Global growth divergence eclipses last year’s synchronized recovery

If 2017 had a theme song summing up market perceptions of global economic growth, it might have been the one from The Lego Movie, “Everything is awesome.” Not so for 2018. 

The global synchronized recovery of last year has given way to regional variation. The U.S. economy remains strong, but growth in China, Europe, and Japan has shown signs of decelerating. Despite the divergence, we think the global recovery still has room to run, with the United States continuing to lead the way, buoyed by the tax cuts and government spending for the next couple of years. However, we acknowledge a number of risks to our view that the next U.S. or global recession is at least two years away.

The United States started the year with choppy economic figures showing that, for all the stimulus measures from Washington, businesses and consumers weren’t laying out much capital. Retail sales contracted in the first two months of the year, and nondurable goods faltered. Since then, commercial loan growth has ticked up marginally, there’s been a moderate increase in capital expenditures, and industrial production has rebounded. Meanwhile, retail sales growth has remained rangebound and real wages continue to stagnate. For all the stimulus the United States has coming down the line at such a late stage in the business cycle, there doesn’t seem to be many signs of an overheating economy.

This should come as a relief to the U.S. Federal Reserve (Fed)—if the U.S. economy isn’t overheating, we’re unlikely to see a typical late-cycle inflation surge, and the Fed can maintain a gradual path toward monetary policy normalization. Traditionally, at this late stage of the business cycle, there’s a surge in inflation and the Fed has to hike interest rates to restrain price rises, pitching the economy into recession in 10 out of the past 13 rate-hiking cycles.¹ Investors seem primed for signs of inflation, as evidenced in part by the U.S. equity market correction in early February. There are legitimate inflationary pressures building in the economy, including fiscal stimulus measures, rising commodity prices, and low unemployment. But for all of the inflationary pressures, there are a lot of disinflationary pressures, too, including low productivity growth, an aging population, and weak wage growth in spite of the strong job market. 

“… if the U.S. economy isn’t overheating, we’re unlikely to see a typical late-cycle inflation surge, and the Fed can maintain a gradual path toward monetary policy normalization.”

What happens from 2020 onward, when much of the recent fiscal stimulus is expected to taper off? One scenario is that policymakers simply extend the stimulus measures. Another scenario is that the U.S. economy faces a fiscal cliff, hindering growth at a time when the central bank remains in tightening mode.

As it did prior to the last downturn, leverage represents a risk for the U.S. economy today. While it was the high levels of consumer debt that were partly responsible for the last recession, it’s rising corporate debt that could be a catalyst this time around—U.S. nonfinancial corporations have been on a debt-issuing binge for the past year.

In aggregate, many measures of nonfinancial corporate leverage look healthy. Debt-to-profit ratios, for example, remain low relative to peaks of the last three business cycles. But by other metrics, nonfinancial corporate debt seems concerning. Net debt-to-earnings ratios for the S&P 500 Index have risen sharply in recent years; these ratios look even worse for the Russell 2000 Index of small-cap companies, which excludes the big pharma and tech companies with battleship balance sheets ballasted by cash. Corporate debt may not be a problem now, while profit margins remain high and interest rates remain low, but if margins or rates head too far in the wrong direction, debt servicing may quickly become a challenge for many American companies.

Trade continues to weigh on global sentiment as the United States pursues a protectionist agenda and threatens tariffs on its allies and trading partners. We expect the trade skirmishes will get worse. So far, the tariffs announced by the U.S. administration would represent the equivalent of an economic mosquito bite—uncomfortable, but unlikely to be a game changer for U.S., Chinese, or global growth. The U.S. administration’s key objective doesn’t seem to be to address bilateral trade balances but rather to ensure U.S. dominance in high tech fields, such as artificial intelligence, machine learning, and quantum computing. These fields also represent a key objective for the Chinese government, as reflected in its strategic plan, Made in China 2025. Neither the United States nor China is likely to back down on this issue, and we expect more tariff announcements. We also expect that the United States will continue to face increasing isolation on the global stage, in part because of the government’s hostile stance toward global trade.

