Investors started 2016 on the back foot. Concerns about the health of the global economy helped to propel the price of risk assets lower. However, there has been abrupt turnaround in prices since mid-February and it appears that a re-assessment of the growth outlook has been partly responsible. In this note, we discuss why confidence in the global growth outlook might have returned, and whether that shift in sentiment is justified.
An obvious place to look for confirmation of the hypothesis that renewed confidence in the growth outlook has supported the recovery in asset prices is in revisions to macroeconomic forecasts. At first glance, this does not look like a promising line of enquiry. The International Monetary Fund revised down its forecast for growth in 2016 between the January and April vintages of its published forecasts. Turning to Consensus forecasts, we find that professional forecasters have also marked down their 2016 growth forecasts for a number of countries – the United States, Japan, Germany, France, Italy and the United Kingdom among others.
Another place to look for evidence that the growth outlook has improved are the actual data on activity. Here, we find a mixed bag. The high profile ‘nowcast’ of US GDP published by the Atlanta Federal Reserve paints a sombre picture of activity in the United States in the first quarter of 2016. On the other hand, the hard data on activity in the production sector and spending of the household sector both point to reasonably solid growth in the eurozone during the first quarter. In Asia, signals from the business surveys and export numbers have also been broadly positive, at the very least suggesting that the pace of contraction appears to have eased, although the recent news from Japan have clearly not been positive.
In short, it is hard to detect convincing evidence from either the revisions to macroeconomic forecasts or the news in the high frequency data that there has been a meaningful shift in the macro outlook. However, we think that this is the wrong place to look for evidence of the shift in investor psychology for two reasons.
First, we need to compare outturns against the right yardstick. We suspect that investors were already more pessimistic than the official sector going into this year and that gap only widened through January and February. The fact that the economists have revised down their growth forecasts in recent months therefore tells us very little, other than perhaps that economists have been playing catch up with market participants on the macro outlook. Likewise, it is perfectly plausible that a mere stabilisation in the data could have triggered a positive reassessment of the outlook if investors had been expecting a further deterioration in activity.
Second, we need to stop obsessing over point forecasts. We do not think that this is primarily a debate about the sensitivity of asset prices to modest revisions to central case forecasts for global growth over the coming year. Instead, we believe that it is a perceived shift in the balance of risks around that modal forecast that has helped to support the recovery in risk assets. In other words, it is not that investors have suddenly started to expect an acceleration in activity in the coming months, rather that they are attaching a lower probability to the risk of a global recession than they were a couple of months ago.
One reason why investors might have become more relaxed about the downside risks is that they have a renewed confidence in the power of central banks. If investors had recently become concerned that central banks had reached the end of the road with negative interest rates and large-scale asset purchase programmes, and lacked additional means to inject stimulus into the economy, then those investors ought to have also become more concerned about the risk of very bad macro outcomes in the future. Even the most optimistic economist would concede that the economy would become more fragile in these circumstances, as there would be no effective monetary (and arguably no fiscal) response if the economy is hit by a negative shock. However, following the March meetings of the Federal Open Market Committee and the European Central Bank Governing Council, investors appear a little more comfortable with the idea that central banks are ready, willing and able to support the economy and that should have reduced the perceived downside risk to activity.
Another factor which played on the minds of investors is the fate of the Chinese economy. Investors clearly became more concerned both about the scale of the financial imbalances in China and the capacity of policymakers to manage the economy. As we noted in early March, these concerns appeared to have decoupled from reality, with investors attaching a high probability to an imminent hard landing of the Chinese economy and/or large depreciation in the renminbi – two events which would have significant ramifications for the global economy. Those fears have since receded thanks to comments from Chinese policymakers that they are committed to supporting the economy, evidence that the positive impact of stimulus is already showing up in the data and the fact that the decline in Chinese foreign exchange reserves has abated. Indeed, one tell-tale sign that sentiment around China has shifted is that investors are now once again worrying about the financial stability consequences of too much growth, rather than too little.
The final factor which has likely driven a shift in the perceived balance of risks around global growth is the recovery in commodity prices. Economists typically think about this problem the other way around, with commodity prices being driven by news on global growth and (at least in the case of oil) higher commodity prices shifting global purchasing power towards countries with a lower propensity to consume. However, the collapse in commodity prices raised concerns about the potential for very large losses on legacy investments in the commodity sector, particularly (but not exclusively) in pockets of the emerging markets, that might have triggered a financial crisis which would have proved hugely disruptive for the global economy. The recent recovery in commodity prices has helped to allay those concerns, reducing the perceived downside risks to global growth.
So where does this thought process leave us? We are not convinced that investors have materially raised their modal (or central case) forecasts for growth, but we have identified a number of reasons why investors might have reduced the probability that they attach to very bad macro outcomes, which implies that their mean (or average) forecasts of growth may have been revised higher. In that narrow sense, confidence in the growth outlook has been resurrected. That shift in the balance of risks should have supported the rally in risk assets, alongside a very low discount rate (see Something has got to give?). However, there is nothing to guarantee that this shift in sentiment will persist. A perceived misstep by a central bank, bad news on activity in China or commodity prices slipping back could all lead to a renewed bout of soul-searching on the risks of a global recession and that would likely trigger a renewed sell-off in risk assets.