Is this still a tougher climb, or have we peaked?
- We see a few solid footholds for the global economy over the next six to 18 months.
- Income is likely to make up a larger percentage of total returns moving forward.
- We are growing cautious toward many global financial markets, but remember: Being defensively invested is not the same as being uninvested.
We expected 2019 to be a tougher climb for investors. That message seemed needlessly cautious in the first quarter, but reads more like an understatement for portions of the second quarter.
Earlier this month, I was enjoying a coffee in Edinburgh with several members of Nuveen’s Global Investment Committee as we discussed the global economy and markets. If not for Scotland’s characteristically overcast weather, we would literally have been sitting in the shadow of the statue of Adam Smith on the Royal Mile. Smith was famous for coining the term “invisible hand” to characterize the ability of free markets to generate efficient outcomes.
What would Smith think of the very visible hands that have intervened in global trade over the past 18 months? How much, if at all, will tariffs and the politics that triggered them affect the global economy and investors’ returns over the balance of this year and into 2020? A tougher climb now seems baked in, but are we even still climbing?
Slower global growth…again
We expected most major economies to grow at a slower pace this year compared to last, but the abrupt nature of the deceleration caught us by surprise. Global business survey results plunged at the end of 2018 and seemed likely to bounce back this year. Most did, but the recovery generally hasn’t lasted: Both global manufacturing and services sector businesses report weaker conditions today than at any time in the past three years (Figure 1). The boom in business investment in the U.S. has given way to more cautious deployment of capital as the benefits of tax reform fade and the effects of the trade war kick in.
Trade Wars: Episode II
Trade was by far the dominant policy issue for markets in the second quarter. An unexpected breakdown of talks between the U.S. and China was quickly followed by yet another layer of bilateral trade restrictions between the two economic behemoths. While we do not believe these new shots in the trade war will mortally wound the global expansion, we expect somewhat slower economic growth in both the U.S. and China than if even a small deal had been struck. Even before the May-June ramp-up in tariffs, China and the U.S. experienced weaker annual growth in imports and exports, both with one another and overall (Figure 2). Such deceleration is not necessarily the product of the trade war in isolation, as trade tends to shrink as a percent of global GDP when overall growth is weaker. But restriction is undoubtedly playing some part in disentangling the world’s two largest economies. While the short-term implications are manageable, we have very few recent examples of what happens when globalization goes into reverse, even temporarily.
Policymakers to the rescue?
Slow global growth is not new to anyone who has been paying attention for the past 10 years. Policymakers have typically responded by lighting a fire under the economy: lower interest rates, lower reserve requirements for banks and greater liquidity through quantitative easing and other unconventional programs.
The trouble is, to one degree or another, major central banks face constraints to maintaining or reintroducing easy monetary policies. The U.S. Federal Reserve (Fed) risks its credibility lest it be seen as too responsive to markets and political pressure. The European Central Bank will welcome a new president later this year, making it hard for the current regime to use forward guidance to communicate its policy intentions. The Bank of England may have its hands full with the outcome of Brexit, depending on how messy things get in October. And China risks inviting a run on its currency, depending on which of the many available avenues for easing it chooses.
In short, while policymakers are unlikely to run out of ideas or ammunition to combat slower global growth, they may find themselves low on credibility, which threatens to substantially reduce their efficacy.
We expect trade wars and tariffs will negatively impact growth, but won’t cause a recession.
And now the good news
Descending from a summit can be just as treacherous as climbing up, but luckily we see a few solid footholds for the global economy over the next six to 18 months: Global consumers remain an important bright spot. Unemployment rates in most major economies are still quite low, and real wage growth has accelerated thanks to the lower supply of available workers and decreasing rates of inflation. In the U.S., both major monthly surveys of consumer confidence show continued optimism about the individual and collective economic outlooks (Figure 3). A broader mix of leading economic indicators remains pointed in a positive direction, even if the partially inverted U.S. Treasury curve is sending recession-predictor models into a tizzy.
We also do not discount China’s political will to support growth while encouraging broader economic reforms. Policymakers have room to implement further stimulus — easing regulation, cutting taxes — in ways that do not cause global financial markets to panic like currency depreciation might. The recent drop in factory output implies that a combination of lower interest rates and more fiscal stimulus may be on its way, based on China’s past behavior.
