We see no economic case for a recession in the global economy in 2020. Unless political risks begin to mount again, trade and manufacturing should recover gradually. After a series of downward revisions the International Monetary Fund (IMF) forecasts global growth of 3% in 2019 (see graph). Over the long term (1980-2018) the average level of global gross domestic product (GDP) growth has been 3.5% so a pace of 3% indicates sluggish economic conditions.
After more than a decade of economic expansion, the key question now is whether the US economy is on a glide path toward its long-run growth potential of around 1.8%, or on a crash path ending in recession. We think it is the former. The US economy should not enter a recession in 2020.
However, with the Fed now on hold after three rate cuts in 2019, there is concern that the Fed has limited scope to respond should a slowdown occur. During past downturns, the effective fed funds rate fell by 630 basis points on average; today’s scope for reduction is just 175 basis points (assuming rates do not go below 0%). Given this limitation, the need for an expansionary fiscal response is all the greater. Fortunately, low rates expand the scope for fiscal policy as any increase in debt does not incur a commensurate increase in interest payments.
GDP growth has slowed to 6% in the third quarter of 2019 compared with a year earlier, its slowest pace in about 30 years. Chinese policymakers are focused on measures to limit risks arising from excessive debt burdens, even if it means weaker rates of growth. Nonetheless, stimulus measures should off set any consequences of a worsening in the trade conﬂict with the US.
Will China lead the way to economic recovery in 2020 and greater cooperation between monetary and ﬁscal policy? It is diﬃcult to give a deﬁnitive answer, but calls for government investment to stimulate economic growth increased late in 2019.
The accommodative policy measures implemented by the ECB and calls for support via ﬁscal policy should continue to prop up the economy. Concern grows about the corrosive side-eﬀects of negative interest rates as the ECB’s bond-buying programme nears its self-imposed limits. It is doubtless time to look again at ﬁscal policies which would change the outlook on many fronts.
Despite repeated disappointments in surveys of business activity and conﬁdence, hard data has shown no signiﬁcant deterioration. Eurozone GDP growth should come at around 1% in 2020. Several fundamental elements have pointed to an acceleration in consumption. Investment surveys appear to have overestimated the downside risks to demand.
Christine Lagarde, the new president of the ECB, has said that governments running chronic budget surpluses are failing to do their bit to support the economy and should come under greater scrutiny.
Equity returns were buoyed by the fall in interest rates in 2019
Instead of taking fright at the deceleration in GDP growth in most parts of the world during 2019, equity markets instead focused on the benefits of lower interest rates and the resumption of monetary policy support from central banks. Consequently, equity returns came primarily from a decrease in the equity risk premium (analogous to a rise in the price-earnings ratio) and a reduction in the discount rate, rather than from hopes for higher profits.
But, this is not sustainable in the long run
A repeat of 2019 is not possible longer term. Forward price/earning ratios are average for the MSCI Europe and emerging markets, but elevated in the US (17x for the S&P 500 versus the median since 1985 of 14.7x; the post-Global Financial Crisis maximum is 18.6x).
In our view, interest rates could yet fall further as US GDP growth decelerates even more. While the decline in rates would again increase the present value of earnings, at this level of nominal GDP growth, profit growth will suffer.
Trade wars, deleveraging and structural maturation suggest something similar in China. In Europe, by contrast, there is still hope for a modest rebound in growth. Even a resolution to the trade war will not clearly boost these figures dramatically. While tariffs between the US and China have increased, their trade accounts for less than 4% of the world total.
The necessary ingredient for sustained equity market appreciation is rising earnings
In a world of modest economic growth, high margins, and increasing labour costs, it is not clear if companies will be able to significantly boost profits. Expectations for 2020 are for a return to double-digit earnings growth in the US and emerging markets and to mid-single digits in Europe. Assuming some normalisation in multiples in the US and stable valuations elsewhere, equity market total returns in 2020 are likely to be less than 10%. We would still favour technology, though selectively. Another consequence of the trade wars is increased opportunity for companies offering alternatives to Chinese technology, production and sales, but equal risk for those companies that depend on them.
We see few reasons to anticipate a sharp increase in interest rates for either US or European government bonds in coming months. Inflation has been muted over the past decade and growth expectations are moderate for next year (and those expectations themselves have been falling).
To offset the risks, we believe the Fed could yet reduce rates even beyond the market’s expectations. A US recession nonetheless seems improbable to us. Consumer confidence remains high, low interest rates have boosted housing starts to their highest level since 2007, and the unemployment rate is at its lowest point since 1953.
In the eurozone, we expect QE to go on and policy rates to remain negative and conceivably drop further. Within the eurozone fixed income market, we prefer the ‘periphery’ to the core or semi-core countries, as yield spreads should remain stable or fall with the renewal of QE.
Overall, we favour structured securities (both asset-backed and mortgage-backed securities) as well as corporate debt markets given low interest rates, which mean corporates can cope with greater levels of debt.
