Feature Stories | Dec 16 2019
This article was first published for subscribers on December 6 and is now open for general readership.
Recession or recovery? The global economy is on a knife edge heading into 2020, due to ongoing uncertainties meeting renewed central bank support. How should investors greet the New Year?
-All hinges on trade
-Political risks ongoing
-Central bank easing to continue
-Recession but a tariff away
By Greg Peel
"At first glance," says Morgan Stanley, "the 2020 outlook looks easy".
The investment bank's economists expect global growth to bottom in the first quarter of the year and then improve modestly thereafter. That implies US and global manufacturing PMIs (purchasing managers' index) should inflect back to expansion (>50), and PMI inflections usually boost equity and credit returns.
However, typically when PMIs have been weak, implying a soft economy, so too have asset valuations been weak, but currently valuations are unusually high. And the economists are not expecting a substantial PMI rebound, indeed they expect an unusually weak one.
The recovery in economic growth Morgan Stanley is expecting in 2020 varies widely in magnitude and timing across the globe, and such an uneven recovery will "collide" with relatively even global valuations.
And of course all hinges on trade, with the enactment of Trump's planned December 15 tariffs – still a source of uncertainty – enough to swing the economists' forecasts toward global recession. This is not, nonetheless, Morgan Stanley's base case.
Morgan Stanley expects US growth to stabilise around trend in 2020 as lower rates help to offset fading fiscal support. External headwinds should ease for the eurozone as the impact of policy stimulus sets in, leading to a modest recovery, while Japan remains sluggish, with the government's consumption tax offsetting a construction boost from the Tokyo Olympics.
The UK should improve on an orderly Brexit resolution and subsequent fiscal support.
On the assumption of an easing in trade tensions, as Morgan Stanley is so far making, although clearly this is the swing factor, China will see a lift in corporate sentiment aided by ongoing policy support. Other emerging markets will also benefit from resultant macro stability and the capacity for further monetary easing.
Morgan Stanley does not foresee subsequent upward pressure on global inflation, with the US forecast to rise to 2% but stay there and eurozone/Japan inflation to remain well below target. For China, higher inflation has been driven by food prices, particularly for pork due to swine fever, but this should reverse by the second half.
Of the 32 central banks Morgan Stanley pays attention to across the globe, 20 have already eased in 2019 and 14 are expected to ease further, taking the global weighted average cash rate to a seven-year low by March. US, eurozone and Japanese rates are forecast to remain where they are while the UK may hike once towards the end of 2020 as Brexit issues ease.
As far as equity investment is concerned, Morgan Stanley is Underweight the US given "peak earnings" risk, over-valuation and "unique" political risk, which can only mean you know who.
The broker is more positive on earnings growth potential in Japan, and sees scope for multiple re-rating in Europe as political risks fade.
The US Election
For at least a year the common view among pundits is that on the one hand, China's intention is to continuously drag out trade negotiations – seemingly getting close before backing off again – right through to the US elections in November, while Donald Trump will be anxious not to risk leading the US into a trade-related recession as that would no doubt upset his voter base at a critical time.
This week Trump declared he would not be fussed if no trade deal were signed before the election, which did not sit well with Wall Street. Given Trump is demonstrably sensitive about any Wall Street sell-off, this comment must surely be a warning to China that he, too, can sit it out without fear, with an intention of thus spurring Beijing into action.
The interesting point here is that if Beijing is hoping it can bring down Trump by not signing a trade deal, thus starting 2021 with a far more rational Democrat president to negotiate with, it is somewhat misguided. While the incumbent far right in the White House and Senate is an ideological chasm away from the Democrat-led House and the current far left Democrat nominee front-runners, one thing the two parties do agree upon is trade.
The Democrats agree China needs to be brought to heel, and thus are not highlighting trade as any point of policy difference. If whoever the Democrat nominee turns out to be is equally tough on trade, and bear in mind protectionism is typically a left, not right wing plank, then Trump may not wish to be seen to compromise, Credit Suisse suggests.
This puts Trump in a difficult position. If he can pull off a trade deal on the basis of Chinese concessions, he will ride into the election as a hero. If China does not back down, he could choose to make concessions to get a deal over the line for the sake of appeasing his tariff-impacted voter base, but then risk appearing weak against his Democrat opponent.
From China's perspective, its plan to hold out for a better deal under a different president may backfire.
The potential twist and turns could be discussed for months, and quite possibly will be. But as far as 2020 outlooks for US and global economic growth or otherwise are concerned, trade is the big swing factor. All forecasters retain trade as their caveat, whether forecasts are for a stronger or weaker 2020. The enactment of the December 15 tariffs is not Morgan Stanley's base case, as noted above, but if those tariffs go ahead, all bets are off.
Morgan Stanley is not alone.
Trade
"The stars are aligning for an equity market rally into year-end," said Shaw & Partners in their November outlook. Indeed, the S&P500 hit new all-time highs throughout November, but aside from easing Brexit fears, the driving force was belief that a trade deal actually was "close", despite being described as "close" by the White House for a good year and a half.
Developments in December have seen doubt creep in once more.
As for Brexit, the recent UK Supreme Court ruling has "substantially" reduced the chances of "no deal", PIMCO suggests, as it has strengthened the role of parliament. Shaw & Partners believes the upcoming UK election will act as a referendum. If pro-Brexit parties win, as the polls suggest, then the new parliament will be able to ratify Boris Johnson's agreement signed with Brussels. In the unlikely event the pro-Remain parties win, Brexit would be cancelled.
Either result is a positive for markets.
