Late last year we noted how rare it was for both bonds and equities to fall together. The reverse has been true in 2019: both asset classes have rallied strongly over the past nine months. It’s a clear indication that capital on a large scale is seeking a home – but not necessarily a sign of investor optimism.
The rally in bonds, which took on a furious pace in the summer, reflects the expectation of low interest rates and low growth far into the future. Global stocks, which are trading close to all-time highs, would appear to suggest a more constructive outlook.
But look beneath the surface and there are signs of concern. Select groups of stocks are in favour, while others – often those most sensitive to the economic cycle – are shunned. This again is not a sign associated with a positive outlook. Are investors right to be anxious?
Consumers keeping the global expansion going – for now
There are now real signs of slowing global activity. This does not come as a surprise, given the headwind of a trade war between the US and China.
For now, the slowdown is focused in manufacturing sectors, which are more dependent on international trade and more sensitive to changes in global demand. Global survey data indicates that manufacturing sectors are contracting.
This doesn’t necessarily mean that a recession is imminent. In the US, which still sets the pace of global activity, consumer spending accounts for a much bigger share of output than heavy industry. And for now, consumption is holding up – thanks to the supportive backdrop of a strong labour market, low borrowing costs and relatively low oil prices.
Over the past decade, consumers have helped get the US economy through two comparable slowdowns in manufacturing without a fall in overall output. However, the risk is that this time industrial weakness will spill over into the broader economy.
Trump’s trade policy may make this more likely: the latest round of tariffs on China includes goods such as toys and electronics, which means consumers will soon bear some of the cost of the trade war. Markets are starting to price in the risk that we won’t get lucky a third time.
Whether or not the US experiences outright contraction, there is little doubt that the weakness in manufacturing will weigh on global output. Schroders has made some significant cuts to its forecast for global GDP in 2020.
We now expect growth of 2.4%, down from 2.6%. If this forecast is realised, such a level of global growth would be the lowest since 2008 – the year of the financial crisis.
Business confidence is waning, especially in manufacturing...
Global Purchasing Managers Index
Source: Thomson Reuters, Cazenove Capital.
...but services dominate the US economy
GDP breakdown by sector
Source: Thomson Reuters, Cazenove Capital. Tools may not equal 100% due to rounding.
Looking ahead: what will an altered world order mean for growth?
Our central view is that tension between the US and China is here to stay, as the world’s two greatest economies increasingly view each other as rivals. Hostility will inevitably come with an economic cost: growth in trade will slow and investment suffer as businesses contend with a higher level of uncertainty.
The US-China relationship will likely experience ups and downs, which could give periods of relief to markets. Last month, for instance, there was speculation that China might soften its hard line on US agricultural imports.
Now though it seems very unlikely that tariffs will be dismantled altogether and we do not expect the relationship between the US and China to resume its former basis. The upcoming US election is an added complication.
On the one hand, President Trump may try to calm the situation to stimulate the US economy. Alternatively, he could escalate it in a bid to revitalise the ‘America First‘ platform which served him so well in 2016. If the economic cost can be delayed until after the vote, this could be tempting.
There are a range of other political flashpoints around the world that could threaten disruptive consequences for markets, of which Brexit is among the most pressing. There remains a significant risk that the UK could crash out of the EU without a deal, which we expect to present a significant shock to UK economy.
Other hotspots are also on our radar, such as Italy and Hong Kong.
Are central banks approaching the limit of their powers?
Markets have responded favourably to easier monetary policy, particularly moves taken by the Federal Reserve. Amongst developed markets, the US central bank has the most scope to lower interest rates, having spent three years raising them. It has now cut rates twice in 2019. In China, the central bank has lowered banks’ reserve ratios in a bid to stimulate lending.
Circumstances are more difficult in the Eurozone and Japan. Central banks in both regions already have negative interest rates. The European Central Bank recently cut interest rates even further into negative territory and launched a new bond buying programme.
However, even the outgoing ECB president Mario Draghi was sceptical that this would do much to stimulate activity, telling markets that it is now ‘time for fiscal policy to take charge‘.
Since the Eurozone debt crisis, there has been strong political opposition to higher government spending – particularly from Germany. However, as the German economy struggles amid the global manufacturing slump, there are signs that its opposition may be softening.
Factors spooking the markets
- China's position as rival rather than partner to the US is becoming more entrenched. This has raised the level of global geopolitical risk.
- Without higher levels of government spending around the world, there is little reason to expect much of a pick-up in growth.
- Schroders puts the probability of global recession at 25%.
- Easy money is keeping asset prices high…but for how long?