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Global Growth Is Out of Sync: Now What?

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In six weeks, the S&P 500 returned all investors’ gains in 2018. These market losses have prompted investors to reminisce on the previous 18 months of “goldilocks” conditions for financial markets. During this time, accommodative monetary policy and broad-based global economic growth supported asset prices at low levels of volatility.

Now, third-quarter economic data suggests that global growth is de-synchronizing. For instance, in the U.S. real GDP estimates for the third quarter posted at 0.9% quarter-on-quarter (3.6% annualized), supported by robust consumer spending. At the same time, GDP growth in Germany and Japan declined on a quarter-on-quarter basis.

There are plenty of caveats softening these figures. For example, both countries were impacted by one-off hits to growth that could rebound in future quarters. In addition, year-on-year figures still point to meaningful growth in both countries. Still, growth rates are certainly beginning to slow. This slowdown was notable even before recent data, particularly in Europe where business and manufacturing confidence have softened throughout the year.

GDP growth remains positive…

Real GDP growth, percent year-on-year change


Source: Federal Reserve Bank of St. Louis; German Federal Statistics Office; JP. Cabinet Office

… but economic momentum is slowing in some major economies.

Real GDP growth percent quarter-on-quarter change

Source: Federal Reserve Bank of St. Louis; German Federal Statistics Office; JP. Cabinet Office

Investors’ ability to take advantage of the economic “benefit of the doubt” is fading. Elevated geopolitical uncertainty makes investors less confident in the pace and composition of global economic growth. Where a rising tide once raised all ships, differing levels of economic growth and monetary policy activity will impact the way investors see investment opportunities globally.

Implications for asset allocation

We think recent bearishness on economic growth and company earnings is misplaced. The economic backdrop for investing is still constructive, with positive GDP growth rates expected across all major economies in 2019.

That said, a soft landing for the global economic recovery does not necessarily mean a soft landing for financial markets. Differences in country-level growth rates can prompt sizable capital flows. To illustrate this dynamic, the strength of the U.S. recovery is contributing to interest rates rising faster there. Because of those higher rates, investors can now expect reasonable returns from short-term fixed-income instruments in the U.S. without having to take major credit or duration risk. This in turn prompts investors to reset their return expectations for riskier assets.

We aren’t concerned about recession at this time, but less robust economic readings do have implications for asset allocation.

Related: Laying Low in a Storm of Equity Volatility and Rising Rates

As we finalize our 2019 plans, we are considering:

  • Lower demand means lower prices for productive assets. A downshift in demand – real or perceived – can create vulnerabilities in financial markets. Recent slower growth in major markets explains a piece of declining energy and industrial metals prices. Lower commodity prices can then translate into weakening inflation and inflation expectations.
  • Interest rate differentials prompt volatility in international markets. Fiscal stimulus and a diversified economy have contributed to U.S. economic outperformance in the past 18 months. Stronger growth has supported the Fed’s interest rate hikes, which in turn promote dollar strength relative to other currencies.The effects of rising U.S. interest rates impact financial markets globally. Within the U.S., monetary conditions are tightening modestly. Interest rate-sensitive sectors such as housing, automobiles, and capital-intensive industries are showing signs of impact (but not yet weakness). Outside of the U.S., local currency depreciation can prompt higher inflation and require interest rate increases, particularly in emerging markets.The question for asset allocation then becomes—where will things go from here? For us, this is a source of careful debate. So far, the U.S. has been the least impacted by geopolitical risks, such as: the trade war, Brexit, and Italian populism. Only an easing in trade (emerging markets) and populist tensions (European markets) are likely to result in a reversal of this dynamic. We think that this is likely, and as long-term investors, we are considering opportunities in international markets. In the meantime, relatively strong U.S. performance is likely to carry the short term.
  • It’s complicated. Bringing each of these items together, lower economic growth can contribute to general market jitters. As earnings and economic growth peak and begin to weaken in some major markets, headlines become more likely to prompt market volatility.

However, we think that strong economic fundamentals and earnings will ultimately prompt equity markets – in the U.S. and abroad – to overcome volatility over the 18-month term. In the short term, geopolitical risk could play a meaningful role in short-term price decreases. In times of turmoil, careful active management stands to do well.

 

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