As global activity stabilises, risk assets have started to recover
Gavyn Davies
Global equities enjoyed a prolonged bull market in 2016-18 during a strong economic upswing © Reuters
Global financial markets have adopted a more positive tone in recent weeks. Equities are hitting new highs, and the yield curve in the government bond markets is beginning to correct a small part of the “inversion problem”, which I discussed last week.
In the course of the decade-long equity bull market since the global financial crisis, there have been several temporary phases of relative weakness that ended with extremely powerful surges in risk assets. These occurred, notably, in 2011-14, following the eurozone crisis, and then in 2016-18, following the China devaluation shock. This latter phase was dramatic, involving a cumulative rise in world equities of 60 per cent from February 2016 to January 2018, according to the FTSE Global All Cap Total Return Index.
There are certainly some similarities between what is happening now and the inflection point in the world economy in 2016. Is it possible that asset markets are embarking on a repeat of the euphoria seen in that period? Market psychology is always unpredictable, but it seems unlikely.
On the optimistic side, there is some tentative evidence that the contractionary forces that have hit the world economy since early 2018 are beginning to abate. The geopolitical policy shocks from Brexit and Donald Trump’s tariffs against China have clearly moved in the right direction, though it remains likely that the damage from the “entrenched uncertainty” caused by these economic policy developments could prove long lasting.
Furthermore, the Federal Reserve has fully reversed the tightening in monetary policy that was intended late last year, without necessarily shifting the stance of policy very far into accommodative territory. Monetary policy in the eurozone and Japan is now, in effect, stymied but overall global financial conditions have benefited from the rise in equities and the narrowing in credit spreads seen this year.
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As a result of somewhat supportive financial conditions, economic activity data are moving broadly sideways, instead of downwards. In the manufacturing sector, which has been at the heart of the slowdown across the world, the JPMorgan global output purchasing managers’ index rose to 50.3 in October, about a point higher than three months earlier.
Furthermore, the global capital expenditure index, calculated by the same source, seems to have bottomed out in 2019 Q3, after a sharp slowdown in the previous year.
Unfortunately, these important signs of recovery in the manufacturing sector have been offset by a weakening in services, with the services output PMI dropping by 1.5 points in October, compared with three months earlier.
The Fulcrum global nowcast, which includes data from both manufacturing and services sectors, has been broadly stable recently, indicating activity growth around 3 per cent. This stability could be consistent with a turning point for global activity (see box).
If a recovery is indeed starting, the next question is on its likely strength. During the 2016-18 upswing, growth in the global economy jumped from 2 per cent to 5 per cent, and remained above the 4 per cent trend rate for several successive quarters. However, some important features of the 2016-18 economic recovery seem unlikely to be repeated this time.
- The US economy is working much closer to full capacity, which implies that future growth is more likely to be constrained by supply shortages than during the previous upswing. Whether or not this leads to an eventual tightening in monetary policy, there seems much less scope for gross domestic product growth to exceed trend for a prolonged period.
- The last recovery benefited from the fiscal stimulus introduced by the Trump administration. According to the IMF, this amounted to 1.6 per cent of GDP over 2017-18, and the focus on corporate tax cuts clearly boosted equity prices and business confidence. This will not be repeated in the next two years. In fact, business and market concerns about the election of Elizabeth Warren as president might well have the opposite effect.
- Macro policy in China is more concerned about deleveraging in the shadow banking sector than it was after 2016. The authorities have so far successfully eased fiscal and credit policy enough to offset the contractionary effects of the US tariffs, but they do not seem interested in pushing the GDP growth rate above the 6 per cent-6.5 per cent target next year. Instead, the authorities seem likely to tolerate a weaker upswing, if this is the necessary consequence of reducing the credit/GDP ratio further.
- The 2016-18 economic rebound benefited from a period of above trend eurozone growth, triggered by a broadening of the European Central Bank’s unconventional monetary stimulus, normalisation of bank credit growth in the eurozone’s indebted economies and an easing of deflationary fears. Lately, these boosts seem to have run entirely out of steam, and the eurozone has been by far the main source of disappointment among the major economies this year. With the ECB’s policy armoury now almost entirely empty, eurozone growth is unlikely to rise strongly next year.
These arguments suggest that any rebound in global growth in 2020 may struggle to replicate the powerful momentum seen in 2016-18.
A final consideration for the market outlook is that the valuation of equities as the economic activity cycle turns upwards is more stretched than it was in 2016. According to Fulcrum’s expected returns model, US equities were priced to produce three-year ahead returns of around 10 per cent per annum in 2016, whereas they are now expected to produce returns of only 4 per cent.
With the global economy apparently avoiding a recession, equity returns next year may be adequate, but not great.
Last two economic and equities cycles compared
Global activity, measured by the Fulcrum daily nowcast series, may be tracing out a flat bottoming-out pattern, similar to that in 2015-16.
Global equities enjoyed a very prolonged bull market in 2017 as the strong economic upswing continued. However, a repeat of this strong economic recovery, and bull market, seems somewhat improbable in 2020-21.
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