Global Debt Outlook: Slowing growth has led to monetary easing around the world
Global Debt Outlook: Slowing growth has led to monetary easing around the world
The weakness in manufacturing and trade made the global economy lose momentum, but the Global Debt Team still expects the prospects of a global recession to be low.
The third quarter continued to see weaker global growth, led primarily by the rest of the world as the US surprised to the upside after what had been much-lowered expectations. As anticipated, global growth slowed, and policymakers responded by moving towards easier monetary conditions in almost every major global economy. The US Federal Reserve (Fed) delivered the first of its two rate cuts so far this year while most emerging market (EM) central banks continued to reduce rates.
What did we see in the third quarter?
The global economy lost momentum, driven by the weakness in global manufacturing and trade. While more domestically oriented sectors of economies have been more resilient, signs of spillovers to those sectors are beginning to emerge. As long as the trade tensions and ensuing uncertainty continue, an uptick in activity is hard to see. A partial trade agreement between the US and China and the prospect of a freeze in the trade conflict for some period will be a relief for the markets and global growth.
A major change in policy since the last quarter is that central banks across the globe are much more proactive now and providing monetary stimulus. Typically, easing cycles last longer than initially expected. We expect easing by central banks will continue until there are clear signs of global economic activity stabilizing and evidence of an uptick.
In the US, the economy is slowing down towards its potential growth rate of just below 2%, with risks to the downside. Investment and net exports have already been headwinds. Consumption growth may also slow down amid a slowing pace of job creation, higher import prices, and inflation resulting from tariffs. Recent business surveys suggest that weakening confidence is spreading to the services sector. While we expect some loss of momentum in consumption growth, we don’t see it as a major downturn but a mild slowdown. The still strong job market, wage gains, low household leverage, and stable consumer confidence suggest resilience. Inflation is around the Fed’s target rate, and we don’t expect inflation will be a game-changer for the Fed in either direction. But the slowdown towards the trend growth rate, and ongoing global risks will require the Fed to provide insurance to sustain the recovery. We expect another 50 basis points (bps) of cuts in 2019 and an additional 25 bps in the first quarter of 2020.
The Eurozone economic weakness continues because of its exposure to global trade. Weakness started mainly in manufacturing and trade, while more domestically oriented sectors of the Eurozone economy proved to be resilient. On the domestic side, consumer confidence has declined from the cyclical highs but nevertheless remains at strong levels. Credit is available. Labor markets continue to improve. As in the US, there is domestic resilience, but there is more need for policy support, given the Eurozone’s more fragile recovery and higher exposure to the global economy. Recognizing the risks, the European Central Bank (ECB) acted in September with a 10 bps deposit-rate cut and a modestly sized but open-ended Quantitative Easing. The ECB has done quite a bit for the time being and is trying to pass the torch to fiscal policy. We expect modest fiscal stimulus in 2020 but nothing major. On the fiscal front, policymakers are more reactive than proactive and will not pull the trigger unless the area faces more significant recession risks.
In Japan, we expect a temporary slowdown in economic activity because of the consumption tax hike and headwinds on the global side. Japan is a major provider of intermediate capital goods that are exposed to the slowdown in global manufacturing and investment. But the domestic side looks more promising. The labor market is extremely tight in Japan. Jobs are plentiful, but labor shortages are widespread. Smaller companies find it especially difficult to hire new workers and are investing in machinery and software to address labor shortages. The tight labor market and investment demand in domestically oriented sectors provide a cushion against downside risks.
China and Asia EM
The stabilization we had projected for the second half of 2019 was based on an expectation of a trade deal between China and the US. There is still hope for a limited trade deal, but we think the broader uncertainty around the US-China relationship will continue to undermine investment sentiment, especially against the backdrop of slower global demand. Besides trade issues and the slowdown in the US and Europe, emerging markets are also facing a structurally slowing China. As China rebalances away from investment-led growth to consumption-led growth, it will not be providing the same lift to EM exports that it did in the past.
On the positive side, we expect further monetary and fiscal easing from China to mitigate some, but not all, of the impact of the tariffs and the global slowdown on emerging markets. Additionally, easier global financial conditions and an expectation of further easing by the Fed will remain supportive of EM assets. Against this global backdrop, we believe benign demand-led inflation pressures and widening output gaps provide room for more interest rate cuts in several countries, such as India, Indonesia, Korea, Malaysia, the Philippines and Russia. We have also seen more supportive fiscal policies in India, Korea and China, and expect other countries to follow suit, such as the Philippines, Indonesia and Thailand. We expect these policies will start to stabilize growth in 2020.
