The global economy continues to experience slow and steady growth, with low risks of recession in the U.S. and Germany. Japan’s outlook is showing mixed signals between the level of activity and sentiment.
The risks of a growth recession in China remain elevated, but policymakers have helped stabilize the economy in the near term.
The following is a more detailed look at developments in major areas of the U.S. and global economies, including a special section on emerging market assets.
Global: slow and steady
The global economy continues to grow at a steady pace, but with a diverse outlook across countries and regions. In the aggregate, the tone of the global expansion has improved in recent weeks, due to the clear emergence of the U.S. from its first-quarter slowdown, greater policy easing in China, and stellar global financial conditions (including the European Central Bank’s renewed commitment to monetary easing).
Although developed-market (DM) economies continue to exhibit favorable cyclical dynamics relative to emerging-market (EM) ones, these divergences have narrowed in recent months as activity in some EMs has stabilized. One source of this stability is the improvement in the current account balances of many deficit countries—such as India, Turkey, and Indonesia—that suffered from capital outflows during the second half of 2013 (see chart, right). With global financial conditions stabilizing and EM countries experiencing smaller financing needs due to lower current account deficits, EM currencies have stabilized in 2014 and are no longer creating inflationary pressures in their domestic economies through rapid depreciation. This shift has allowed some countries to moderate their monetary stances after a period of rate hikes, with Turkey cutting its benchmark rate and Brazil and India pausing. Significant policy easing in China has also been a key ingredient in stabilizing the near-term trends for EM economies.
Nevertheless, most emerging markets continue to face late-cycle challenges. Many larger EM economies still have inflation rates above their central bank targets due to persistent inflationary pressures from lagging cyclical productivity and structural bottlenecks. Corporate profitability remains weak, and bank lending and monetary conditions are tighter than they were one year ago. Although the switch to more EM policy easing measures may be positive for near-term growth, these late-cycle dynamics leave developing economies susceptible to a potential negative shift in sentiment in global financial markets (see “Emerging-market assets: Is the rebound sustainable?” below). The global business cycle expansion remains slow and relatively steady, with significant divergences among countries and regions.
U.S.: growing at steady pace
The U.S. economy remains firmly in a mid-cycle expansion, boosted by continued improvements in employment and corporate fundamentals. Initial unemployment claims have fallen to their lowest level in eight years, and the number of workers willingly leaving their jobs each month (a positive indicator) continues to reach new post-recession highs.1 Employee earnings are slowly trending higher, although the level of earnings growth remains weak relative to pre-recession levels.2 Even though inflation rates have ticked up in recent months and pose a risk to the benign consumer backdrop, they are not yet strong enough to suggest that late-cycle pressures on the U.S. economy are imminent.
The slow-but-steady pace of the U.S. expansion continues to provide a stable outlook for corporate revenues. Cyclically-adjusted productivity levels are still rising and interest expenses remain low, suggesting corporate profit margins are under minimal pressure. Business sentiment has continued to improve, and corporate capital expenditure plans remain in an upward trend.3 The housing market remains in a soft patch, however, as demand continues to adjust to the rapid price appreciation and higher mortgage rates during the past year. The U.S. economy continues to grow at a steady pace, underpinned by incremental gains in employment.
Europe: mid-cycle expansion
The majority of economies in developed Europe continue to improve, although the pace of expansion remains muted. Roughly 80% of developed European economies have experienced growth in their leading economic indicators (LEIs) during the past six months, suggesting that the expansion remains broad-based (though this percentage is down from roughly 95% at the start of the year).4 Manufacturing bullwhips—the difference between new orders and inventories—remain generally positive and signal a constructive outlook for continued expansion in industrial activity. Financial conditions remain in an improving trend, although the deflationary pressures that contributed to the European Central Bank’s unveiling of new monetary policy measures have persisted; the headline consumer price index rose just 0.5% year-over-year as of June.5 The escalating violence in Ukraine presents a growing risk to Europe’s outlook, and tougher European Union sanctions on Russia may have negative implications for European companies as well.
At the country level, the U.K. remains a major driver of the current European expansion, with industrial production, retail sales, and housing permit issuance continuing to accelerate on a year-overyear basis. On the other end of the spectrum of large economies, France is experiencing an extremely slow recovery. Germany, while still solidly in a mid-cycle expansion, has seen its pace of growth ebb in tandem with broader developed Europe. Though most peripheral economies have seen sluggish growth, they have generally retained their early-cycle dynamics, with unemployment no longer rising and manufacturing bullwhips continuing to improve. Despite a subdued magnitude of expansion, Germany and most of developed Europe remain in a mid-cycle expansion.
Japan: muddled outlook
Japan remains in the late-cycle stage of its expansion, with an uncertain outlook in the aftermath of the April consumption-tax hike. Evidence of weaker activity since April is broad-based, as industrial production growth continues to slow and both the Service Purchasing Managers’ Index (PMI) and construction activity remained in contraction.6 The manufacturing PMI has moved back into expansionary territory, although the level is much lower than it was earlier in the year.7
Although current conditions remain difficult, some forward-looking indicators have shown signs of recovery. Business sentiment surveys have rebounded,8 while consumer confidence has risen to its highest level in 2014 but remains well below levels reached in 2013 (see chart, right).9 The outlook for Japan remains muddled; sentiment indicators show a large gap between higher future expectations and weak current activity.
