The global economy continues to improve, with the near-term risk of recession declining in Germany and China while remaining low in the U.S. and Japan. China remains in the late cycle, where risks from a deteriorating credit situation may become more acute. Overall, global recession risk is the lowest it has been since early 2011. (See Recession Risk Scorecard, below.)
The following is a more detailed look at developments in major economies around the world.
Global: considerable momentum
The global economy entered 2014 with considerable momentum. Worldwide recession risk declined to its lowest level in three years, and the upturn in global trade and manufacturing has reinforced the upswing. The aggregate progress is largely due to improved cyclical dynamics in developed economies such as the U.S. and much of Europe.
Europe: low risk for recession
The economic recovery in many European countries is shifting from the early-cycle dynamics that characterized most of 2013 to a more stable, mid-cycle growth phase. Germany’s economy continues to grow steadily, supported by robust construction activity and rising business and consumer sentiment. Financially, the eurozone periphery has stabilized, with 10-year government bond yields continuing to fall toward 2010 levels (which was prior to the escalation of the European sovereign debt crisis), while Ireland and Portugal are exiting the bailout programs extended to them during the crisis.1 France remains a laggard, exhibiting weak growth dynamics. Broadly, a weak banking sector and high unemployment have been offset by improvements in financial conditions, global demand, and capacity utilization.
U.S.: remains in mid-cycle expansion
The U.S. economy remains in a mid-cycle expansion, with few late-cycle pressures and hints of early-cycle dynamics supporting growth. The classic signs of a late-cycle phase—deteriorating corporate profitability, rising inventories relative to sales, and tightening of credit availability—remain absent. Corporate profit margins have benefited from the falling cost of inputs and gains in cyclical productivity growth; inventories remain lean relative to sales; and despite the Federal Reserve (Fed) paring back quantitative easing, credit availability continues to improve. Indeed, gains in cyclical productivity growth are typically associated with early-cycle expansions. Despite softer December employment data, leading employment sentiment indicators, such as the number of workers willingly leaving their jobs, remain in an upward trend. Along with low inflation, this creates a positive backdrop for real wage growth and consumer spending going forward.
Japan: consequence of consumption tax hike?
Japan remains in a mid-cycle expansion, exhibiting low risk of recession and broad-based cyclical improvement. Nearly all leading indicators improved in December, signaling sustained positive momentum supported by monetary and fiscal stimulus, the first two arrows of Abenomics. The third arrow, structural reform, has been largely elusive but may prove necessary to achieve the wage growth required to fuel sustained consumption. A recent uptick in consumption data is likely at least partially due to consumers pulling forward purchases in anticipation of a forthcoming increase of the consumption value-added tax from 5% to 8%; significantly reduced household activity may follow the April tax hike.
China: stable but credit imbalance poses risk
China continues to exhibit late-cycle dynamics amid muted recessionary risk. Policymakers have provided enough central bank liquidity to maintain near-term stability, but they have also shown signs of attempting to tamp down the rapid increase in shadow financing for construction and infrastructure projects. Reduced liquidity has contributed to higher borrowing rates, which could threaten rapid credit expansion, and along with high inventory levels and deteriorating corporate profitability, likely sows the seeds for slower growth.
Emerging-market economies: facing headwinds
Most other emerging-market (EM) economies also remain in late-cycle expansion, and most face headwinds that fall into at least one of these categories:
- Slowing liquidity growth from the Fed’s taper pushes up the cost of capital, which may make the environment more challenging for countries that have relied on rapid credit growth in recent years, such as China, Thailand, Turkey, and Brazil.
- With slowing liquidity growth making foreign capital flows more precarious, countries with large foreign borrowing needs (i.e., with substantial current account deficits) have seen their bond yields rise and currency values drop; those countries include Brazil, India, Indonesia, Turkey, and South Africa (BIITS). Weaker currencies put upward pressure on inflation, and as central banks raise interest rates to stabilize these trends, higher rates provide an additional headwind to growth and solidify a generally stagflationary dynamic.
- Incremental new demand for commodities has ebbed as EM economic expansion—particularly in China—has slowed, putting downward pressure on prices and diminishing revenues for EM economies that rely heavily on commodity exports, such as Venezuela, Russia, and Chile.
- Rising political turmoil has muddled the economic outlooks of countries such as Thailand, Ukraine, and Argentina. All of the BIITS face some degree of political uncertainty in 2014 due to significant presidential and parliamentary elections.
Despite these headwinds, select EM economies have more favorable and stable cyclical outlooks. Countries that have healthier domestic macroeconomic environments, such as South Korea and the Philippines, or that are more closely tied to developed economies, such as Poland (Europe) and Mexico (U.S.), will likely be better insulated against the global headwinds listed above (see chart, above right).