Developments in Italy represent another key threat to global growth. The new Italian government, consisting of the populist and anti-European Lega and Five Star Movement, has already set out on a collision course with Brussels. The most pressing issue will probably be Italy’s fiscal policy: The new government aims to introduce a flat tax and a universal basic income measure and would like to roll back a number of pension reforms implemented in 2011. There’s no clear way for Italy to pay for these reforms other than through deficit financing that would almost certainly break a number of eurozone fiscal rules. In our view, the leaders in Rome have three options:

• Snap back in line with Brussels quickly
  
• Ease back in line with Brussels slowly
  
• Attempt an abandonment of the euro
  

Easing back in line with Brussels slowly is the most likely outcome, but we wouldn’t be surprised to see the new government attempt to leave the euro first—tantamount to driving Italy off an economic cliff, in our view—before ultimately capitulating. Regardless, all three options are likely to result in market volatility and yields on Italian government securities rising. Europe has no clear plan about what to do if Italy gets into trouble. 

The last time Italy exhibited fiscal profligacy, the European Central Bank (ECB) intervened and then-Prime Minister Silvio Berlusconi had to resign. This time, the ECB doesn’t have much room to intervene without increasing support for populist, anti-European political parties. Italy could apply for a bailout funded largely by the ECB with strict conditions attached, but it seems unlikely that any Italian government—particularly this one—would agree to any conditions.

We don’t think that the current global growth story is set to expire in the next few years, but there’s been evidence of a growth divergence between the United States and other major economies across the world. The U.S. economy, buoyed by recent fiscal stimulus measures, is likely to fuel global growth over the next couple of years, but there are a number of risks to our view, some of which may become more prominent from 2020 onward, as the effects of the U.S. stimulus measures begin to wane.

Investors frequently get too swept up in their fears of the future to enjoy the present, but today’s many blessings shouldn’t be taken for granted. They include one of the longest economic recoveries on record, high corporate profits, still-low interest rates, buoyant stock markets, low unemployment, high levels of household wealth, a booming technology sector full of current and future wonders, and a stable financial system. If only such conditions could last. 

How will credit markets respond as central banks move toward tighter monetary policy? Can U.S. equities live up to their lofty expectations? Have economies outside the United States really rolled over, and how much will a growth slowdown weigh on those markets? Is the U.S. dollar ready to tear higher and, if so, can emerging-market assets stand on their own? What about threats to free trade? 

While we’re aware of these mounting challenges and the potentially negative inflection points, the investment environment remains positive on the whole, at least for now. We’d encourage fellow investors to enjoy this moment—it’s as good as it gets.

“We’d encourage fellow investors to enjoy this moment—it’s as good as it gets.”

Bond yields had been stuck in neutral, caught in countervailing forces—rising short-term U.S. interest rates, on the one hand, and the low rates prevailing in other developed markets, on the other hand. More recently, we’ve seen the resolution of those forces propel bond yields higher and bond prices lower, signifying an end to the more than 35-year bond bull market.

While our longer-term view of U.S. fixed income overall remains decidedly negative, the rise in yields on 10-year U.S. Treasury notes places government bonds at a somewhat more attractive entry point than they were only a short while ago. On a much more cautionary note, there’s been a significant buildup of credit risk in the U.S. corporate bond market, especially in light of the bulge in BBB-rated issues, which reside just one step above junk bonds. At $2.5 trillion, the size of the BBB-rated segment is 2.5 times higher than the outstanding supply of BBBs in the aftermath of the 2008 global financial crisis. U.S. credit markets can ill afford the one-notch slip that would render these bonds ineligible investments for portfolios with high-quality mandates. Our eyes are fixed on this area as an early warning sign of financial stress.