China: stable near-term outlook
Policymakers in China have helped stabilize recent activity with a variety of easing measures. Incremental monetary stimulus and easier borrowing conditions have generated a reacceleration in the pace of money supply and in the growth of financial institution lending during the past four months. Money supply is now rising at a 22% annualized pace, compared to 14% a year ago. Financial institution loans are growing at 16%, versus a year-ago pace of 14%.10 This incremental stimulus has helped push the HSBC China Manufacturing PMI bullwhip solidly into expansion territory for the first time this year.11
Policy easing and stimulus measures have reduced the probability of a growth recession somewhat over the past two months, but recession risks remain elevated amid pronounced late-cycle pressures. Most significant among these pressures is the overcapacity in the real estate sector, which has been the center of China’s credit and investment boom during the past several years. Incremental easing of lending and purchasing conditions geared toward residential property markets may provide some near-term stability, but most measures of real estate activity remain weak, including new construction activity, home price trends, sales, and rising inventories. As such, the continued weakness in the economy’s property markets remains a substantial downside risk to the financial and economic stability of both China and the broader Asian economy. China’s near-term outlook has stabilized somewhat following recent policy easing actions, but greater credit creation will not eliminate the risks of China’s formidable credit and property imbalances.
Emerging-market assets: Is the rebound sustainable?
Following the Federal Reserve’s public signaling of its intent to taper its quantitative easing program in mid-2013, emerging market (EM) equity and debt asset classes posted negative returns and underperformed most other asset classes during 2013. However, these asset classes have rebounded this year and now stand among the top performers so far in 2014. The turnaround has been a result of a number of factors, including improved global financial conditions and lower global bond yields, EM election outcomes that have generally been perceived as favorable, and some stabilization in the EM economic outlook.
The performance of EM equities started to improve during the second quarter, boosted in part by China’s policy easing. Low equity valuations set a low bar for investor sentiment, and EM economic data has recently begun to surpass subdued expectations. Nevertheless, the late phase of the business cycle—in which most EMs remain—has not typically provided a strong backdrop for equity returns. Corporate fundamentals have generally stagnated in the late cycle, as weakening cyclical productivity and rising inflation put pressure on profit margins. Revenue growth has typically slowed amid decelerating economic activity. Today, the aggregate earnings per share for EM companies is at nearly the same level as two years ago. Despite some recent signs of a modest increase in earnings growth, these late-cycle dynamics remain a fundamental headwind for EM stocks.
The commitment of developed market central banks to “low for long” interest rate policies, and the corresponding decline in DM government bond yields, has helped boost investor sentiment for EM debt. EM debt is considered a hybrid fixed-income category, with both fixed-income and equity-like characteristics. Its return profile is affected by movements of two principal components: U.S. interest rates (Treasury yields) and sovereign credit spreads (additional yield to compensate for default risk)—see chart, right. Roughly three-quarters of the U.S. dollar-denominated EM debt index is composed of high-quality investment-grade bonds that are affected more by changes in U.S. Treasury yields, while the remainder is represented by lower quality high-yield debt that is more susceptible to EM economic and credit fundamentals (see February Business Cycle Update section entitled, “Emerging market assets: Less uniformity in the investment landscape”). During 2014, EM debt has benefited both from a decline in U.S. yields and from a tightening of credit spreads. Credit spreads may be pressured during the late cycle as credit quality begins to deteriorate, but the interest-rate component is less tied to the EM cycle and more heavily influenced by Federal Reserve (Fed) monetary policy and the U.S. economy.
The near-term positive momentum in EM equities may continue amid subdued expectations and low equity valuations, but latecycle dynamics continue to provide a challenging headwind for corporations in EM economies. For EM debt, our expectation that interest rates are not likely to increase sharply in the near term provides a supportive backdrop for our outlook. However, a potential Fed policy surprise (as in Q2 of 2013—see chart, above right) represents a considerable risk to both rates and spreads, particularly because EM debt yields and spreads have fallen near record lows. Over a long-term horizon, we believe EM economies will be the fastest growing during the next 20 years, with EM assets representing considerable growth opportunities as part of a diversified global portfolio.
Summary and outlook
The benign global backdrop—incremental growth, stable inflation, and accommodative monetary policies—remains intact. This environment has been underpinned by steady, mid-cycle trends in the U.S. and Europe (see “Typical Business Cycle” below). The cyclical outlooks in Japan and China, as well as in many large emerging markets, remain more challenged. However, the tone of the global business cycle has improved recently due to even better sentiment in global financial markets as well as a move to greater policy stimulus in China.
The risks of a disruption to this supportive cyclical climate are several. China, as well as many other emerging economies, faces significant late-cycle pressures after years of rapid credit growth and a lack of structural reform. Many economies remain vulnerable to a potential slowdown in global liquidity growth, which becomes more likely as economic improvement in the U.S. and U.K. pushes them closer to monetary tightening. Geopolitical risks abound; in particular, Russia’s involvement in Ukraine and the potential impact on oil supplies from instability in the Middle East.
From an asset allocation standpoint, the stable mid-cycle outlook in the U.S. and Europe favors exposure to equities in those markets. In the near term, emerging markets may continue to benefit from stabilization amid subdued expectations and low equity valuations, but persistent late-cycle pressures threaten the sustainability of their outperformance. On a tactical basis, the risk of investor complacency amid low market volatility—alongside elevated valuations after the multi-year rally in risk assets—suggests high-quality fixed-income assets may provide protection against a potential spike in equity-market volatility.
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