Short term outlook 2020: Is the global economy heading for a recession?
Global economic slowdownThere is no question that the global economy is slowing. This can be seen not just from the decline in manufacturing confidence, but also in the lower production levels in industry in many countries, a substantial dip in global trade and a contracting economy in Germany in the second quarter of 2019.
China has also seen a drop in the pace of growth in lending by banks, industrial production and retail sales. The negative yield curve in the US is an important leading indicator of a recession and often a component of broader composite leading indicators, such as those published by the OECD. There are few countries in which the OECD leading indicator is still rising and this is evidence of weak momentum in the global economy. Yet the US yield curve is not infallible. Since the 1950s, there have been two recessions without the yield becoming negative. There are also two instances in which the yield curve was negative without it leading to a recession. Nevertheless, the 1960s saw a huge slowdown in growth in the US and in the late 1990s the Asia crisis, the collapse of enormous hedge fund LTCM and the Russian rouble crisis caused severe turbulence on the financial markets. The signal in that negative yield curve is clear. So why shouldn’t we trust blindly in it? Firstly, because interest rates are low. On all the occasions on which this signal proved to be correct, the US central bank was in the midst of a series of interest rate hikes. The real official interest rate in the US is just 0.6 percent at the moment and the Fed is cutting interest rates. The low long-term interest rates are also caused by a structurally high demand for long-term government bonds. The signal of a negative yield curve works even worse outside the US.
And figures on service sectors and job markets sketch a less sombre picture. What is the cause of a recession? Traditionally, we look for rising inflation and interest rate hikes by central banks, very rapid increases in corporate investment and debt, or a sharp upturn in the oil price. In a recession, these lead to less corporate investment, higher unemployment and lower consumer spending. We have not seen any of these indicators yet. Inflation is low and central banks are putting in implement expansionary monetary measures. There are high levels of debt generally, but compared to the global economy this has in fact fallen over the past few years. Moreover, lower interest rates mean that the global economy can cope with a higher level of debt. Nor is there overinvestment in our opinion. However, the negative impact of the trade war between the US and China is becoming increasingly visible. Earlier, we mentioned weak global trade and industry, but there are signs that this weakness is spreading to corporate investment and job markets. All in all, there are still several question marks against a global recession.
Will central banks deliver?
And what about central banks? The extremely stimulatory monetary policies were gradually scaled back over the course of 2017 and 2018. The US Federal Reserve has switched from a bond-buying programme to reducing its balance sheet and was raising interest rates up until December 2018. The ECB has terminated its bond-buying programme and the Japanese central bank has been buying up a much smaller amount than its own target figure for some time. The reversal in central bank policy in 2017 and 2018 was perhaps such that the global economy is still being adversely affected by it. Central banks reverted fully to expansionary policies in the first half of 2019, but there are other major uncertainties as well. Take the trade war between the US and China, Brexit or political and budgetary problems in Italy. A great deal is now expected of central banks and the question is whether they will live up to those expectations. In the US in particular the tight job market and slightly higher inflation could restrict the central bank’s scope for policy-making. As for the ECB, the question remains as to whether it will have any effect if the bank resumes buying government bonds when German 10-year yields already stand at -0.7 percent and their Dutch counterparts at -0.5 percent.
2020: a challenging investment climate
Whether there is a global recession or not, we anticipate a challenging investment climate in 2020. We believe that the global economy is slowing to such an extent that it will be difficult for businesses to generate earnings growth. This would be a setback for the equity markets, given that analysts are still forecasting solid earnings growth at the end of 2019 and in early 2020. The trade war does not look as if it will be resolved quickly either. Equities also contain advantages, however, such as attractive dividend yields. Yet some caution is due here. Within equities for the time being we still prefer the US, where the economy is doing better and there is greater capacity for an expansionary monetary policy. At the moment we are mainly seeking refuge in safe corporate bonds in Europe and emerging market debt listed in US dollars. These continue to offer attractive yields. Yet for now our allocation policy is geared more to capital protection than attempting to earn high returns.
What could reverse this? A deal in the ongoing trade war would of course clear the air. A more expansionary monetary policy combined with fiscal stimulation would also be positive for risky asset classes. There is talk of fresh tax cuts in the US, but it remains to be seen whether a compromise will be reached between the Republicans and Democrats before the presidential elections in November 2020. Germany and the Netherlands are also considering additional government investment programmes, and these are an increasingly attractive proposition in view of the negative bond yields. However, Germany has given itself little constitutional leeway and a previous programme barely got off the ground in the Netherlands. It’s certainly worth keeping a close eye on the stimulatory monetary and fiscal policies, but for the time being we believe that the negative effects of the trade war and a potential earnings recession will prevail.