As the era of central bank distortions appears to be drawing to a close, the normalization process for bond yields will be painful for today’s bondholders, which will pave a better way for the bondholders of tomorrow. Until then, we remain negative.

After eight consecutive quarters of accelerating U.S. economic growth, the trend is shifting lower, and corporate margins can’t continue expanding indefinitely. The leadership of information technology—representing roughly a quarter of the U.S. market’s capitalization—is at some risk, as regulatory pressures mount for the sector’s leading companies. We’re marginally less excited about mega-cap tech exposure and have been paying more attention to sectors with a value tilt, including financials, energy, and materials.

For nearly a decade, the equity market has seen little competition from bond yields. U.S. equity investors need to mind late-cycle markers, such as interest-rate hikes and wage increases, which threaten profit margins. Of course, the threat to global supply chains from new tariffs would also weigh on business results.

We’re generally optimistic in the near term, but we recognize the way forward is likely to be much more volatile than the path that led us to this point.

An all-out global trade war tops our list of longer-run worries. What’s threatened is the economic order of the past four decades that has allowed for massive global efficiencies and supply chains interconnected across economies. The current tit-for-tat tariffs merely scratch the surface. Relative to a few months ago, we’re slightly less positive on the near-term outlook for European stock markets. Small company stocks in Europe have been marching higher with far less visibility than their mega-cap counterparts. In our view, there’s a lot of leverage in earnings and margins coming to the small-cap sector from a very low base. To the extent that some of these smaller companies remain insulated from trade protectionism, a down-in-cap bias represents a good alternative to larger stocks in Europe and elsewhere.

In our view, the U.S. dollar remains locked in a broad longer-term trading range, and we think its recent strength is unlikely to test the upper bounds. U.S. dollar bulls argue that relatively high interest rates and a more robust growth trend in the United States will keep the greenback strong. But just wait. The combination of twin U.S. deficits—trade and budgetary—will ultimately reassert pressure on the U.S. dollar, especially once the rest of the world starts lifting rates, too. The U.S. dollar has traded against a major currency basket index, the U.S. Dollar Index, or DXY, in a range between 80 and 100 over the past 15 years. A big inflection point carrying the U.S. dollar materially higher or lower is likely to wait.

Our near-term view of emerging-market equities is now slightly less positive than it was before, but expected returns over the longer haul are higher here than most anywhere else. Over time, trade agreements, such as the modified Trans-Pacific Partnership, will continue to open the vast Asian markets to benefits and efficiencies among the signatories. Investors will look to this open trade region over time and should be rewarded with efficient supply chains, the expression of competitive advantages, stronger corporate margins, and better price-to-earnings multiples. In the long run, the major Asian economies will find a way to work together; however, the short-term adjustment period in the face of trade tensions could be difficult. Investors might consider using any severe dislocations to buy opportunistically.

Our take on emerging-market debt is similar. We recently toned down our fearlessly positive view because of risks associated with tightening global financial conditions and barriers to world trade. We see value in the attractive balance of credit quality and yields, but the path forward will be difficult over the next several months. A strengthening U.S. dollar has put pressure on emerging-market economies. Moreover, emerging markets thrive on trade, which has been challenged by the U.S. administration’s posturing and provocations; however, we view these challenges as transitional, the long-term picture as much brighter. Most developing economies are likely to expand their range of intercountry trade opportunities and carry on.

We believe a major breakout is afoot for commodities and natural resource markets, with industrial metals, materials, and other natural resources poised for higher prices. Oil prices have stabilized and share prices of energy companies have rebounded from abysmal lows. While oil stocks have lagged the gains in the price of oil itself, the gap should narrow prospectively. Energy is one beaten down area of the stock market we like right now. Given the volatility of commodity prices, investors would do well by accumulating commodities and commodity equities slowly over time, accelerating purchases during major setbacks. Commodity prices often break down significantly near recessions, but the low prices often provide the opportunity to own what may evolve into a superb bull market over the long haul.

1 Bloomberg, 6/7/18.