The fourth quarter of 2019 marked another quarter of weak global growth, led by manufacturing as trade in automobiles and electronics posted more disappointing results. Policymakers responded by easing monetary policy in almost every major global economy, in moves that were largely anticipated. The US Federal Reserve (Fed) delivered the last of its three rate cuts, the European Central Bank (ECB) restarted its quantitative easing (QE) program, and several emerging market (EM) central banks — including those in Brazil, Russia, and India — reduced interest rates.
What were the macro drivers in Q4 2019?
The economic narrative did not change much from the third to the fourth quarter. The global economy continued to lose momentum, driven by weakness in global manufacturing and trade. While more domestically oriented economic sectors remained resilient, spillover effects began to emerge from elevated trade tensions through the quarter that only began to dissipate toward the end, as did tail risks related to Brexit and US funding markets.
As more global central banks eased monetary policy, global growth appeared to stabilize. Risk assets generally performed well, finishing the year with strong returns.1 The fourth quarter capped 2019 as the year when easier US financial conditions provided a boost to asset prices, even as growth momentum faltered.
Global economic growth peaked in 2017 and slowed for nearly two more years, but began to stabilize in the fall of 2019. While economic activity data do not yet suggest acceleration, global forward-looking surveys point to a gradual pick-up in activity. In developed markets (DM), domestically oriented sectors have been resilient, despite weakness in manufacturing.
In the US, strong labor markets, income growth and high levels of consumer confidence supported Q4 consumption. We expect the US economy to slow to its potential rate of just below 2% in 2020, as a result of waning fiscal stimulus that has supported the economy over the past two years and an increasingly tight labor market that could decrease the pace of job and aggregate income growth. Investment was a drag on growth last year and we do not expect a strong rebound this year. However, reduced trade uncertainty and an anticipated recovery in global trade should stabilize investment. A housing recovery, supportive monetary policy, and consumption growth should also support the expansion. Inflation is still below the Fed’s target, and we expect it to increase gradually. Given the Fed’s emphasis on the symmetry of the inflation target, and the fact that the Fed has a higher tolerance today for inflation to overshoot the target than it did in the past, we expect the Fed to be on hold this year, barring unforeseen shocks.
In the eurozone, we expect growth to stabilize, thanks to receding headwinds from global trade plus modest fiscal and monetary stimulus. The major negative swing factors in Q4 eurozone performance were the external and auto sectors. The synchronized global growth that peaked in late 2017 led to above-trend eurozone growth, given its strong export-oriented sectors. As world trade lost momentum, so did the eurozone economy, especially manufacturing. The important auto sector is also experiencing challenges from new emission standards on top of global trade issues. We expect these headwinds to abate in the coming quarters and support stabilization of eurozone growth. Eurozone inflation has been below target, but stable. We expect inflation to increase slightly in 2020, but remain well below target. We expect the ECB to continue its modest QE program throughout the year, with possible changes communicated toward the end of the year as it concludes its review of monetary policy.
China and Asia EM
As we wrote in our last quarterly update, the Asian economies are showing green shoots of recovery. Purchasing manager indices (PMI) have finally entered expansionary territory and export growth, although not yet positive, has begun to stabilize. There are some signs that the new cell phone cycle and 5G roll-out may support the electronics cycle in 2020, but global manufacturing weakness (dominated by autos and electronics) has not shown signs of abating yet. The Phase I trade deal between the US and China, easier financial conditions on the back of recent monetary easing in the region and Fed signals that it has paused should boost confidence. Several Asian countries, including China, India, Korea and Indonesia, have also announced growth-supportive fiscal policies. Nonetheless, a continued structural slowdown in China and its rebalancing from an investment-led to consumption-led growth model will likely diminish the stimulus to EMs and commodity prices going forward compared to the past. In addition, the Phase I deal will likely not end geopolitical tensions between China and the US and we foresee potential complications as more difficult issues are brought to the table, either in the implementation of the Phase I deal or with a Phase II deal. Against this backdrop, we expect a mild and gradual recovery in Asia in 2020. Besides these more structural headwinds, the coronavirus is rapidly becoming a substantial downside risk for Q1 and potentially Q2 growth in the region. In China, the epicenter of the virus, Q1 growth could take a substantial hit, but we hope better preparedness than in the 2003 SARS epidemic, and authorities’ policy response, will allow for recovery later in spring, once the virus is hopefully contained.
