The near-term risk of recession has subsided in most of the world’s major developed economies. Germany has entered an early-cycle recovery, as indicators across Europe have started to support a positive outlook. Japan’s early-cycle recovery has begun to broaden. The U.S. remains in a mid-cycle expansion with low recession risk.
Meanwhile, China’s credit tightening and slower GDP outlook have raised its chances of a growth recession,* and emerging economies in general face greater cyclical downside risks (see Recession Risk Scorecard, below).
Recent trends in the world’s largest economies
Much of Europe remains in contraction, but some areas show signs of early-cycle recovery. Manufacturing, though still anemic in most European economies, has improved dramatically since the beginning of the year. New manufacturing orders continue to outpace inventory growth, supporting a positive outlook.1 Financial markets in Europe were rattled by the second quarter’s spike in volatility, but capital markets have settled in recent weeks, and borrowing rates for sovereigns and corporations remain low relative to the past few years. However, banks continue to tighten credit standards amid modest demand from households and businesses, leading to a mixed credit environment.2
Many other leading indicators across Europe are generally positive or improving from a low base. Germany’s economy remains in early-cycle expansion, and expectations are positive as consumer and business confidence have continued to recover.3 Sentiment indicators for Italy and Spain are still at depressed levels, but have shown some improvement.4 Economies in the eurozone periphery continue to grapple with high unemployment and the need to implement structural reforms, although regional financial stability has benefited from the massive improvement in current account balances that has reduced the need for external financing (see the chart above, right). Although weak European economic conditions linger, the worst of the recession appears to have passed, and some economies may be moving into the early cycle.
The Japanese economy remains in a strengthening early-cycle recovery. The lift in economic activity has broadened in scope, with 89% of leading indicators improving over the past month.5 Ongoing support from fiscal and monetary stimulus has provided a widespread boost to the economy. Both consumer and business expectations are still near their cyclical highs.6 Efficiency gains in recent years have lowered the yen breakeven rate, setting the stage for the recent yen depreciation to boost Japanese corporate profits through currency translation benefits and market share gains.7
Financial conditions remain positive, as banks have eased lending standards for consumers and businesses in the midst of healthy demand for credit.8 Financial markets have stabilized over the past month, but volatility continues to exceed the low levels of the past two years. Uncertainty still surrounds the potential implementation of structural reforms.9 Yet the Upper House election victory of Prime Minister Abe’s party could remove any barriers to his “third arrow” of pro-growth strategies to promote private investment.10 Japan’s economic recovery has become more broad-based, although medium-term sustainability will depend on future policy measures.
The U.S. economy remains firmly in the mid-cycle expansion phase of the business cycle. The housing sector has provided a strong tailwind to the economy amid tight supply and demand dynamics. Despite recent price gains and rising rates, affordability remains high, with home prices and mortgage rates still modest relative to historical averages.11
The U.S. labor market continues its slow improvement. Business payrolls expanded at a moderate pace in June, and the unemployment rate held near cyclical lows at 7.6%.12 The healing labor market, rising asset values, and better access to credit have helped keep U.S. consumers resilient and sentiment near cyclical highs.13 Retail sales were softer than expected in June as the restraining effects of the fiscal consolidation persisted, but the overall positive trend in spending continued.14 And while sluggish overseas demand and government sequestration cuts have weighed on the manufacturing sector, the recovery in core capital expenditures may point to businesses’ growing willingness to invest.15
As financial markets experienced higher volatility and interest rates, the Bloomberg Financial Conditions Index weakened in June but has since rebounded to approach cyclical highs. Credit spreads have tightened over the past month after stretching wider last quarter on increasing volatility.16 While consumer prices rose more than expected on higher energy prices, core consumer prices held stable.17 Overall, inflation rates have stayed low, and inflationary pressures remain relatively benign. The U.S. economy continues to expand at a moderate pace as improvements in employment, housing, and consumer sentiment offset the effects of fiscal consolidation and rising interest rates.
