By Invitation. It’s not all gloom for major economies

As the sun sets on the year gone by and we look ahead, we can at best call the situation somewhat mixed. While the overall “most likely” picture has several downside risks, it is not all gloom and doom. Let us remember that we are entering the new year without great expectations — in such a scenario, markets can be surprisingly resilient.

In this column we briefly look at the macro economic outlook for the US, the Euro Zone and China. Then we consider both the macro-economic and the equity market outlook for India.

Our economists believe the US business cycle is maturing but it still has some steam left till about 2018-2019, before we see the next decline. Growth is expected to range between 2.5 and 3.5 per cent over the next two years, driven by domestic demand as the labour market reaches full employment. Domestic consumption and housing demand — which account for 75 per cent of the US GDP — should be well-supported.

The lowest rental vacancy in more than 30 years is effecting rental inflation and supply is still lagging. We expect residential investment to rise further and support growth. On the external front, headwinds will probably reduce and the drag from a stronger dollar should ease. While inflation has been declining so far, the year ahead could see this trend bottoming out. Factors such as the tightening labour market and base effects of energy prices could push headline inflation higher.

For the Euro area, we expect growth to clock in around 1.5 per cent in 2016 and thereafter slow down towards the 1.0 per cent level. Positives such as low oil prices and a weak euro are, to some extent, offset by slower global trade growth, a consequence of weaker demand outlook in China and emerging markets, policy uncertainties and debt burdens.

Inflation pressures are likely to remain low — almost surely below the 2.0 per cent benchmark. The immediate recovery in 2016 should be driven by consumption with little contribution from net export or capex. While consumption represents 55 per cent of the Euro area GDP, it has accounted for 72 per cent of the recent growth. Investments have been subdued due to structural and cyclical factors.

On the corporate front, Société Générale analysts expect a strong boost in profitability in 2016 due to lower oil prices, higher productivity and wage moderation. What will cap corporate income growth will be limited pricing power due to a large slack in the economy.

Among the key risks are several elections, notably in France and Germany, both in 2017. These will impact the progress of reforms. Additionally, the Euro area remains vulnerable to potential external shocks. France and Germany are expected to post growth around the Euro area average of 1.5 per cent, while Ireland will outperform (2016 GDP forecast at 3.2 per cent).

China faces the difficult choice of balancing its long and short-term objectives. While the leadership has conveyed its commitment to structural reforms to improve long-term prospects, doing so could put pressure on short-term growth targets.

We expect that the relatively high growth target set at 6.5 per cent per annum for 2016-2020 may force the authorities to slow down the reform process. The stock market rescue in the third quarter, selective tightening of capital controls and a renewed increase in off-budget government borrowing via local government financing vehicles have all helped stabilise growth — at the cost of reforms.

We think the government will have to make similar choices in 2016. Export-led growth should increase to sustain overall growth at 6.5-7.0 per cent. Hence, in a bid to support investment-led growth, the government will possibly have to choose the degree of credit support to be given to low-return public investments and possibly stall fiscal reforms in the near term.

An underlying weakness in the Indian economy still persists. There have been positive developments such as marked improvement in government infrastructure spending and bringing stalled projects to life, all of which could eventually generate demand. On the negative side, private sector capex remains weak. Core sector activity also remains weak, with the exception of coal and, to some extent, electricity.

On the monetary policy front, we think the RBI will pause. The bigger challenge seems to be the lack of more effective transmission of monetary policy action. On the fiscal front, the government may be forced to look for alternate sources of revenue generation. Here we expect the focus to remain on improving indirect tax collection.

The bottom line, though, remains unchanged — India will probably remain the fastest growing large economy in the world. Private sector capex growth may be tough in the near term, given the low levels of capacity utilisation. Hence a lot will depend on investment execution by the government.

The India equity market remains a top pick in the Asian region, though there may be some rough waters to navigate before the next upturn happens. A variety of factors may pose serious headwinds for now.

The writer is Head Global Markets, India, at Société Générale

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