Emerging-market assets: Less uniformity in the investment landscape
Emerging-market (EM) assets faced significant headwinds in 2013, with equities and bonds falling 2% and 7%, respectively, and significantly trailing their developed-market (DM) counterparts.2 Much of the volatility and underperformance occurred mid-year, as investors began to anticipate higher interest rates in the U.S. and slowing global liquidity growth. A shift in investor appetites toward generally improving DM economies has continued amid an increasingly challenged cyclical outlook for EMs, as DM equities have now outperformed those of EMs over the past several years.
Summary and outlook: higher volatility; consider global stocks, investment-grade bonds
The global business cycle began 2014 in solid shape; nevertheless, differentiation among countries is likely to widen as the year progresses. Developed markets generally display superior cyclical dynamics, and the U.S. economy’s mid-cycle expansion appears durable. In contrast, Europe’s maturing expansion will likely remain subdued, Japan’s midcycle dynamic may face serious challenges in the spring, and Canada and Australia confront some late-cycle pressures despite overarching stability. With cyclical improvements being led by mature developed economies (which tend to have slower growth trends than emerging markets), global expansion has been gradual and steady, buoyed by mild inflation and accommodative monetary policies.
EM economies show a widening dispersion of cyclical dynamics. Many face at least one of a variety of late-cycle pressures, including rising borrowing costs, persistent inflationary pressures, and slowing corporate profit and productivity growth. Rising political risk and a heavy election calendar in some countries has exacerbated these trends, and the monetary policy outlook is mixed. Improving demand from advanced economies has boosted some external sectors, but the Fed’s tapering, and weak commodity prices, have had negative countervailing effects on nations with current account deficits and resource-focused export regimes.
As discussed in the previous Update (“Solid Economic Trends into 2014, but Market Volatility Ahead,” Dec. 2013/Jan. 2014), the paring back of the Fed’s easy-money policies, and risks in China and Japan, could provide catalysts for higher market volatility as the year progresses. From an asset-allocation standpoint, global equities appear relatively attractive, with a more favorable outlook for developed countries on a cyclical basis. The underperformance and increasing dispersion among EM assets may provide opportunities for active selection within that category. The muted pace of economic growth and subdued inflation support a steady outlook for U.S. fixed-income assets, where investment-grade bonds may provide diversification in the event of a risk-off correction.
Stocks: low valuations
The recent trend reverses a tremendous run by EM equities over the previous decade. Between 2001 and 2006, the MSCI Emerging Market Index increased by 18% annually, experiencing a broad-based rally in which the worst performing country registered an enviable 7.6% annualized return.3 Recently, however, cyclical headwinds have contributed to multi-year valuation lows for EM equities generally, as well as greater differentiation among countries’ equity returns and valuations. The disparity is also apparent across EM equity sectors, with financial and energy stocks in the cheapest historical quartile of price-to-earnings valuations, while industrials and consumer staples are in the most expensive quartile.4 Performance correlations among EM stocks have declined significantly over the past several years (see Exhibit A, right), supporting an environment that may reward increased selectivity and provide opportunities for active investors.
Debt: better yield than U.S.
EM debt valuations have also become more attractive. EM debt is a hybrid fixed-income category, with roughly three-quarters of the U.S. dollar-denominated EM debt index comprised of high-quality investment-grade (IG) bonds, and the remainder represented by lower-quality high-yield (HY) debt. EM debt was adversely impacted in 2013 both by the rise in interest rates and by widening credit spreads. Overall, EM debt now offers a better yield than U.S. HY corporate debt, and is also at its cheapest valuation in a decade, relative to an equivalent IG/HY mix of U.S. corporate debt.5
The extra yield EM debt enjoys relative to U.S. HY corporate debt is almost evenly divided between interest-rate (duration) and credit-spread differentials. Due to its investment-grade component, much of the EM debt category is relatively interest-rate sensitive and trades similarly to high-quality U.S. corporate bonds. Because EM debt in aggregate is longer in duration than U.S. HY corporate debt, its index has almost twice the interest-rate risk. Currently, the spreads of most IG countries’ issues within the EM debt index are relatively close to those of U.S. IG corporates, and therefore offer limited additional yield over investing in U.S. IG corporates instead.
In contrast, lower quality HY debt issuers—particularly Venezuela, Ukraine, and Argentina—account for the bulk of the EM debt index’s credit spread relative to U.S. corporate bonds (see Exhibit B, below). As a result, EM debt valuations in aggregate may appear attractive relative to U.S. corporate debt, but the divergence in yields across countries may require significant selectivity, as well as attentiveness to balancing portfolio risk exposure between interest-rate and credit risk.
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