Over the last few years allocations to private debt and real assets have increased significantly. This is partly a consequence of the effect non-conventional monetary policy and low interest rates have had on conventional asset classes. As yields fall and the search for yield intensifies, investors focus their attention on the same sectors of asset markets, which in turn become more expensive and less liquid. Investors have to contend with risks such as portfolio concentration, rising correlations and abrupt swings in volatility.
Private debt attracts investors as it provides a means of avoiding some of these risks, which in our view will be with us for some time. In 2019 we saw a return to non-conventional policies among leading central banks. We see little prospect of interest rates rising significantly in the near future.
In this new environment, when companies seek ﬁnancing they increasingly turn to institutional investors and asset managers. Private debt has provided a source of assets that meets the needs of institutional investors’ liabilities in an environment where traditional asset classes can no longer play this role.
Asset-backed securities, like most private debt assets, are backed by a Euribor and margin-based coupon, which offers protection from the risk of a rise in interest rates. They constitute one segment of the private debt and real asset markets that we see as offering investors a solution relative to the risks they will face in 2020.
Emerging market debt (EMD) did well following the reversal in US interest rate policy in 2019 and the subsequent decline in US government bond yields. After negative returns in 2018 for both USD and local currency, EMD generated attractive positive returns in 2019.
Will strong returns continue into 2020? We expect global bond yields to remain low, anchoring stable income from emerging bonds, which generate an important advantage relative to traditional fixed income. At the same time, select opportunities in high yielding assets and the potential for emerging currency appreciation have the potential to generate significant gains. We project returns of between 5 – 10% for the asset class in 2020.
In November, we held our annual Investment Forum, where world renowned academic experts joined BNP Paribas Asset Management’s investment professionals and senior management to debate the structural forces set to drive economic, political and market developments – and our own investment discussions – over the coming years. The below themes are distilled from the Forum.
Presidential tweets have resonated in financial markets, but as Amy Celico from Albright Stonebridge Group explained at the Forum, there has been a much broader and deeper change in Washington’s views on China.
While US policy towards China through to the Obama administration had been one of constructive engagement, it has now shifted to strategic competition. This is based on the belief that China was not going to change fundamentally despite greater integration in the West’s economic system. A policy change looks unlikely regardless of who wins the US presidential election, even if the means of strategic competition might change. A Democratic president may, for example, try to bring Europe and Japan on board as allies to pressure China more effectively on intellectual property rights.
A more assertive China
The 2013 election of Xi Jinping as president was followed by what were viewed as more assertive economic policies, for example the Belt and Road Initiative or Made in China 2025. The West’s resistance to some of these has led China to become more reactive in its dealings with the West. Leaders have to navigate a host of flashpoints and Ms. Celico believes China will remain defiant while it burnishes its global position relative to its main geopolitical competitors.
Beijing’s priorities are enhancing control of the party over all aspects of society, and reinforcing state-owned enterprises to drive growth. The top economic priority for 2020 is managing the slowdown – annual GDP growth has fallen from 6.8% early in 2018 to just 6% in Q3 2019. The goals of deleveraging and rebalancing the economy remain in place, but achieving them is more difficult with lower growth.
One consequence: the Belt and Road Initiative is becoming leaner as China builds on recent successes while responding to international scepticism and growing competition in global infrastructure investment.
As for the relationship with the US, technology competition is the most visible area of tension and the risk of at least a partial decoupling of the two countries’ systems is rising. The US is now pursuing export controls and investment restrictions in the interest of national security. China’s own rules governing critical information infrastructure and data flows reinforce this decoupling trend. A limited trade deal will likely not stop the development of policies to restrict technology flows.
An additional challenge for foreign companies operating in China are policy uncertainty and regulatory obstacles. The latest EU Chamber of Commerce in China survey showed that 48% of respondents expect regulatory obstacles to increase over the next five years; the US-China Business Council survey had 34% of companies pessimistic or somewhat pessimistic on the five-year outlook for their business in China. While most felt it was still a priority to be in China, they were well aware of the challenges.
What does this mean for investors?
We believe investors will need to re-evaluate the opportunities presented by the Belt and Road Initiative given that the amount and breadth of investment is not likely to be as high as initially projected. We will need to closely evaluate the business models of both US and Chinese tech companies to identify the sources of technology, production, and sales.
While the new restrictions will hinder some companies, others will be able to benefit from reduced competition. Non-Chinese companies may find it difficult to compete in areas using artificial intelligence as the technology depends on vast amounts of data. This is often more readily available in China than in the West where privacy laws restrict access.
Investments in companies operating in China must be regularly evaluated to account for the evolving business and regulatory environment, to anticipate threats to business models as well as new opportunities.
The drag on US growth from the trade war has roughly cancelled out the boost from tax and interest rate cuts, believes Professor Jason Furman of Harvard Kennedy School and Peterson Institute for International Economics who participated in this year’s Forum. The key question now: is the economy on a glide path toward its long-run growth potential of around 1.8%, or on a crash path ending in recession? Professor Furman’s view (and ours): it is the former.
