It's coming, it's coming, though range of possible outcomes is wide

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Money through a magnifying glass

For months, many confidence indicators in the world economy have risen. But so called harder data on actual economic activity has stubbornly refused to improve. This clearly cannot last forever, something will have to give. Either confidence will weaken or real activity will strengthen (or a bit of both, of course). I would bet on the second option: harder data is set to improve materially in the months ahead.

For the first time in many years equity analysts are revising their profit forecasts upwards for eurozone companies. Han de Jong Han de Jong Chief Economist

Something special

Recent days have seen an even more pronounced pattern of what we have seen in the last couple of months in US data. While the labour market has been tightening gradually and the housing market remains strong, industrial production growth has remained weak even though business confidence indices have moved higher.

20170220-Philly Fed, Empire State and US industrial production

The Philly Fed index, which measures business confidence in the Philadelphia Fed district, surged to 43.3 in February, from 23.6 in January. The February reading was the highest in over 40 years. This is truly spectacular. Of course, it is just a single indicator and it may have been distorted and it may get knocked back in March, but it is still remarkable. It suggests something special is going on.

The Empire State index, which is the equivalent for the New York Fed, rose from 6.5 in January to 18.7 in February. This was less impressive than the Philly Fed index, but it was strong all the same. So if these sort of indicators are pointing at a remarkable development, what is it, what causes it and can it last?

Nothing special in industrial production (yet)

Clearly, if these sort of confidence indicators are highlighting something it is a significant gain in economic momentum. And that should come through in the industrial sector especially as that is the most cyclical sector of the economy. However, that does not seem to be happening. US industrial production was weak in January, falling 0.3% mom and virtually unchanged on the year. Manufacturing was a touch stronger, but not remarkably so.

Data on industrial activity are actually a little more convincing in other parts of the global economy. Industrial production in the eurozone fell back 1.6% mom in December (though this may be partly due to statistical effects), but the year-on-year rate remains firmly in positive territory: 2.0%, versus 3.2% in November. Japan's industrial production growth is running around the same level: not spectacular, but not a disaster either. In both economies the industrial sector has clearly gained momentum in recent month, consistent with confidence indicators. As I have argued many times, logistics data are supportive of this view as well.

20170220-Industrial production eurozone and Japan

The eurozone did not see a lot of data releases in recent days, but January car sales were strong. The yoy growth rate accelerated to 11.0% in the eurozone, though it must be borne in mind that car sales can be erratic early in the year due to tax changes.

As regards the question whether confidence will weaken or harder data will strengthen, I think the latter is more likely because of the overwhelming evidence of improving confidence everywhere and because I think there are several factors supporting stronger growth

If growth is getting stronger, what is causing it?

Many commentators are focusing on the new US president as cause of the upturn in business confidence. He may be part of the equation, but I think focussing on Trump alone is completely missing the point. The improvements in confidence indices were underway before the US election. I think what is happening is the reversal of what happened between mid 2014 and mid 2016. During that period, a number of factors held economic growth back. Some of them are related, but mainly it was a coincidence of factors. These include: short-term movements in China's business cycle, caused by policy interventions; the collapse of investment in the oil sector due to the decline of oil prices from mid 2014 on; the inventory cycle, the deleveraging process, continued austerity in many countries, etc.

In my opinion more or less all these negatives are turning at the same time. Efforts by the Chinese policymakers to prop up growth appear to be successful. The recovery in oil prices has led to more investment in the sector. The inventory cycle has turned. The IT cycle in the world is strengthening. The process of deleveraging is completed in some cases, and advanced in others. Austerity is abating or tuning into stimulus. The availability of credit has improved materially in recent quarters in key economies, while the cost of credit remains very low.

The profits cycle has turned up globally. For the first time in many years equity analysts are revising their profit forecasts upwards for eurozone companies. Having fallen in four consecutive quarters US corporate profits (on a national income basis) turned up in the course of last year. Typically, investment spending by firms follows the profits cycle, so investment spending should pick up as well. This is starting to come through in surveys on investment intentions. It would not only support overall economic growth, it should also help to raise productivity, allowing the economy to grow a little faster without causing inflation.

Large parts of the rest of the world are set to follow a similar path, making this a relatively synchronised global gain in momentum. That makes it more likely to have legs. What also helps is the fact that there would appear to be very few bottlenecks in the economy that could derail the favourable development. Policymakers can also be a threat as policy mistakes can kill a recovery and push the economy down. But that does not look very likely either.

What we must consider, of course, is the many uncertainties that are around. They include the unpredictability over President Trump's policies, Brexit, the risk of EU disintegration, the elections is various European countries etc. If these uncertainties cause a significant number of unpleasant surprises then all my optimism goes out of the window and a much more negative scenario is conceivable in such a situation. So there essentially is an unusually wide range of possible economic outcomes. For now, I think it is wise to stick to an optimistic one.


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