The global economy continues to register modest improvement, with low risks of recession in the U.S., Germany, and most other developed economies. However, Japan’s outlook has deteriorated and recession risks are rising. (See Recession Risk Scorecard, below.) The markets remain in a holding pattern amid this mixed global backdrop.
Emerging markets in general continue to experience late-cycle pressures, and the near-term risk of a growth recession in China has risen in 2014.
The following is a more detailed look at developments in major economies around the world.
United States: weather-induced deceleration ending
The U.S. economy remains firmly embedded in a mid-cycle expansion with a low risk of recession. The harsh winter has finally come to an end, with evidence that the softening data experienced in early 2014 was largely weather-related. After a string of disappointing reports through early April, the Citigroup Economic Surprise Index has recently shown that fewer economic indicators have missed expectations (see chart, right). New core durable goods orders bounced back and indicated an improving outlook for capital expenditures,1 consumer confidence surveys have continued to improve, and manufacturing activity has remained solid. Corporate profit results have surpassed subdued expectations, so far, with about 50% of companies having reported first-quarter earnings.2 In the credit markets, conditions remain solid despite the ongoing tapering activity by the Federal Reserve (Fed). Corporate bond spreads are at their tightest levels of this cycle, and banks have provided consumers and corporations greater access to credit. Housing was the main exception to the broad trend of improvement, as sales and construction activity continued to weaken amid lower home affordability.3
The labor market continued to show steady signs of progress. The headline unemployment rate has failed to decline so far in 2014, primarily due to re-entrants to the labor force pushing the participation rate higher. This growth has partially offset the multiyear decline that had been taking place largely because of aging demographics.4 Leading indicators of employment remain in an improving trend, including the four-week average of initial unemployment claims, which fell back to near its post-recession low.5 Tighter employment conditions should help increase wage growth over time, which, coupled with low inflationary pressures, provides a solid outlook for real incomes and consumer spending. The U.S. economic expansion appears to be exiting the weather-induced deceleration with its steady outlook intact.
Europe: despite risks, economy continues to improve
Most European countries continue to display either early or mid-cycle dynamics, with low risk of recession. Purchasing manager indices (PMIs) are in expansionary territory across the core economies, indicating a broad-based improvement in manufacturing. France, which had previously lagged, registered an expansionary PMI for the past two months. Persistent growth in Germany’s construction and consumption sectors has bolstered Europe’s largest economy. The U.K. continued to experience a broad-based rebound, with solid activity in housing, retail sales, and industrial production.
Peripheral economies are generally in an early-cycle phase, with unemployment no longer rising and solid pent-up demand following years of recession. Improved competitiveness and stable global demand growth have boosted exports, with current account balances shifting dramatically into surplus for most countries.
Improving financial and credit conditions are reinforcing the better outlook in Europe’s periphery. In most countries, bond yields have fallen to post-crisis lows. Portugal regained access to sovereign bond markets in March, and Spanish government bond yields have recently declined to all-time lows—falling to levels below even that of U.S. government bonds (see chart, above). Though bank credit remains tight, lending standards have become less restrictive than a year ago, and have loosened for small and medium enterprises for the first time since 2007.6
Risks to the expansion remain, including the potential for further spillover from Russian actions in Ukraine, which has not yet affected real activity but has negatively impacted business sentiment in some areas. Bank stress tests may have a dampening effect on lending in the near-term, as banks move to shore up their balance sheets. The European Central Bank expressed concern that deflationary pressures remain, as consumer price inflation was an anemic 0.7% year over year,7 and a stubbornly strong euro has been providing little support for exports. Despite risks, the European economy remains in a solid trend of improvement.
Japan: moderate, but rising, recession risk
Japan’s economy remains in a mid-cycle expansion, though late-cycle pressures have emerged and recession risks are rising (see Viewpoints article " Japan's economy faces challenges,” Mar. 2014). Many activity indicators have decelerated over the past two months, and leading indicators took a sharp turn lower, suggesting a slower pace of growth ahead.8 However, favorable credit conditions have provided a tailwind as lending standards continue to ease, helping to fuel growth in household and corporate loans.9
The heavily anticipated consumption-tax increase from 5% to 8% was implemented at the beginning of April, and while it is too early to gauge its full impact, leading indicators suggest a marked reduction in future consumption. In anticipation of the higher tax, consumer expectations fell sharply, and a growing number of businesses expect conditions to weaken.10 Because consumers increased their borrowing for high-priced items during the months leading up to the tax hike, consumer credit growth is likely to subside, as reflected by the growing number of households that are expecting to borrow less over the next three months.11 Recession risk in Japan is moderate but rising, with the effects of the increased consumption tax creating a major challenge to cyclical sustainability.