The recent rate cuts are part of a much longer period of lower rates since the early 1980s. To the degree that this decline has been driven by rising government debt, slower productivity growth, changing demographics – older people save more – and rising inequality – richer people save more – it is more likely to persist over time.
With low interest rates, the concern is that the Fed is left with little scope to respond to the next recession. Given this limited potential for monetary policy action, the need for an expansionary fiscal response is all the greater.
Possible policy changes and their impact
Beyond the immediate outlook, Professor Furman discussed policy changes that could come depending on the outcome of the presidential and congressional elections. A strong economy and incumbency status make it more likely than President Trump will be re-elected, in his view. In that case, who will be appointed as Chair of the Fed in 2020 will become an important issue for the markets and the outlook for monetary policy.
The election may have significant implications for tax policy: estimates range from USD 17 trillion in tax increases to USD 1.5 trillion in tax cuts depending on the candidate.
Sectors which could be impacted:
An increase in the minimum wage would affect a meaningful share of the workforce, and infrastructure spending could rise. Professor Furman highlighted the convergence between candidates on trade, at least with China, with many calling for tariffs or other restrictions.
The digital age has brought dramatic benefits to society, but also costs and it often falls to governments to implement regulations to minimise these costs. At the Forum, 2014 Nobel Prize winner in Economic Sciences Jean Tirole from the Toulouse School of Economics discussed the challenges of regulating market power in a disrupted global economy.
Regulators are having to take into account the rising ‘techlash’ in society, with growing calls for large tech companies to be broken up, regulating them as public utilities, using tougher antitrust enforcement, or engaging in industrial-policy programmes in big data and artificial intelligence (AI).
Regulating change with agility
One of the challenges regulators face is antitrust policy. In the past, when regulators took on monopoly providers such as AT&T or Standard Oil, identifying and separating the essential parts of their business (e.g., the local telephone loop, rail tracks and stations) was simple.
With tech companies, this is more challenging because businesses are changing rapidly. In the case of data, it is hard to separate data from the activities that generate it. For professor Tirole, competition policy and consumer protection are the best tools to manage the industry, but regulators need to adapt them to a digital context and make them agile.
Regulators strive to preserve competition in a market so that consumers receive the best service at the best price. In the digital age, this means assessing the behaviour of incumbent firms to ensure that tie-ins or loyalty rebates, for example, do not limit price competition. Acquisitions can be used to take a rival out of a market, or ’best price’ guarantees can end up allowing a platform to tax non-users.
Given the dominance of US and Chinese technology firms – all of the world’s largest 20 technology companies are from these countries – there have been calls, particularly in Europe, for the greater use of industrial policy to promote ‘regional’ champions. The proposed merger of Alstom and Siemens was the most recent example, albeit in another industry.
Industry policy – yes or no?
Arguments in favour of industrial policy are that there are cluster effects (infrastructure and information sharing, the potential for low-cost job mobility), industry spill-overs of public research & development, or the preservation of competition (the argument for having both Airbus and Boeing).
Economists are nonetheless sceptical. History shows that governments rarely succeed in picking winning industries or companies, and the involvement of the state increases the risk that it becomes captured by the industry itself. There are exceptions, however, such as the US Defence Advanced Research Projects Agency, the National Institute of Health, and the National Science Foundation.
The lesson to heed is following the evolution of regulatory policy closely and its adaptation to the digital age will be particularly important in 2020. There could just be changes that affect the value of businesses, but there could also be those that actually breakup a company.
Increasingly, climate change is recognised as a disruptive force, both for the global economy as a whole and for investors. At this year’s Forum, our Global Head of Sustainability, Jane Ambachtsheer, and Head of Climate Change Investment Research, Mark Lewis, presented their views on forecasting climate change over the next three and 30 years.
Though the Paris Agreement targets a rise in global temperatures of well below 2°C, current policies have us on a path to a 4°C increase, with significant (negative) consequences. These include:
Governments will act when science, economics, technology, and public support align, but the critical questions are when and how will it happen – in a smooth and coordinated manner or in a delayed and disruptive one?
The impact on industries and financial markets
Importantly, financial markets are underprepared for climate-related policy risks and as governments are forced to take action, investor portfolios are exposed. We must ask ourselves how the policies will affect the economy, which sectors are most at risk, and which asset classes will be impacted.
Some of the industries that will be affected:
The key message: there will inevitably be a policy response from governments to climate change as the impact on their citizens becomes ever greater.
In our report Wells, Wires, and Wheels: EROCI and the Tough Road Ahead for Oil, Mark Lewis explains why oil will need a much lower long-term breakeven price to remain competitive for transportation. Such a lower price will sharply reduce the future return on investment in the industry and the amount of stranded assets will rise.
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