Global Growth Has Stalled, Now What?

Written by: Robert Serenbetz | New York Life Investments

Global economic growth is fading. Nearly every major developed economy is now firmly in either a ‘slowdown’ or a ‘downturn’. Trade tensions, geopolitics, and increased economic uncertainty may continue to weigh on economic potential. Therefore, we believe it is too early to count on a reversal and uptick of global economic growth. Without a catalyst for reversal, countries that rely heavily on trade and manufacturing face the biggest risk.

We remain suspicious of any efforts to alleviate the Trade War

In recent weeks, the trade war between the United States and China showed some signs of easing. There are reasons for this: National Security Advisor John Bolton – a hawk on China policy – left the Trump Administration, China reached out to re-start good-faith talks, and meetings were scheduled for next week. Unfortunately, we suspect that these changes are unlikely to provide durable relief to trade uncertainty. A trade deal is not imminent and structural resistance to a significant deal exists on both sides. Meanwhile, already-imposed tariffs remain in effect and are unlikely to be removed. As a result, we believe the ongoing negotiations will continue to pose uncertainty for businesses as they ebb and flow between escalation and détentes.

China continues to slow

China is the world’s second-largest economy and an important component of our international and emerging markets views. The country faces two types of slowdown. One is cyclical, due in part to trade wars. The other is structural, where the Chinese government is purposefully shifting the economy from manufacturing-driven to consumption-driven growth, which will weigh on potential GDP growth rates over time. The Chinese government has provided a regular stream of monetary and fiscal stimulus to generate a “soft” economic landing. Therefore, we believe the government will be able to avoid an economic crash despite ongoing risks. However, economic data does not support headlines suggesting a China resurgence – at least not yet. For example, industrial production growth has collapsed. In August, annual growth eased to just 4.4%, the slowest pace since 2002. It appears a recovery is being held back by foreign-owned companies who remain unwilling to invest in capacity as the production slowed. The removal of further tariff threats could improve the situation in China. However, we question if major organizations would ramp-up production, increase business investment, or increase capacity utilization in today’s weak global environment.

Europe appears most at risk

As a net exporter, the European Union is particularly sensitive to global trade dynamics and the slowdown in China. Industrial production and manufacturing surveys show sustained weakness, especially in Germany, where the U.S.-China trade war, Brexit, and late cycle headwinds pushed leading data into contraction territory. The European business climate is weak, and future expectations indicate that any improvement is unlikely. Even the services sector, which proved resilient earlier in the year, is beginning to soften. These conditions are made potentially worse by a handful of political and demographic risks that skew Europe’s growth prospects to the downside. In response to these conditions, the European Central Bank (ECB) has loosened monetary policy cutting interest rates by 10 basis points to -0.5% and will begin purchasing financial assets (quantitative easing) in November. We believe the ECB action will help to put a floor on European equity markets, but looser financial conditions on their own will fail to promote a significant resurgence in growth. Without fiscal stimulus, we view European markets as higher risk without the potential upside.

Limited upside in Japan

At the outset, it appears the Japanese economy could provide some glimmer of hope. The government has infused 2 trillion yen (roughly 1% of GDP) in proposed fiscal stimulus through education subsidies, infrastructure investment, shopping vouchers, and tax breaks on big purchases. However, Japan has also been disrupted by trade wars – globally and in its own trade dispute with South Korea – and slowing growth. As such, we are not optimistic about its ability to add value relative to other regions. In the short term, we are also monitoring a value added tax (VAT) rate rise on October 1, which could soften consumer spending for the next few quarters.

Emerging markets have the potential to rebound

So far this year emerging markets have substantially underperformed U.S. and developed international equity markets despite similar corporate profits growth. As a result, valuations have grown more attractive in emerging markets broadly relative to other regions, which may face downward revisions. Meanwhile, many of the other risks that have commonly plagued developing markets in the past including a strengthening dollar, rising interest rates, and structural imbalances, appear as though they may now be in the rearview mirror. The combination leads us to believe that an asymmetric return opportunity may be at hand: emerging markets could enjoy significant upside should global economic growth stabilize, while the risks appear to be no worse than equal to other markets in the event the current slowdown continues to worsen from here.

Portfolio positioning

Our base case economic scenario does not include a recession in the next 12 months, but persistent policy uncertainty and slowing growth increase market risks. We are slightly underweight U.S. and other developed market equities where we believe risks are skewed to the downside. We remain neutral emerging markets, however, as we believe they offer significant upside should the economic environment stabilize. Should even a partial trade deal between the U.S. and China come to fruition or a significant rebound in global growth stem from fiscal stimulus, we would reconsider our current aversion to risk assets with emerging market equities offering an appealing opportunity to add stock exposure to our portfolios.