Shaw believed, as it prepared its November outlook, Trump needs a result on trade to support his election campaign given the easing of trade tensions should support US growth in 2020. Equity markets globally are further supported by an abundance of liquidity as central banks around the globe spent 2019 easing policy.
Shaw thus suggests investors be Overweight equities (trade again being the caveat) at the expense of more conservative asset classes. Shaw agrees with Morgan Stanley in being positive on Japan, and on Europe once Brexit uncertainty is lifted, but disagrees on the US, seeing further upside potential.
Amundi Asset Management also cites the US election as reason there will not be a material escalation in the trade war, which would damage the US economy, even if the "noise" around trade is ongoing.
Retreat in global trade is a major change to the structure of growth, says Amundi, but will not lead to a full-blown recession. Not at a time of cumulatively loose monetary policies and with a partial trade deal in sight.
Like Shaw, Amundi's 2020 investment outlook was written in November.
Monetary and Fiscal
A theme that will become prominent next year and beyond, Amundi believes, is the combination of monetary and fiscal policies, which may extend the cycle further.
Beyond the short term, the trend towards a more aggressive policy mix could potentially lead to further unorthodox measures if the risk of recession intensifies. The result may be an extension of the credit cycle that could eventually end in an "explosion", although not as early as 2020.
Credit Suisse lists as one of its primary risks for 2020 the potential for the Chinese "triple bubble" in credit, real estate and investment to unwind. China has experienced the fourth biggest increase in credit to GDP of any economy over a ten-year period and the three topping China – Ireland, Spain and Thailand – all ended up in major recession.
An unwind of the bubble requires a sharp drop in Chinese house prices, Credit Suisse suggests, and to date this is not happening.
For Amundi, the risk of more aggressive policy is one of investors being forced to pile into already crowded or illiquid areas where risk is masked by excessive policy accommodation.
Instead of fearing global recession, investors should focus on adjusting portfolio exposure to the de-globalisation trend. They should also prepare for a mature and extended credit cycle, Amundi advises, with higher liquidity risks due to more stringent regulations post the GFC.
In other words, strong corporate balance sheets are fundamental.
PIMCO believes the global economy is about to enter a "window of weakness" which should persist heading into 2020. Uncertainty remains as to whether it will be a window into recovery or recession.
During this period, PIMCO suggests, it would be prudent to focus on capital preservation, to be relatively light in taking top-down macro risk (meaning assets held from a global economic perspective, as opposed to bottom-up micro risk, which is stock-specific), to be cautious on corporate credit and equities, and to be ready to take advantage of opportunities as they present, which would imply holding a level of cash.
PIMCO's base case scenario is for global GDP to slow further for the next several quarters on trade uncertainty and widespread global political uncertainty. Labour markets and consumer spending have remained firm in most advanced economies but PIMCO sees the slump in trade and manufacturing as spilling over into the wider economy via lower corporate profits, hiring and investment.
The analysts expect US GDP growth to slow to 1% in the first half of 2020, down from 2% in the June quarter 2019 and 3% in the March quarter.
Surprisingly, amidst ongoing trade-related recession fears, PIMCO has found no tangible evidence the trade war is adversely affecting the US economy.
If anything, the US trade deficit has improved slightly relative to trend in 2019, implying a slight boost to GDP growth, rather than drag other claims to see. Developments in capital spending by US corporations have also shown some recent improvement, if anything.
Core inflation measures have rebounded slightly in recent months, but only from exceptionally low levels seen early in the year. PIMCO does not expect Fed policy, nor current GDP growth rates, will provide any meaningful upward pressure on inflation.
Another of Credit Suisse's perceived major risks is an aggressive pick-up in US wage growth, signalling the labour market is at full capacity, occurring at a time when underlying measures of US inflation are starting to rise.
PIMCO forecasts a small pick-up in eurozone GDP growth in 2020 on the back of better performances from Germany and Italy. Other large eurozone economies could slow somewhat but should be supported by accommodative monetary and fiscal policies across the continent.
Key risks include a disorderly Brexit, higher crude prices, further trade war escalation and renewed political risk in Italy. The UK's outlook is obviously Brexit-dependent.
China's economy is slowing both structurally and cyclically, PIMCO notes, at a time the global economy is softening. Chinese policymakers have decided currency devaluation makes sense, but the challenge for small businesses remains finance availability, as banks continue to show caution. The PBoC will likely continue to provide accommodative monetary policy, with the overarching aim of preventing "froth" in the property market.
PIMCO does not expect a quick, permanent turnaround on the US-China trade front. Once again, the greatest risk is escalating tensions. Recession is not the base case, but it wouldn't take much to tip over an economy that is moving at stall-speed, the analysts warn.
Look Elsewhere
Aberdeen Standard Investments holds a similar view to PIMCO, seeing secular stagnation leading to low growth, weak inflation and low interest rates. Not just in 2020, but for the next five years.
Aberdeen's global growth forecast for 2020-21 has been downgraded to 3.1%, well below the GFC average. A recession could be avoided next year, the analysts suggest, but the risks have clearly increased. The same key risks are rattled off – trade, Brexit, political uncertainty – and Aberdeen throws in the trade conflict underway between Japan and Korea, which has not received much attention given US-China has sucked out all the oxygen.
The late stage of the cycle and the lack of room for corporate margin expansion suggest equity returns will be below their long term average and a classic rotation from equites into bonds will no longer be appropriate given bond yields are so low (and in many cases negative).
To that end, Aberdeen recommends investors look beyond the comfort of traditional asset classes with a cautious, diversified approach for better risk-return. The analysts provide examples of structural themes worth pursuing over the next decade – climate change, technological disruption, ESG, 5G and AI.
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