Finally, liberalizing economic reforms like those being attempted in Brazil, Spain and India — as well as the residual impact of the tax code changes in the U.S. — continue to light the way for global growth. Of course, some major economies appear to be heading in a less liberal direction, so much so that we are devoting our next section to this trend.
Global populism and its investing implications
With Nuveen’s GIC holding its midyear meeting in the U.K., it was difficult to escape the topic of Brexit and the recent European parliamentary elections. European politics are fractured, and established political parties and politicians are losing ground to…well…something else. Just what to call that “something else” is hard to figure. Recent election results and opinion polls in developed and emerging markets countries alike seem to confirm the rise of some measure of economic populism. What, if anything, does this mean for investors and investment managers?
We draw a clear connection between economic populism and economic and market uncertainty. The elections of unconventional candidates or previously non-mainstream political parties often bring promises of sweeping changes to the status quo: institutions, personnel and attitudes toward markets.
The World Uncertainty Index by Ahir, Bloom and Furceri, uses data from the Economist Intelligence Unit to create a country-by-country measure of uncertainty that encompasses economic and political factors. The broad global index shows a clear, continuous rise in global uncertainty since just before the financial crisis, with a new spike in the first quarter of 2019 (Figure 4). The authors find that uncertainty today leads to higher volatility and lower output in the future. While lower output (i.e., growth) has certainly been a hallmark of the 2010s, higher volatility has not, nor have stagnant risk asset returns.
Why haven’t rising economic and political uncertainty taken a more serious toll on markets? The answer: constraints. Even the most strident or charismatic politicians may find their honeymoons cut short by outside forces. Populist economic policies often entail temporary or permanent increases in budget deficits to promote stimulative (i.e., popular) economic policies. But these outcomes can be counteracted by an independent central bank, a rating agency or a community of international investors that moves its money to a more stable destination.
Before we worry about the implications of economic populism, we must first ask whether it can prevail as a practical governing philosophy. In many, though not all, cases (think of the Brexit frustrations or the Trump administration’s difficulty appointing Federal Reserve Board Governors), the best grade we can give is an “incomplete.” As such, we will surely return to this topic in future quarters.
The right equipment for a downward climb
The world’s economy is slowing down, whether due to higher tariffs, higher interest rates or higher vote totals for populist political parties. How should investors react over the balance of 2019 and into 2020? Nuveen’s GIC proposes three clear themes for investors to keep in mind over the next several quarters:
- Keep Fed expectations in check. Markets currently believe the Fed will undertake a series of preemptive and successful interest rate cuts in the very near future. Both U.S. bond and stock markets rallied in early June, as economic data continued to disappoint to such an extent that investors saw the Fed’s intervention as inevitable. But what happens if the Fed behaves more patiently than expected or if, heaven forbid, economic conditions improve and negate the need for such action? We don’t think long periods of simultaneous rallies in stocks and bonds are sustainable. If the Fed disappoints in the next six months, we could see periods of rising interest rates and choppy or falling stock markets.
- Focus on the trade war’s real world impact. Tariffs impact companies before consumers. Consensus 2020 earnings estimates for the S&P 500 and MSCI Emerging Markets Indexes have both fallen this year, but they’ve fallen by more in emerging markets (Figure 5). Analysts are not, to our mind, accounting for the impact that higher taxes and higher wages will have on U.S. profit margins over the next several quarters. Despite the more resilient earnings outlook in the U.S. compared to other markets, U.S. stocks have grown more expensive both in absolute P/E terms and against their emerging markets peers. Tariffs are more toxic for companies’ bottom lines than for the economy as a whole. Investors would be well advised to consider that fact before rushing to buy every tariff-related dip.
- Be prepared for the base case and the worst case. Nearly every Nuveen GIC member used the word “defensive” to describe their portfolio management strategies. But being defensively invested is not the same as being uninvested. With income (interest or dividend payments) likely to be a larger percentage of total returns moving forward, investors should continue to diversify the sources of that income: corporate bonds, dividend-paying stocks and real assets have outperformed when the economy is stable but markets are jittery, as we expect them to be.
In the following tabs, you’ll see specific asset class views and a discussion of risks from each member of Nuveen’s GIC. As you’ll see, we generally are approaching markets more defensively. And in the wrap-up, Nuveen’s Solutions team pulls together all of our views and offers practical advice on applying them to portfolio construction. The bottom line is that we think investors will continue to experience a tougher climb, but it remains a climb all the same.
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