DISCLAIMER: The person is speaking in a personal capacity and does not represent the institution that employs them.
BSI Economics organized another meeting at the Café de la Paix on Tuesday, February 13, 2018, to discuss the outlook for economic activity and market conditions since the recent increase in volatility. These discussions brought together a journalist from Les Echos, a chief economist in the insurance industry, an asset management strategist, a head of institutional economic research, two economic forecasters, and an economist attached to the French government.
Financial markets and the real economy: between reflation and lowflation
After a period of exceptional gains for the month of January, the markets corrected in early February in response to renewed volatility linked to long VIX positions that were unwound in a cascade, causing two ETFs to halt trading during the session. It was the rise in volatility that drove the market, not the market that caused this volatility. Economic fundamentals remain solid, while markets are expected to maintain their momentum towards reflation, combining accelerated activity, rising commodity prices, a gradual rise in inflation rates, and normalization of interest rates.
Consequently, the recent market correction is technical in nature and has restored confidence in the ability of equity markets to continue their upward trend: expected earnings growth over the next 12 months has increased in the United States (from 12% to 15%), valuations have become more attractive (P/E ratio from 19 to 18), and technical support makes repositioning opportune.
The dollar remains a question mark for 2018. US fundamentals are strengthening and would justify an increase in the US currency: wages are accelerating (from 2.7% to 2.9% year-on-year), bolstered by a constantly improving labor market, growth forecasts for 2018 have been revised upwards (2.5% growth), and confidence indices remain at record highs (consumers and businesses).
Conversely, repeated announcements by the US government in favor of a strong dollar and a more unfavorable growth differential compared to the eurozone are contributing to net speculative long positions on the euro. Finally, the dollar index is currently hovering around a historic support level. Major investors now anticipate a stronger euro against the dollar at the end of 2018, close to 1.30.
On the real economy side, however, several factors contrast with reflation expectations. In France and Europe, the recovery remains moderate and growth potential remains below its 2000 level (1.4% in France in 2017 compared to 1.9% in 2000).
There are several structural reasons for this:
– First and foremost, the labor market, where the unemployment gap could be virtually closed in France (9.4% in 2017). Such high structural unemployment can be explained by high youth unemployment (25% in France compared to 21% in the eurozone and 7% in Germany), a large number of job vacancies (130,000 in 2017) and long unemployment spells (16 months compared to 6 months in the United States).
– In terms of foreign trade, France’s trade balance deteriorated by €20 billion in 2017 (-€62.3 billion), albeit due to cyclical factors linked to higher oil prices and the economic recovery, but the current account deficit remains one of the worst in the eurozone.
– In terms of the budget, France had the highest deficit in the zone in 2017 (-2.9% compared with -2.4% in Italy), and the possible rise in long-term interest rates poses the risk of higher debt costs: a 1% interest rate shock would increase the interest burden by €6.9 billion (+0.3 percentage points of the deficit) by 2020.
At the European level, the monetary environment remains accommodative and rates are expected to remain unchanged in 2018, which increases private sector debt (at its highest level since 2000) and the risk of a bubble. The phenomenon of « lowflation » (continuously low inflation despite positive growth) could therefore persist in Europe, and the transmission of wage inflation to price inflation is not guaranteed.
