The state of the world economy is spooking analysts. In October, the IMF downgraded its global growth forecast for 2015 to 3.1 per cent, from the 3.3 per cent it predicted in July. Last week, the OECD added to the gloom, trimming its 2015 forecast for world output growth to 2.9 per cent on the back of an intensifying emerging market slowdown. “Anything below 3 per cent is dangerously slow,” says Tom Elliott, international investment strategist at wealth manager DeVere Group. “We’re entering alarm bell territory on a global scale.”
Other indicators are flashing red. According to Deloitte’s chief economist Ian Stewart, global trade is now growing at the slowest rate outside recession on record. Guy Miller, chief market strategist at Zurich Insurance Group, adds that all investors need to be aware that “this is a world of too little growth in aggregate, with too much debt, and with inflation that is too low. That’s not a happy environment and leaves little margin for error.”
A Chinese slowdown, dollar strength, emerging market woes, structural problems plaguing the Eurozone, market volatility, and a weaker-than-hoped-for US economy are all part of the mix.
But what does this mean for investors? “Recent volatility in markets has a number of causes, but the outlook for global growth has been a cause for significant concern,” says Paul Niven, fund manager of the Foreign & Colonial Investment trust. There is not always a direct relationship between investment performance and the economic fundamentals, but “global growth – and expectations for the outlook for growth – are important… as they influence bond markets, due to rate and inflation expectations, as well as corporate fundamentals,” he says.
Reasons to be fearful
“We think there’s a real risk that sustaining current equity valuations will become more challenging,” says Jason Hollands of Tilney Bestinvest, “and the potential for a more meaningful market reality check than we saw at the end of the summer is rising”. He is referring to the big drops registered in stock markets across the globe in August, triggered by fears over the health of China. Stocks have since rebounded, but the wave of deflationary pressures China is exporting around the world due to the knock-on effect on demand for raw materials and commodities has not disappeared.
As a consequence, Hollands says Tilney Bestinvest is “trimming overall equity exposure”. And it’s not just emerging markets and Asia that are out of favour. “We think the valuation premium for US equities might start to be eroded as liquidity flows start to weaken once the Fed starts raising rates.” Relatively overweight Europe and neutral on Japan and the UK, Hollands adds that “we hold no exposure to commodities other than a small, new position in gold, as an insurance policy should confidence collapse.”
Others are equally gloomy. ETF Securities and Roubini Global Economics have upgraded their view of the probability that an “adverse scenario” will hit the global economy to 30 per cent over the medium term. Their downside scenario sees the S&P 500 sinking to 1,500 over the next 12 to 18 months. The index is currently at over 2,000.
Even if the global economy doesn’t plunge into recession, the monetary easing that countries are undertaking to stave off crisis – what many deem a beggar-thy-neighbour race to devalue their currencies – continues to distort asset prices. Although all eyes are on the Fed, Matthew Beesley, head of global equities at Henderson, recently noted that there have been over 70 different central bank easings during 2015.
“Unfortunately, with governments either unable or unwilling to provide the required fiscal support, we’re all too dependent on central banks to provide or prop up what little growth there is,” says Miller. And for investors, “central bank actions dominate investor psychology and where people put money”. Anticipation of even more Bank of Japan action, for example, helped drive Japanese equities 8.94 per cent higher between January and the end of October, despite a lacklustre economy. “Investors are playing the broad averages rather than identifying fundamental drivers and idiosyncratic opportunities. They’re doing that because of high correlations and the fact that they’ve got liquidity behind them, which still dominates market moves.”
Some worry this is a house of cards. “The really interesting thing is that QE is as much a part of the problem as any solution to stimulating growth,” says Elliott. “It is keeping zombie companies and banks afloat. Look at recent European banking results. It’s a legitimate question to ask: shouldn’t these banks have been allowed to go bust or be forced to merge with rival banks?” And with some hawks in the Fed openly talking about the need to clear out the deadwood, coming Fed rate hikes may not have the benign effect on developed market stocks that many anticipate.
The trouble is that too much caution may not be in investors’ interests either. October saw 42 of 47 global equity markets rise by 7.51 per cent on average, the best month since October 2011. As John Bilton, global head of multi asset strategy at JP Morgan Asset Management, argued in a recent note, however, “with positions washed out, sentiment still fragile and macro data still mixed, few participated fully in the move and many simply didn’t believe it”.
He is keen to point out that the US is not in recession. Niven agrees: “our view is that markets have become somewhat overly pessimistic with regards to the outlook for global growth.” The US continues to perform relatively well, Europe is recovering from a low base, and Japan may soon look rosier. “I continue to believe that equities offer the best potential returns for investors,” says Nick Peters, portfolio manager at Fidelity Solutions. A survey of investors by Barclays found that as many expect an upside surprise to global growth as a downside surprise.
Indeed, in a world of greater divergence, says Peters, while the outlook for global growth remains challenging, pockets of both value and opportunity remain. He highlights bottom-up factors that are likely to continue to support Japanese equities against a background of a slowing China and disappointing Japanese growth: “increased dividend pay-out ratios, a friendlier shareholder culture, and a higher allocation to equities from government pension funds”.
While QE may not be having the effect on growth that many hoped for, in Europe too there may be opportunities worth seizing. “From the corporate side, Europe should do better. You’ve got a very attractive combination of low funding costs, low oil prices, low labour costs, and a decent cyclical recovery,” says Miller.
Perhaps more likely than a rotation out of risky assets like stocks, driven by the world falling into recession, is something less spectacular. A “continuation of the sharp rally in risky assets or a rapid deterioration into recession are equally implausible,” says Bilton. More probable “is an unconvincing grind modestly higher into year-end, with stocks and bond yields slightly higher, commodities still weak and credit providing the best of the returns.” Miller says that, “although the bull market is maturing, I still think it remains in place, with further gains to be had for risk assets of credit and equities”.
He also doesn’t think we’ve entered a world of prolonged, low global growth, with consequently poor long-term returns for investors. “This is not like Japan in the 1990s, when there was no incentive for corporates to invest. Nor do I think that we are in a period of secular stagnation. Currently, there is an incentive to expand and grow. Returns on capital in Europe and the US are still in the double-digits, while funding costs are historically low.”
In fact, the global economy may be in a better state than some indicators and markets suggest. According to Henderson Global Investors chief economist Simon Ward, who correctly forecast the UK growth pick-up in 2013, both global real narrow money growth and record global auto sales suggest that the world economy is now reaccelerating.