QUARTERLY INVESTMENT STRATEGY: MORE OF THE SAME IN 2016
Economic cycles do not generally tend to follow calendar years, but an annual outlook is always a good opportunity to review and reassess current convictions and positioning. Our base case as we turn to 2016 is that the current cycle – with its subdued but stable growth, mainly tertiary engines, weakening world trade and form of globalisation “reversal” – has sufficient stamina to continue for another year. Wreaking havoc, on the upside or the downside, could be a marked change in the US dollar (USD) and oil price complex.
Already four years old, the current economic and financial cycle is actually much more advanced than the on-going debate on the US interest rate trajectory would suggest.
Its asynchronous nature and subdued pace are also relatively atypical by historical standards. A year ago, in this same publication, we attempted to gauge potential growth levels for each of the major economies, concluding that a paradigm shift to durably slower global growth is underway, with far-ranging implications. Constraining the world economy are mostly structural, but also certain cyclical, factors. We wrote in particular about poor demographic and productivity trends (both being essential components of an economy’s potential growth rate), as well as headwinds from persistent excess capacity and leverage. Two additional factors emerged in 2015: China’s economic transformation, which has admittedly been underway for some time but really began to hurt global growth during the past year, and US dollar strength, which pressured economic and financial conditions in emerging markets – revealing their own imbalances, most notably mounting private debt.
Going forward, we continue to see the world economy growing at a 2.5-3.0% pace, below consensus and International Monetary Fund (IMF) forecasts (each in excess of 3.0%) but still above potential growth that we would put around 2.0%. The US should also extend its 6-year cycle of 2.0-2.5% growth in 2016. Our forecast is 2.1%, below consensus but above potential. We expect Eurozone growth to level off around 1.5%, again below consensus but above potential, while China should pursue its slow adjustment (we forecast growth of 6.3% versus 6.5% for the consensus but 5.0% potential).
The second characteristic of the current economic cycle is that it is mainly driven by tertiary sector activity (services and domestic consumption), across both the developed and emerging spectrum. Manufacturing and industrial sectors have fallen prey to the secular adjustment of the commodity complex, with low prices hurting the production of energy goods.
As services are not included in merchandise trade figures, the current cycle is also marked by much lower global trade growth, particularly when compared to prior cycles. This slowdown appears rooted more in structural issues than in global demand weakness. The downward multiplier has only been amplified by nations striving to secure their energy independence, amid momentous geopolitical reshuffling. The slump in oil prices is clearly having a large impact on world trade, in that it has radically altered the distribution of global imbalances.
Last but not least, in tune with slowing trade, the decade-long globalisation wave has come to an end. Even under stable world growth conditions, exports from emerging economies are low relative to historical standards – resulting in a slowdown in investment, technology and knowledge flows, as well as gains from specialisation, in turn hampering productivity growth. The growth differential between emerging and developed economies is thus likely to continue its, already well advanced, path towards normalisation.
While we attribute a 60% probability to the just described base case scenario, we cannot rule out a more positive or more negative outcome, each being equally probable (20%), depending on developments in the US dollar and commodity complex.
The high degree of synchronisation observed since the 1990s between the US dollar and the commodity cycle is closely associated with the growing economic influence of China. The 2000-2010 decade was one of weak dollar and rising commodities prices, inducing an investment boom in emerging (commodity-producing) countries. In more recent years, the situation has been one of a strong greenback and falling commodity prices, returning growth leadership to western (commodity-consuming) economies and creating the conditions for extended deflation in global product markets.
Should the climax of this USD/commodity shock be at hand and it then proceed to fade during the course of 2016, world output and trade growth would recover to some degree – as necessary adjustments to spending in the producer world diminish. On the other hand, in the event the USD/commodity shock intensifies, defaults in the production sphere are likely to materialise, with the risk of breaking the current cycle and causing global growth to fall into recession, led by China and the US.
At this point, and to conclude, economic and financial indicators suggest that 2016 growth will be broadly in line with that of the past few years, supported by the resilience of western demand and a degree of stabilisation in industrial output, but also still undermined by structural adjustments in emerging economies. While low rates of inflation are a concern for certain economies, the world as a whole is not at risk of deflation since much of the downward pressure on prices is still coming from falling commodity prices. It is what can be called “good” disinflation, in that it lifts consumers’ real income.
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