The global economy is not out of the woods yet. The latest round of PMI data imply a continued contraction in euro area growth rates. This supports the view that a return to above-trend growth is unlikely. Instead, we are in for a period of sub-trend growth and when the Fed runs out of ammo, a recession could be on the horizon.
Market Pricing Lacklustre Growth With No Recession
The last year has seen advanced economies’ move toward the slowdown phase of the business cycle. Unsurprisingly, cross asset returns have taken note of the shifting gears in global growth. In the US we have seen a modest underperformance of equities vs govies, consistent with a labour market no longer tightening (Chart 1). Despite all this, market measures of risk premium remain extraordinarily low. HY spreads and implied vols in equities and FX remain sub-10% of their historic ranges – rates vol being the exception (Chart 2)…
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The global economy is not out of the woods yet. The latest round of PMI data imply a continued contraction in euro area growth rates. This supports the view that a return to above-trend growth is unlikely. Instead, we are in for a period of sub-trend growth and when the Fed runs out of ammo, a recession could be on the horizon.
Market Pricing Lacklustre Growth With No Recession
The last year has seen advanced economies’ move toward the slowdown phase of the business cycle. Unsurprisingly, cross asset returns have taken note of the shifting gears in global growth. In the US we have seen a modest underperformance of equities vs govies, consistent with a labour market no longer tightening (Chart 1). Despite all this, market measures of risk premium remain extraordinarily low. HY spreads and implied vols in equities and FX remain sub-10% of their historic ranges – rates vol being the exception (Chart 2).
Together these observations suggest the market is pricing a regime of modest around-trend growth but low recession risk. This may not seem at odds with the economic data, which have not yet shown full-blown contagion of the manufacturing slowdown into the services sector. Meanwhile central bankers – keen to avoid being trapped in a recession – have eased pre-emptively.
Chart 1: Market Pricing Around-Trend Growth
Source: Macro Hive
Chart 2: Market Not Pricing Recession
Source: Macro Hive
Plausible Growth Scenarios:
From here, things can plausibly go one of three ways.
1. Growth heads above-trend
2. Growth meanders around trend
3. Growth heads sub-trend
Scenario 1: Above Trend – 30%
We start by asking ourselves: What would we need to see to price in a sustained recovery in market growth expectations?
A first and easily dismissed candidate would be a “trade war resolution”. It has become increasingly apparent that there is no quick solution to the US/China trade conflict. As long as Trump remains POTUS the market (and economic agents) cannot remove the risk of trade war escalation. The most obvious impediment to Trump’s re-election would be a US recession, which would put us in Scenario (iii). Thus, it is difficult to see how a trade deal could meaningfully reflate market growth expectations.
What about aggressive monetary stimulus? The only game in town here is the Fed, whose aggressive pivot dwarfs action from other central banks. The hope would be that this re-ignites a consumer recovery with positive spillovers to the global economy. Market watchers will be encouraged by the rebound in US housing data and retail sales. However, the consumer has been noticeably conservative this expansion following the pain of the GFC. It seems a tough ask for Fed cuts to deliver a meaningful balance sheet expansion of the US household given uncertainties that remain in place. As a result, spillovers abroad from Fed cuts are likely to be limited, particularly in the euro area where the cost of capital is already extremely low. Continued US economic outperformance would most likely manifest in a stronger dollar, aggravating trade tensions that reduce the aggregate growth pie.
Fiscal stimulus in the euro area (particularly Germany) would be a game changer for the challenged monetary union. This would have self-reinforcing positive spillovers: higher inflation rates in Germany would reduce the painful competitiveness adjustment peripheral economies are still undergoing. Discussion is moving in the right direction, but there is no sign yet of anything imminent.
Overall, we are unable to put a high probability on a higher growth outcome –around 30%.
Scenario 2: Around Trend – 20%
Scenario (ii) is a low-volatility regime with lackluster positive returns in risk assets and conducive to a build up of carry trades. As outlined in our opening, this seems to be roughly the regime the market is pricing now. We can plausibly stay in this regime a little longer, but the presence of both positive and negative feedback loops in Scenarios (i) & (iii) makes it difficult to stay here indefinitely. We assign this a low probability around 20%.
Scenario 3: Sub-trend Growth – 50%
The US economy does not seem on the verge of endogenously destroying this expansion. Corporate profit margins remain healthy and the consumer has seen a substantial reduction in the cost of borrowing. This already appears to be supporting the household/ retail sector. However the same cannot be said for the euro area and China, the other two key economic blocs. The trade war has played its role here, but self-reinforcing cyclical and structural forces are also at play.
The euro area is experiencing a much more typical “late cycle” malaise than the US – rising unit labour costs are eroding corporate profit margins (Fig. 3). This raises the risk of firms reducing headcount. The temporary resolution of Italy’s political crisis is certainly a positive development, but the underlying imbalances within the EMU will surface as the economy weakens. Already low inflation and a lack of monetary ammunition increase the risk of deflation.
Chart 3: Euro Area – Rising Unit Labour Costs Compress Corporate Profit Margins
Source: Macro Hive
China’s structural adjustment to a slower growth regime continues. Key uncertainties remain around how this slowdown will impact the more leveraged sectors of the economy. So far policy makers have been cautious on pulling the traditional credit levers – particularly in the property sector.
If policy makers are unable (or unwilling) to muster an effective stimulus package, the risk is that growth continues to slow. The US economy would be unable to escape the global trend indefinitely. Because we still do not see a strong evidence of pre-emptive stimulus in Europe/China, we think the probability of growth heading sub-trend is higher than above-trend (at around 50%).
Bottom Line
We think it is more likely market growth expectations return sub-trend than bounce above trend. This is a different regime from what is currently priced and would suggest being cautious on extrapolating the recent rates sell-off – central banks could be forced to ease substantially further. Risk assets will underperform if rates don’t rally as much as risk premium rises – i.e. the “Fed put” proves insufficient. As the Fed depletes its ammunition this becomes an increasing risk.
Sam is a macro strategist focussed on bridging the gap between the macro and the market. He previously worked in Nomura’s asset allocation team, having held roles in FX strategy. He can be contacted here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs)