Despite the widespread pessimism recently fueled by the new low in the U.S. Institute for Supply Management (ISM) manufacturing PMI, a broader look across the world suggests green shoots are starting to sprout and improve the outlook for 2020, contrary to the conventional wisdom. For example, the JPMorgan global composite PMI, which peaked in December of 2017, has risen since July (Exhibit 1). This measure rose throughout 2016 and 2017 and has since retraced all of that rise. Overall, it shows how the third mini-cycle in this ten-year-plus economic expansion has played out in real time.
Uncertainty over the staying power of the expansion has reached a crescendo much as it did in early 2016, when recession fears were rampant after the second mini-cycle fizzled out. Is a new, fourth wave up possible or is the third slowdown going to end in recession? Leading indicators and the overall condition of the global economy suggest to us that a fourth wave higher is more likely.
Exhibit 1: Monetary Tightening Slowed the Global Economy. Easing Is Starting to Turn Things Around.
First, each of the mini-cycles in this expansion has had identifiable drivers of the up and down phases. In the case of the third-wave slowdown tracked in Exhibit 1, the overwhelming force for deceleration was Federal Reserve (Fed) rate hikes and the quantitative tightening which began in 2017. This turned out to be a policy mistake because it created a big deflationary shock that has driven inflation expectations below 1.5% (based on 5-year breakeven inflation rate), a low point last seen at the end of the second-wave slowdown in early 2016, when recession fears were similarly rampant.
The global slowdown that began in early 2018 initially bypassed the U.S. because of fiscal stimulus but also because higher rates and tighter liquidity hit the rest of the world harder than the U.S. That's because U.S. consumers and banks deleveraged during the first few years of this expansion and were therefore less vulnerable to higher rates, while borrowers outside the U.S. took advantage of zero rates to leverage up, making them more vulnerable to tightening U.S. monetary policy. One exception to the relative U.S. immunity to Fed tightening was housing, which became a drag on GDP growth after 2017.
Fortunately, the Fed's reversal of policy has begun to turn the global economy around. Not surprisingly, the areas most impacted by the tightening are starting to show the most response to the easing. A global leading indicator compiled by BCA Research "has started to climb higher signaling a potential end to the current global growth slowdown." Like the global PMI, the BCA leading indicator bottomed in July. The BCA analysis goes on to note that "this improvement is broad-based across countries and regions focused mostly within EM countries (with the U.S. and Germany lagging the global move)." Clearly, lower rates are now helping the parts of the world economy that were most hurt by Fed tightening, especially emerging markets (EMs) that had borrowed a lot of U.S. dollars. While the U.S. is lagging this global turnaround, we would note that housing, which was the U.S. sector most impacted by tight Fed policy, is leading to the upside now and is expected to make a positive contribution to third-quarter U.S. gross domestic product (GDP) growth for the first time since the fourth-quarter of 2017.
The turnaround in the BCA global leading indicator is likely to continue if the past relationship with its diffusion index is any indication. The percentage of countries in the index that are rising has increased from almost none to over 60% in both emerging and developed markets. The diffusion index tends to lead the leading indicator for the next 12 months, consistent with a pickup in global growth over the next year.
All in all, the pattern and timing of the global slowdown is consistent with the notion that the damage the Fed caused is being reversed, and lower interest rates are starting to work their magic.
Every slowdown creates a narrative on why the eventual upturn won't materialize. This time around it's the trade war. Deglobalization began with the 2008 financial crisis. Since then, the ratio of world trade to GDP growth has dropped from 2-to-1 to 1-for-1. There are multiple reasons for this decline, including China's rebalancing to slower, more domestic-led growth, changes in technology and relative prices for shipping and labor, a stronger dollar and, most recently, the increasing use of tariffs and other protectionist policies around the world.
Advances in communications and transportation technologies make the long-run trend toward a more tightly knit global economy inevitable. However, this increased economic interdependence has outstripped the ability of national governments to cope with the rising strains from globalization. The slowdown in trade partly reflects a focus on the tensions between national and global governance, as "Brexit" clearly shows. These tensions are further exacerbated by the fact that China's integration into the global economy has come without a corresponding change in its attitude toward Western values concerning transparency and property rights. China was admitted into the World Trade Organization (WTO) and allowed to enter equity markets without having to meet the same trade rules and accounting standards as everyone else. It is somewhat backward to label calls for a level playing field as being protectionist and anti-trade. On the contrary, abiding by the rules everyone else plays by is the essence of free trade.
China's reluctance to do this has naturally put the trade spotlight on it. The Hong Kong situation also illustrates the inherent contradictions in the current one world, two systems global economy. Elsewhere, progress is being made toward a freer, fairer system, including with Canada, Mexico, Korea, Japan and eventually, we expect, with Europe and the U.K. The implications of China's reluctance to accept Western standards are straightforward. Companies are rerouting their supply chains to avoid these problems. This process is well under way and will necessitate an upswing in capital investment to build out the new, decoupled trading system.
