SINGAPORE (Dec 19): Morgan Stanley is in the view that the ongoing global economic cycle will stay stronger for longer, on the back of a pick-up in investment growth, a gradual rise in core inflation, steady removal of monetary accommodation, contained financial stability risks in the US, and a moderate slowdown in China.

In the latest edition of Morgan Stanley Research’s Sunday Start series, Chetan Ahya, Global Co-Head of Economics and Chief Asia Economist, Economist, expresses confidence in a number of critical factors which he believes will evolve in a benign fashion going in to 2018.

In the economist’s base case, he expects global investment growth to accelerate meaningfully into 2018 to see global GDP growth rise further above trend.

This is because the further advancement of developed markets (DMs) will incentivise more capital-deepening on rising capacity utilisation and a pick-up in wage growth, he explains, while emerging markets (EMs) are likely to see stronger consumption growth and steady experts growth which will in turn raise capacity utilisation.

“With DM central banks lifting real rates in the backdrop, the strength of capex growth will be particularly important at this juncture as higher productivity growth is needed to keep the recovery stronger for longer,” notes Ahya.

Morgan Stanley also expects DM core inflation to rise in the year ahead, albeit without crossing central bank targets of around 2%Y, as cyclical factors such as tightening in labour markets become more supportive.

US core personal consumption expenditures (PCE) are projected to rise an average 1.7%Y in 4Q18 from an estimated 1.5%Y in 4Q17, while core inflation in the euro area is seen to increase to 1.6%Y from 0.9%Y previously, and in Japan to 1%Y from 0.2%Y.

Ahya reckons DM banks will move towards less expansionary policies over the year, and thinks the Fed will therefore raise rates to a total of 75bp in 2018 while shrinking its balance sheet as planned.

On the other hand, he believes the European Central Bank (ECB) is due to end quantitative easing over the year, with the Bank of Japan (BoJ) to adjust its Japanese government bonds (JGB) 10-year yield yield target in 3Q18.

Nonetheless, the economist expects the anticipated productivity pick-up that comes with stronger investment growth to support the global economic growth cycle for longer, which will help to partially offset the headwinds from gradual central bank tightening in DMs.

The biggest risks to the global cycle, however, are more likely to emerge from the US, says Ahya.

This is particularly so for the non-financial corporate sector, which appears the most exposed to higher interest rates as this point given their increased leverage over the years.

Ahya points out that weaker debtors with high leverage and high interest exposure are more likely to see a more pronounced impact from Fed rate hikes, while overall financial conditions may tighten meaningfully as credit spreads widen in this context.

Lastly, contrary to concerns over tightening in China resulting in a deeper slowdown in the republic’s growth, Morgan Stanley is in the view that a combination of factors should help to provide an offset to the gradual pace of tightening. These are namely a sustained strength in exports growth; an improvement in consumption supported by better wage growth; a healthier state of inventory in China’s property market; as well as improved industrial sector profits, supported by cumulated capacity cuts.

However, Ahya cautions that the slowdown in China’s growth could be more substantial than projected in the base case should policy-makers take up aggressive tightening in the year ahead.

From a markets perspective, Morgan Stanley’s strategists have highlighted the possibility of a more challenging market backdrop as the year progresses, inflation rises and financial conditions become less supportive.

This presents an opportunity to reduce risk later in 1Q18, suggests Ahya.

“With regards to positioning, [our strategists] prefer DM in equities, EM in fixed income and USTs within DM bonds. They remain cautious on US HY, given rich valuations and cycle risks,” he adds.