China: rising recession risks
China remains in a late-cycle expansion. Recent trends have been difficult to interpret because of delays in some economic data releases, but the odds of a growth recession appear to have risen in recent months. Official data releases assert that growth remains roughly in line with policymakers’ stated target of 7.5%. However, other indicators have suggested a greater softening of activity, including the HSBC China Manufacturing PMI, which reported that China’s manufacturing activity has been below the expansion level for four straight months.
Policymakers have implemented some tightening measures aimed at reining in excess credit creation and lowering the risk of financial instability (see Viewpoints article “China’s Economic Outlook: Rising Imbalances,” Jan. 2014). Interest rates remain elevated relative to recent years, and monetary authorities have been selective about injecting liquidity into interbank markets only during times of rising distress. The government has recently allowed the country’s first corporate bond default, in an effort to discourage the flow of non-bank financing to higher-risk projects. Furthermore, policymakers engineered a devaluation of China’s currency in order to slow the rapid inflow of speculative foreign capital via short-term carry trades. As a result, the renminbi has steadily depreciated over the past few months (following almost a decade of appreciation), which may improve the competitiveness of China’s export sector. However, policy action has yet to confront China’s massive credit imbalances decisively, and there have even been some modest easing measures in recent weeks. China’s near-term outlook is heavily dependent on policy decisions, but recession risks have risen and policymakers continue to struggle with the difficult task of preventing financial instability while maintaining a fast pace of growth.
Global: steady growth in developed countries continues
The global economy has retained its modest positive momentum, led by the cyclical upturn in developed-market (DM) economies. Leading economic indicators have risen in almost all DM economies over the past six months, versus in just half of emerging-market (EM) economies.12 Late-cycle pressures in many EM countries—including deteriorating corporate profitability and credit conditions—stand in contrast to the generally improving outlook and mid-cycle dynamics in most DM economies.
The global inflation backdrop is divided largely along the same lines. Persistently high unemployment in many DMs has led to weak wage growth and low inflation, particularly in the U.S. and Europe. In contrast, many EM countries (excluding China) have experienced ongoing inflationary pressures amid weaker currencies, tight labor markets, and rising food prices. As a result, despite softer economic growth, inflation in many emerging economies continues to run above the upper bounds targeted by their central banks, whereas the rates of inflation in most developed economies are below target levels (see chart, right). The higher inflationary pressures in EM countries are consistent with a late-cycle dynamic, and remain a headwind for corporate profit margins.
Global monetary policy has become more mixed in recent months. Some EM economies, including Brazil and Russia, have continued to hike interest rates amid weaker currencies and persistent inflationary pressures. Others have forgone additional measures after tightening in recent months, such as Turkey, Indonesia, and India, while other EMs—including Hungary and Thailand—have cut interest rates to combat slowing growth. Among developed economies, the U.S. Fed is poised to continue paring back its quantitative easing program, but central banks in the eurozone and Japan are maintaining an easing stance, and may be inclined toward additional measures in the coming months. In general, monetary policy remains highly accommodative for developed markets, while EMs as a group are experiencing rising policy rates for the first time since late 2011 (see chart, below right). Although many EMs have seen improvement in their current account balances, and have become more competitive as a result of currency depreciation in 2013, the tighter monetary conditions are another late-cycle headwind for the EM growth outlook. Steady growth in developed countries continues to buttress the global economic expansion, while worldwide, country outlooks are becoming increasingly diverse.
Outlook: favorable for U.S and European stocks
The global economy remains on reasonably firm footing. Benign cyclical trends in most DM economies, particularly in the U.S. and Europe, continue to underpin modest global growth. Emerging markets as a group are experiencing late-cycle pressures, including higher inflation, and credit and monetary tightening. The outlooks for individual economies have become more diverse, with less uniformity of monetary policy and more divergence across countries and regions.
A number of risks to the global outlook linger. We continue to be concerned that the hike in Japan’s consumption tax could trigger a demand shock across Asia. Meanwhile, the increased potential for a growth recession in China raises the risks of greater turbulence as policymakers there grapple with maintaining financial stability. In addition to these country-specific risks, the Fed’s further tapering of quantitative easing will likely continue to slow global liquidity growth, providing less of a tailwind for asset prices and for countries that have benefited in recent years from rapid credit creation. Finally, geopolitical risk remains elevated due to continued tensions between Russia and Ukraine, where a more direct confrontation could have much greater economic repercussions within Europe and beyond.
Global financial markets have experienced some volatility so far in 2014, but in general the improving business cycle backdrop has largely offset the rising risks listed above. From an asset-allocation standpoint, we remain most favorably disposed toward equity markets in the U.S. and Europe due to their firm cyclical environment. Although EM equity prices and some commodities have stabilized in recent weeks and valuations remain low relative to historical levels, the near-term cyclical backdrop for EMs remains challenging. Because mounting risks could catalyze greater equity-market volatility to some extent, high-quality bonds may provide downside protection through their low correlations with equity-market returns.
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