China remains in a late-cycle phase, with several signals that the government is willing to tolerate a slower pace of growth. Interbank lending rates have fallen following an upward spike in June, and the move by authorities to restrict liquidity represents a tightening of credit provided by non-bank entities. The latest GDP data release puts China’s economy on a trajectory to fall below official growth estimates for 2013, and consumption growth has slowed amid anti-corruption measures. Solid activity in real estate and infrastructure development has offset some of the weaknesses in other parts of the economy. However, excess capacity (particularly in the overheated property market), weak corporate profitability, and waning credit growth are raising the near-term risks for the outlook. China’s late-cycle expansion continues, but most risks are to the downside.
In general, the global economy continues to follow a slight upward trend. Leading indicators in two-thirds of the world’s largest economies have shown gains over the past six months. Global purchasing managers’ indices (PMI) for the 30 largest economies indicate that a slim majority of countries experienced manufacturing expansions in June, though two-thirds had better readings than in the previous month.18 Pronounced divergences across countries and regions may better define the global cyclical backdrop than the overall trend. Developed countries are improving for the most part, but the outlook for many emerging markets has deteriorated.
Emerging economies are beset by several cyclical challenges. First, financial conditions have deteriorated in many emerging markets as the recent widespread rise in interest rates has limited their appeal to international investors, putting downward pressure on currencies and upward pressure on borrowing rates. Second, decelerating growth in China has weighed on the prospects of its direct trading partners in Southeast Asia and, more broadly, on many emerging-market commodity exporters. Third, inflation in some countries has persisted despite economic slowdowns, adding stagflationary pressures as wages grow and weaker currencies lead to higher import prices. Last, political issues, including protests in Turkey and Brazil, have exacerbated many of the current economic challenges.
As a result, many emerging economies are exhibiting late-cycle dynamics. Countries that had been attracting foreign stock and bond investments to finance their current account deficits— including Brazil, South Africa, Turkey, and India—have lately recorded widening deficits and increased financing needs, just when foreign capital flows have become more precarious. Monetary authorities in many countries—such as Brazil and Indonesia—have stopped easing and even started hiking interest rates to strengthen currencies and keep inflation from rising too quickly. Brazil may be heading into recession, as business and consumer confidence have sagged, job creation has stalled, and monetary tightening has begun to constrain credit growth. The global economy is slowly gaining traction but shows tremendous cyclical dispersion, particularly when comparing developed economies to emerging ones.
Summary and outlook
On a cyclical basis, developed countries are generally in a more favorable position, with the U.S. economy firmly in a mid-cycle expansion, Japan’s early-cycle momentum broadening, and Europe showing signs of moving toward an early-cycle recovery. The outlook for emerging markets has dimmed as growth in China slows, and countries such as Brazil face stagflationary conditions and rising recession risks. After a significant bout of volatility during June related to the shift in the global interest-rate backdrop, financial markets have stabilized in recent weeks. While we expect uncertainty around monetary policies to continue to inject volatility into markets during the months ahead, widening global economic divergences may play a key role in the performance of different asset categories.
The increased dispersion in the direction and rate of change across different economies has two overarching investment implications. First, a broad underlying trend of incremental cyclical improvement in advanced economies has created a context for economically sensitive assets to generate more favorable returns in developed than in developing markets. For the first time since the early 2000s, developed-market equities have outperformed emerging market equities on a sustained basis (see the chart, right).
Second, these regional divergences have created a global environment of generally lower correlations across equity market returns. The 36-month correlations between U.S. and non-U.S. stocks in both developing and developed countries have fallen to their lowest levels since 2008, when the global financial crisis caused correlations to spike (see the chart above, right). After that, relatively synchronized monetary policy shifts kept equity return correlations elevated, but a backdrop of decreasing correlations may provide more investment opportunities across diverging regions and countries.
From an asset allocation perspective, increased diversity and reduced correlation may favor greater selectivity. U.S. equities have been supported by the improving economy, low inflation, and accommodative monetary policy, while the outlook for fixed income has become more challenging due to expensive valuations and upward pressure on interest rates. European equities look attractive, as their low valuations may be too pessimistic given the potential for a near-term shift into the early-cycle phase. Emerging- market equities also enjoy relatively low valuations, but the late-cycle characteristics of many developing economies will likely create headwinds to sustainable rallies in their currencies, bonds, and stocks in the near future.
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