The EM economies of Latin America have joined the global economy in taking another leg down to growth projections everywhere. We now expect both lower growth and inflation in the region. The disappointing slowdown has intensified in Mexico and Brazil, where we still see traction coming later, as well as in the region’s smaller and open economies as lower commodity prices will likely postpone recoveries. We have not materially changed our inflation outlook, as output gaps are even wider and inflation risks are lower, and exchange rate pressures have been countered by lower commodity prices. As we expected, central banks across the region have joined Chile and are now fully engaged in adding stimulus, and they are still easing, having revised down their budget of policy rate cuts. We believe both the Brazilian and the Mexican monetary authorities are breaking with past behavior.
On the other hand, Argentina has been the greatest exception in the region, as it experiences negative growth and double-digit inflation. It has turned completely around from its economic recovery and now faces a damaged outlook from a meltdown in asset prices following the defeat of President Mauricio Macri in the primary elections in August. Argentina needs swift macroeconomic stabilization, as the new president who takes office in December will have to make critical decisions on the country’s fiscal path, the debt process, and International Monetary Fund (IMF) negotiations. Market conditions would remain volatile in this context, as we likely head to a debt restructuring with haircuts alongside a new IMF program.
All other economies are slowing down further, and all central banks have room to cut rates to support growth, following the lead of the Chilean central bank. For the core economies, Mexico is a beneficiary of the US-China trade dispute because it has helped manufacturing, especially in the auto sector, which has gained market share. Still, the economy has been hurt by the US slowdown and uncertainties over domestic policy, which has included a fiscal retrenchment that is sharply reducing growth. In our opinion, the new administration of President Andrés Manuel López Obrador represents a positive historic change in the country’s political landscape, and the economy comes with a good starting point of low debt levels. In Brazil, we are optimistic about the reform agenda and expect the central bank will drive expansionary conditions further, testing historically low levels for the policy rate. Economic activity has faltered on global and local shocks, and domestic uncertainties have meant there is, for now, no support for a more benign environment of relief from credit and fiscal constraints. We think traction will come later, as the Brazilian growth model adjusts to a more sustainable path at the expense of the current growth rate in a slow transition.
Our most recent discussions about the global economy have continued to highlight the potential for global growth to continue falling. Still, that will be balanced by easing financial conditions globally, and most importantly in the US.
In a continuation of our view from Q3, we still see global growth momentum slowing in Q4 but at a slower rate. Our expectations for stability in non-US growth have been pushed out further amid concerns that a comprehensive trade deal between the US and China is out of reach, and even a narrower, focused one may be difficult. We do believe that China will provide stimulus, but that will be aimed at the domestic economy through policy measures such as tax cuts, which would have a limited global impact.
We expect global growth, which we estimate to be 2.6% currently, will fall further in the first quarter of 2020. We still anticipate the probability of a global recession to be low, however. In such an environment, we believe financial conditions and valuations will be the primary drivers of market returns. We expect the Fed will ease further as growth slows. We also believe other central banks — notably in Brazil, Mexico, Chile, India, Indonesia and Russia — will be accommodative. We continue to expect that the mix of moderate growth with falling inflation will have a positive impact on asset prices.
The shift in economics and the policy environment is allowing us to keep a stable outlook with regard to our portfolio positioning. We still believe that the US dollar will continue to slowly decline as the easier financial conditions reduce the cost of being long other developed market currencies such as the euro and yen. As financial conditions affect market performance, we expect EM currencies will benefit from carry, while developed market currencies could benefit from valuations. In our portfolios, we are favoring carry from currencies such as the Brazilian real, Indian rupee, Indonesian rupiah, and South African rand. We also favor the Norwegian krone and Polish zloty over the euro.
We continue to favor emerging market interest rates over developed market rates. Real yields in emerging markets remain close to highs when compared with developed market yields. We favor long-end interest rates in Brazil, India, South Africa, Indonesia, and Russia and front-end rates in Mexico and Colombia.
Hemant Baijal is Head of Multi-Sector Portfolio Management – Global Debt at Invesco. He leads the Global Debt team and also serves as a Senior Portfolio Manager. Meral Karasulu is Director of Fixed Income Research for the Global Debt team, covering emerging economies in the Asia-Pacific and Central and Eastern Europe regions.
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The opinions referenced above are those of Hemant Baijal and Meral Karasulu as of October 29, 2019.
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