Why the global economy—and markets—still have room to run
Although some of the risks that have weighed on the global economy may be starting to fade, it is too soon to sound the all-clear. We anticipate that 2020 will be a year of moderate global growth and contained inflation, with risks skewed to the downside.
Expectations of a U.S.-China trade deal, accommodative monetary policy and a clearer timeline for Brexit have spurred equities to all-time highs, while interest rates remain well below year-ago levels. This apparent ebbing of geopolitical and policy uncertainty has coincided with a slight improvement in manufacturing activity—albeit from depressed levels—but this is occurring at a time when consumption is showing some signs of pause.
The trajectory of growth in 2020 will likely be uninspiring, with the rest of the world looking a bit better but the U.S. economy growing at a trend-like pace. The risk of recession should remain contained, but other risks may continue to build. The pace of profit growth looks set to decelerate further on the back of falling margins, which could potentially lead businesses to pull back on hiring. Further, geopolitical risks persist, leaving the economy and markets susceptible to a flare-up in the medium term.
Moderate pace of economic growth
Over the past year, while global manufacturing slid into contraction, the consumer once again rode to the rescue, helping to keep the global economy afloat. An improved inventory picture suggests that better times may lie ahead for the industrial economy, but we are not out of the woods yet. The overall pace of growth in the coming year should remain soft before gradually accelerating toward trend over the first half of the year.
Any improvement in manufacturing activity (EXHIBIT 1) should provide a lift to European and emerging markets growth, while the fading drag from inventory drawdowns should allow the U.S. manufacturing sector to gradually come back online. Labor markets should continue to tighten, pushing wages higher and providing support for the consumer.
Improvement in manufacturing activity should give a boost to European and emerging markets growth
EXHIBIT 1: GLOBAL PMI FOR MANUFACTURING AND SERVICES
In aggregate, this should lead to an environment of moderate economic growth. The risk is that corporate profitability decelerates more sharply than we expect. S&P 500 profits look to have risen by about 5% in 2019, and we currently forecast low to mid single digit growth in 2020. However, that outcome will depend on what happens to profit margins. From a peak of 12.1% in 3Q18, operating margins fell to around 11.3% at the end of last year. If profit margins settle at 11% for 2020, earnings growth should be around 3%, but if they deteriorate below 11%, earnings growth will start to approach zero. And waning profitability could encourage companies to slow their pace of hiring, putting pressure on the consumer and therefore on the outlook for GDP growth.
Inflation and monetary policy
Moderate economic growth would suggest limited risk of a significant pickup in inflation. Wage growth is not likely to accelerate meaningfully, and energy prices look set to remain range-bound. Beyond these cyclical factors, there are also structural forces at work. Little if any inflation in physical goods should keep a lid on overall inflation going forward; at the same time, aggregate demand is likely to remain soft, as the gains from capital markets and wages over the course of the cycle have accrued to wealthier individuals, who tend to spend less of their disposable income than those in lower income brackets. The bottom line: The pace of inflation should remain relatively steady.
Against this backdrop, policymakers will stand ready to act if the economic data begins to show signs of deterioration. With its mid cycle adjustment complete, the Federal Reserve (Fed) has said that policy will remain data dependent, while the European Central Bank (ECB) has stated that it is ready, willing and able to act if necessary. It is unclear what will come next from the Bank of Japan (BoJ), but a recently approved fiscal package should provide a lift to the Japanese economy in 2020. At the end of the day, accommodative global monetary policy looks set to continue providing support for the broader expansion.
In sum, 2020 looks to be a year of moderate growth, contained inflation and accommodative policy. While the potential for a further deterioration in corporate profitability presents a risk to this view, a recession over the next 12 months is not our base case. But we may well see more of the geopolitical shocks that have buffeted the economy over the past 24 months, particularly with a U.S. presidential election on the horizon.
In this delicate investing environment, we look to mute portfolio volatility through a focus on quality companies and strategies that generate robust streams of income without adding to a portfolio’s equity risk. Investors who take this approach, we believe, can be well positioned to capture any upside in risk assets in a way that allows for a more comfortable ride. There will come a time to turn more defensive, but we have not yet reached that juncture—from where we sit, markets still have room to run.