We expect meaningful recovery in Latin America as major economies such as Argentina, Brazil, and Mexico show signs of rebounding. Brazil is a bright spot with strong momentum in domestic demand-led growth and its structural reform agenda, amid low inflation and low interest rates. Mexico is expected to emerge from no growth to displaying signs of growth, supported by the construction and oil sectors. Argentina is likely to be in the headlines because of its debt restructuring process and economic regime change, but its economy may still contract this year after posting declines in three of the past five years. We do not expect contagion to the region from Argentina’s woes, given its generally constructive macro background of low inflation and interest rates along with moderate fiscal and external balances. We are monitoring the potential for social unrest, but it has abated somewhat and has been largely due to idiosyncratic factors. The largest economies — Brazil and Mexico — are unlikely to experience unrest due to the popularity of their presidents. We expect Chile to bear the largest cost in terms of growth from prolonged uncertainty surrounding a new constitution to satisfy social demands. In the absence of generalized structural reforms, especially given politically charged conditions in the region, positive growth outcomes or improved sentiment in the developed economies or China could improve the outlook for the region. Most regional central banks (Mexico being the exception) have lowered policy rates to accommodative territory and are comfortable with the benign inflation outlook, even in the context of weaker exchange rates.
Recent economic data have begun to confirm our expectation that early green shoots of growth will spread across the global economy. Trade has shown signs of stabilizing, led by the electronic cycle and a slowing decline in global auto sales. We expect global growth to be stable to marginally higher over the next two-to-three quarters. The coronavirus could impact this expectation due to China’s contribution to global growth.
Several tail risks that were embedded in the markets in Q4 have receded materially, in our view. The Phase 1 trade deal between the US and China reduces the potential for an escalation of the trade war in an election year and may provide a tail wind to global growth. Greater clarity on Brexit could help stabilize sentiment in Europe and the Fed’s actions to smooth the US repo market should improve the functioning of US dollar funding markets. While the debate over the Fed’s balance sheet expansion and its impact on markets continues among market participants, perception may be more important than reality, and when combined with the reduction of other risks, should be helpful to risk assets, in our view.
In a change from our expectations last quarter, we expect better growth in 2020 than in 2019 as growth rates could trend upwards. This change is driven by our slightly optimistic outlook on China, which has recently been challenged by the coronavirus breakout, and our more optimistic outlook on Latin America, as outlined above. This should leave the major global central banks on hold. The impact of the coronavirus, however, could influence them. For the Fed, we believe the bar to raising rates is higher than lowering them further if growth falters. In EM countries, we believe there is still room for lower policy rates.
While discussion about the use of fiscal policy to combat low growth intensified in Q4, we do not expect major global fiscal stimulus at this juncture. We believe Germany should engage fiscal policy to help its manufacturing-heavy economy become more flexible, but the debate is at the very early stage and we do not expect policy changes in 2020.
The outlook for global growth is clearer and more positive, in our view, with reduced downside risks. We expect non-US growth to improve relative to US growth and, therefore, do not expect US financial conditions to tighten. Our base case is for US financial conditions to remain at very easy levels or ease further. However, the room for error for some asset classes, such as US credit markets, is low, in our view, given high valuations.
Within rates, we continue to favor EM interest rates over DM interest rates. Other than US Treasuries, we do not see value in developed market duration and continue to focus on relative value trades to generate alpha. We remain overweight EM interest rates for both carry and capital gains in select countries such as Mexico, Indonesia, and Russia.
We continue to expand our risk budget allocation to currency risk, where a slow slide in the dollar is likely to continue unless US growth falters, in which case, we could see a more significant sell-off. We are focused on carry in several EM currencies such as the Indian rupee, Indonesian rupiah, Mexican peso, and Russian ruble. We are focused on DM and some EM currencies for capital gains, including the Norwegian krone, the Brazilian real and Japanese yen, as we expect US dollar depreciation.
In our view, the asset class with the largest downside potential, if risks to our outlook materialize, is credit. In our base economic case, credit should continue to deliver carry. However, given current valuations, we favor a marginal reduction in allocation and favor European structured credit.
Coronavirus and its impact
As we finish writing our outlook, we are faced with a black swan event in the outbreak of the virus linked to the Wuhan wet market. The impact of this global scare will likely be to lower growth in the near term. However, its medium-term impact on markets is still unclear as we await an economic policy response. While we do not expect to make immediate changes to our portfolio, we are evaluating certain country level exposures.
- J.P. Morgan GBI-EM Global Diversified lndex (bonds) returned 13.5% in 2019. The MSCI World Index (equities) returned 28.4%.
Blog header image: Markus Spiske / Unsplash
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Carry is defined as the profit investors gain from selling a certain currency with a relatively low interest rate and using the funds to purchase a different currency yielding a higher interest rate.
Investing involves risk and is subject to market volatility.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
The opinions referenced above are as of February 11, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations