Another pivotal year of European elections

The United States is not the only source of political risk for the global economy. Europe faces a number of political challenges over the coming year.

The Renzi-instigated Italian constitutional referendum did not pass, further clouding the outlook for the country's economy and banks. The French presidential elections will take place through April and May and, while a center-right victory is the most likely outcome, a victory for Marine Le Pen cannot be ruled out. Article 50 will probably be triggered by the U.K. government before the end of March in an environment in which U.K. and EU ‘red lines' look increasingly difficult to reconcile. Destabilizing outcomes could reinforce the peripheral European spread widening that has taken place in recent months amid speculation that the ECB ‘backstop' has become more equivocal. However, we doubt policymakers would stand still in the face of market movements that threatened to undermine four years of policy and economic repair.

The surprise election of Donald Trump has the potential to reshape the domestic policy landscape in the United States and the country's relationship with the world. However, the specific implications of a Trump administration remain to be seen. In the meantime, what's more clear is the trajectory that global growth, inflation, and policy were on before his election.

Our first observation is that there was increasing evidence that global activity was finally on the up after two years of decelerating growth. Global manufacturing sentiment troughed in the first half of 2016, and global industrial production has modestly improved. At a regional level, stronger growth has been most clearly evident in the United States, those emerging markets that experienced the deepest recessions and trade-sensitive European economies, such as Germany. Underlying activity has also been edging up in China. This is mainly because the Chinese authorities have been happy to revert to credit and fiscal stimulus measures to prop up growth, while pushing the rebalancing the economy requires further out.

This improving real economic outlook has been matched by rising headline and producer price inflation. The pick-up is due to both a partial rebound in commodity prices and the base effects from their pre-February falls washing out of the inflation numbers. However, signs of stronger underlying inflation are more difficult to come by. Wage growth and core inflation are on a gradual upward trajectory in the United States, and will also rise in the United Kingdom due to the collapse in sterling. However, in the eurozone, Japan, Australia, and Sweden there is scant evidence from either wages or the details of inflation data that underlying inflation is moving back towards central bank targets.

This improving global growth and headline inflation environment implies that we are probably past the maximum monetary policy impulse. The Federal Reserve will want to follow December's rate hike with further increases in 2017, should economic data and market conditions allow. Meanwhile, the European Central Bank and Bank of Japan seem more intent on increasing the sustainability of their existing policies than adding significant new stimulus. However, it will be hard for either to disengage from unconventional policies altogether.

Stronger nominal growth also means a return to positive corporate profit growth. Falling commodity prices, the stronger dollar, and decelerating real and nominal growth were important drivers of the sharp decline in corporate profits over the past two years, with the biggest drops occurring in emerging markets and major commodity-producing countries. With these factors beginning to turn around, corporate profit growth and margins are likely to improve over the next year.