Dismal risk asset performance in recent weeks has some investors questioning whether weakening global growth expectations warrant lower asset prices or whether the sell-off could itself be the catalyst that pushes the global economy toward recession. When it comes to the financial market outlook, we believe emerging markets are the swing factor.
Mixed economic results in the US, an ever-widening range of possible outcomes for China and persistently low oil/commodities pricing are all contributing to create a messy picture of the global economy. All of this has quite reasonably led to sizable corrections since the start of 2016 in equity and credit markets. But in terms of the global economy, there are reasons to remain cautiously optimistic. We look for an improvement in risk appetite in coming weeks following on from the global equity rally that we have seen since the 2% rally on 12 February in the S&P 500.
The upside from lower energy prices is yet to come
In the US, a pause in monetary tightening by the Federal Reserve (Fed) has lessened widening policy differential expectations that were driving trend strength in the US dollar. While Chair Yellen highlighted global risks and credit conditions as concerns justifying the decision, it is clear that the Fed’s bias to tighten remains in place and we should see another 25bp hike before the end of the first quarter in 2016. Consumer confidence remains supportive and recent headwinds to activity from falling inventories and bad weather should fade.
Ultimately, low energy prices should also be growth positive but so far, the bulk of the benefit to households has been spent on deleveraging rather than consumption (see exhibit 1 below). As this trend reverses, the marginal gain in consumption will better offset the negative growth contribution from the energy sector. The bottom line is that consumer momentum remains in place and we have already seen January retail sales beating expectations; rising 0.2% month-over-month, versus the 0.1% consensus forecast.
Exhibit 1: US households have, so far, taken advantage of lower energy prices to reduce their financial leverage. This is reflected by a higher level of saving – graph showing US household savings rate and crude oil (West Texas Intermediate (WTI)) price
China muddles through
The consensus view on China, however, is considerably worse as a multi-year program of economic reforms is made more difficult by an overvalued exchange rate, a build-up of bad loans in the financial system and a draw-down in reserves as the central bank combats capital flight. The International Monetary Fund (IMF) has repeatedly cut growth forecasts for the country and now expects 6.3% this year and 6% in 2017.
While this result would mark a considerable slowdown from past years, it still represents a likely muddle through scenario in which the government retains a number of policy tools and options sufficient to avoid a more stressed outcome. In particular, bank funding from a large pool of domestic savings, additional fiscal stimulus, potentially re-tightening capital controls and allowing a modestly more flexible exchange rate will all help preserve economic stability. So while China will likely not provide much additional positive growth impetus for the global economy, avoiding a more bearish scenario is supportive of the regional outlook and at the margin, commodity prices.
Emerging markets are the swing factor
The swing factor in all of this remains the wider emerging markets universe. The asset class’ overabundance of commodity producers and reliance on foreign capital has triggered a massive revaluation of emerging markets foreign exchange (EMFX) and sharply lower economic activity. With most EM currencies now looking cheap across a number of valuation metrics, we should see lower volatility in coming quarters. Outside of Latin America, there also seems to be more capacity for monetary easing with commodity prices and developed market conditions providing disinflationary pressure.