This week, following previous downgrades in November, the Organisation for Economic Co-ordination and Development (OECD) revised its forecasts for global growth for 2019 and 2020, highlighting trade disputes and Brexit uncertainty as key factors further reducing G20 global growth prospects. It’s most recent forecast now pins global growth at 3.3% in 2019 and 3.4% in 2020, down from 3.5% in both years. The organisation cited ‘high political uncertainty, ongoing trade tensions and a further erosion of business and consumer confidence’ as key contributors to the slowdown, highlighting the UK and Italy as areas at risk of recession.
Given increasingly weak Chinese trade data, it would be easy to portray China as the epicentre of the global growth slowdown, however in recent weeks, weaknesses have been exposed in key global economies, culminating in the OECD’s downgrades this week. Eurozone economies are becoming increasingly impacted by weaker trading conditions and Brexit uncertainty, with the OECD cutting its German GDP growth forecast to 0.7% from 1.6% as the export-driven economy struggles to deal with lower global demand. In the US, falling personal income and low consumer spending are likely to result in lower growth for the US economy in Q1 2019.
The economic data released over the first two months of the year confirms that the actual story is much more than just a China slowdown. The largest contributors to this slowdown appear to be weaker import growth in non-China Emerging Markets, deceleration in the Eurozone and downturns in key sectors such as electronics. With global growth looking to be weak for most of the year, a decline in markets is becoming increasingly likely.
The slowdown in world trade
Back in December, we saw an escalation of downside risks to global growth which confirmed our thesis that a sharp slowdown in global trade is likely to occur within the first half of 2019. It is our view that the impact of this slowdown is still feeding through the system, with more negative data yet to come. The below chart shows the reduction in world trade to date, with trade declining sharply towards the end of 2018. Given the extent of the slowdown, import growth could turn negative in the coming months.
- The impact of Emerging Markets
When we look at the composition of this reduction in world trade, we see the impact that non-China emerging markets (EM) have had in this slowdown. Their impact on reducing global growth is almost double that of China’s. As a high proportion of EM debt is denominated in US dollars and with most EM economies being commodity driven, the slowdown in EM comes broadly as a result of rising US rates, a stronger dollar and falling commodity prices. A broader slowdown in EM import growth may be under way, however Fed easing has somewhat reduced pressure on EM economies in recent weeks.
- European Deceleration
The European economy has struggled since the start of 2018 as domestic factory orders slowed and retail sales growth halved from a mid-2017 peak. At the same time, exports declined, resulting in slower import growth. As a result, as the global economy continues to slow, there are significant weaknesses emerging in the European economy. Earlier today, the European Central Bank downgraded growth expectations for the Eurozone from 1.7% to 1.1%, and announced stimulus in the form of TLTRO’s (cheap loans to banks) in an attempt to stem the weakness in the bloc.
When we look at the impact of the deceleration in Europe on GDP, it is clear that this factor has had a significant impact on reducing global growth. Europe’s import growth peaked in Q3 2017 when it contributed 1.5% of world trade growth which was around 6% year on year. This contribution had shrank by two thirds by Q3 2018, therefore Europe’s contribution to the slowdown is roughly similar to China’s.
- China’s Slowdown
In China, policy tightening in 2018 resulted in decelerating growth across a number of sectors. Policy is now becoming more accommodative, however there is typically a 6-month lag before stimulus begins to take effect. At the end of 2018, Chinese import growth was at its weakest point since early 2015, however in comparison to the 2015 slowdown which was linked to domestic weakness in China, the recent slowdown is largely a result of the impact of US trade tariffs. This can be seen in the below chart which shows the sectors hit by the slowdown, with high tariff imports such as electronics seeing the largest reduction. Larger import tariff items have declined by around 60% year on year, while for those with 10% tariffs, imports have declined by around 10%.
As weaker trading conditions begin to feed through into Chinese company earnings, another cause for concern in the Chinese economy is the recent surge in bond defaults, as slower economic growth and a low appetite for corporate bailouts resulted in $17.8billion in defaulted domestic bonds last year. With a c. 6 month lag on stimulus feeding through into corporates, the default rate is likely to increase further in the first half of 2019 as a result of slower growth.
- US Policy
US policy has been supportive of global growth over the last two years, however the positive impact of US fiscal stimulus peaked in Q4 2018 and now is beginning to wear off, exposing weakness in the US economy. In the meantime, rate hikes and the Fed’s balance sheet reduction have contributed to a reduction in global growth.
What this means
While it is easy to paint a picture of weaker growth in China causing a global trade slowdown, it is clear that a combination of factors have created the lower global growth environment we are now experiencing, and therefore it is unlikely that there is one factor or one catalyst which would reverse the trade slowdown. When we look at the global economy, we see that while a trade deal between the US and China would reduce tariff-related problems, there is significant weakness elsewhere in the global economy which would persist, with the extent of the impact of the trade tensions over the first quarter of the year still yet to be seen. Based on the current data, we see further weakening in Europe, continued weakness in the emerging market economies and less supportive US fiscal stimulus on the horizon, which supports our expectations for a decline in markets. It is clear that economic weakness is widespread, with significant risks to equity markets which are not confined to one factor which could be reversed and change our thesis.
Is there further Equity Market Upside?
Given the current risks, despite recent resilience in markets, we would need some surprisingly good news to boost valuations substantially higher, with markets already pricing in good news such as a trade deal between the US and China, no further tightening from the Fed this year and TLTROs from the ECB, however with details still yet to surface on the trade agreement, continued Brexit uncertainty and further guidance expected from the Fed later this month, there is a potential for negative shocks. Additionally, investors are becoming increasingly wary of a potential drop back in markets, with equity valuations remaining elevated following the equity rally in the first months of the year against a backdrop of significantly slower earnings growth. According to Goldman Sachs Group, this year’s gap between equity performance and fund flows in near the widest since the financial crisis, with the proportion of assets being rotated from equities to cash around the highest since 2009. This calls into question the sustainability of the rally, with caution suggesting a turnaround in sentiment.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline this half. Overall, global indices rallied over the week on optimism over a US-China trade agreement, alongside favourable currency movements. The exception to this were US markets, which declined as a result of weaker economic data. Following a challenging week, the OBI portfolios performed consistently, ending the week relatively flat.
When we look at portfolio performance over the last month, it puts our current strategy into context, with lower volatility for consistent performance in comparison to the benchmark as we await a drop back in markets. This is largely the result of the high level of diversification within portfolios, and illustrates that the market rally was relatively confined to January.
Overall, while we know missing out on the gains from January is painful, we continue to see significant risks ahead in equity markets, with investor sentiment tilting towards the downside and risk off sentiment spreading as risks intensify. The economic data continues to support our expectation for a drop back in markets in H1, therefore we remain defensively positioned going forward. It takes time for the data to feed through structurally, therefore as we wait for the data to feed through into markets, we are expecting volatile market conditions to continue, however it is key to bear in mind that the scenario will take time to play out. We must view intra week market fluctuations in the context of longer-term market trends and stay content in the knowledge that portfolios are protected from the excessive risks in markets.