consumption and investment providing a strong contribution.
November’s CIPS survey offered mixed news from the manufacturing sector. On the plus side, activity remains firm, with the weaker pound boosting export orders, and the sector is on course to see output grow in Q4.
But there are more worrying messages for the wider economy, with input cost inflation remaining rapid and increasingly feeding into higher factory gate prices. It is surely only a matter of time before consumers begin to feel the heat.
PMI data were a mixed bag in November. Whilst a recovery in manufacturing activity is underway, growth is likely to remain uneven across the region. This is consistent with our view that the improvement in global trade growth is going to be gradual. However, the outlook for next year is increasingly uncertain.
The economy may have been more severely affected by July's coup attempt than previously expected. Monthly indicators show that the economy likely contracted in Q3, leading us to revise our GDP growth estimates to 2.8% in 2016 and 2.9% in 2017 (down from 3.1% and 3.2% previously).
Turkish assets have had a difficult November, with ten-year bond yields rising more than 100bp to 11%, while the lira has lost 10% of its value due to a resurgent dollar following Mr. Trump's victory and also a series of adverse domestic developments. The central bank was forced to act, but a 50bp hike to its main one-week repo rate was insufficient to stem the lira's weakness. And without a clear intention from the CBRT to maintain a tightening cycle over the next few months, the TRY is unlikely to find much respite.
Rebound in energy activity underpins strongest real GDP growth print since 2014 but underlying details remain soft. Growth should firm next year, supported by stronger export growth, expansionary fiscal policy, accommodative monetary policy and a reduced drag from low oil prices.
Income up strongly in October but spending more tepid. In spite of the soft start to the quarter, the trend in real consumer spending remains firm and should be supportive of real GDP growth north of 2.5% in Q4. Positive developments in the labor market and inflation combined with modest GDP growth should keep the Fed on track for a December rate hike.
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