Signs of this transition are everywhere. China is buying from Canada and Australia, for example, to punish the U.S. for tariffs. Maine lobsterman have been hit hard by Chinese tariffs, while Canadian lobster sales to China are booming, according to a recent Wall Street Journal article. In another article, the WSJ notes that "trade has been so buoyant that Australia logged its first current-account surplus…since 1975 in the second-quarter of this year." Australia ships about a third of its exports to China. "Those exports are in demand as Beijing accelerates construction spending to head off damage caused by Washington raising tariffs." Rather than reducing trade, the new attitude toward China's commercial tactics is to reroute trade and supply chains. That's why despite all the talk about trade damage, the reality is more similar to the trade dynamics in the 2012 and 2016 mini-cycle slowdowns rather than something much worse. The main impact of the trade war is on the longer-term perspective that businesses have about Chinese investment. That changed perspective is likely to fundamentally alter the patterns of global trade in the future. Nevertheless, business will go on, and leading indicators suggest it will pick up in 2020.
U.S.-China trade negotiations are set to resume this Thursday, ahead of a postponed U.S. tariff hike to 30% on $250 billion of Chinese exports next week. Since the 2016 presidential election and the initial imposition of tariffs by the U.S. administration on its trading partners in early 2018, global investors have retreated from EMs with each introduction of new trade restrictions. On only three occasions over the past two years have net portfolio capital flows into EM equities turned negative on a sustained basis, and each has coincided with a major escalation in trade frictions (Exhibit 2). Most recently, the announced tariff increase from 10% to 25% on $200 billion of Chinese imports this past May pushed the early-2019 rise in net inflows into reverse. And portfolio capital has continued to leave EM equities with the subsequent application of tariffs to virtually all remaining Chinese imports.
Exhibit 2: Investor Flows Into Emerging Markets and Escalating Trade Frictions.
Alongside China itself, the emerging countries most directly exposed to the rise in trade frictions, and the corresponding weakness in both actual and planned capital expenditure, have been the other north Asian markets of Korea and Taiwan. As we have shown in the past, these markets are the biggest global contributors as a share of GDP to value added in Chinese exports to the U.S. And they are also among the most manufacturing-oriented economies within the emerging world. For Korea specifically, manufacturing activity has been further undermined by the ongoing trade dispute with Japan. The two countries have imposed reciprocal curbs on exports of key industrial production inputs, and new boycotts of Japanese products by Korean consumers do not suggest that any resolution is imminent. Correspondingly, the manufacturing PMI for emerging markets remains subdued, with the three north Asian markets below the EM average in contraction territory. And over recent months, the new orders component of the index has been particularly weak alongside the resurfacing of U.S.-China tensions in May.
Company reports from global exporters operating in China within industries such as textiles and consumer electronics have also identified U.S.-China tariffs as a major reason for recent moves to relocate production capacity away from the mainland. This is a trend that was already underway before the start of the trade war, due in part to rising labor costs and tightening environmental standards. But it has accelerated as the conflict has progressed and is likely to persist, especially if the conclusion of this week's talks leaves room for tariffs or non-tariff barriers to rise further in the future.
Other emerging economies in the region will be among those to benefit from further supply chain relocation. Global manufacturers have highlighted a range of markets as preferred destinations, including those in southeast Asia, and this has been evident in the pattern of regional exports to the U.S. over the past 12 months. Chinese manufacturing exports to the U.S. have contracted by 12.0% on a year-on-year basis, while exports to the U.S. from the five largest emerging economies in southeast Asia (Indonesia, Thailand, Philippines, Malaysia and Vietnam) have risen by 13.5% (Exhibit 3).
Exhibit 3: Asia Manufacturing Exports to the U.S. Have Diverged as Trade Frictions Have Risen.
For investors in EM equities however, the impact of this shift is likely to remain a net negative given the underrepresentation of southeast Asian markets and the large weighting of north Asia in public market benchmarks. China alone commands a 32% weight in the MSCI index, well in excess of the combined 8% weight for southeast Asia. And north Asia as a whole (including Korea and Taiwan) accounts for the majority (56%) of total EM capitalization (Exhibit 4). The outlook for these three north Asian markets is therefore critical to the return prospects for emerging markets as a group. And for this reason, the likelihood that no comprehensive agreement is reached in this latest round of trade talks reinforces our current tactical bias away from EMs.
Exhibit 4: Emerging Equity Market Capitalization Highly Concentrated in North Asia.
We would nonetheless highlight individual segments within the broad market where returns have improved this year after the across-the-board weakness of 2018, and which should continue to outpace the rest of the market while the global economy is growing. Specifically, information technology and consumer discretionary have been by far the top performers in EMs over the course of the year so far, in line with the trend established since the start of the economic expansion. Both sectors are tied to the rapid growth in consumer spending (both online and offline) within the emerging world, and we expect this underlying trend to continue through the current trade standoff. Along with the new communication services group (which includes the large Chinese and Korean internet companies), we would expect these to remain the key sectors for growth as the economic expansion continues.
For consumer discretionary in particular, rate-sensitive sub-industries such as autos and household durables should receive a further lift from the turn toward more accommodative monetary policy in Asia. There was a net total of 15 central bank rate increases across the region last year for a cumulative 475 basis points (bps) of tightening, which contributed to the extreme weakness in the sector (consumer discretionary was the single worst EM performer in 2018). But across Asia, central banks are now in easing mode and have reversed the majority (335 bps) of last year's rate hikes. Indeed the degree of monetary easing in EM Asia during the third quarter was the most in the region since 2009 (Exhibit 5).
Exhibit 5: Central Banks in Emerging Asia Have Eased Aggressively Over Recent Months.
Policy support is therefore acting as a catalyst for cyclical improvement in EM consumer stocks, but both consumer discretionary and technology remain fundamentally geared toward the growing consumer class, as well as the expanding emerging world digital economy in areas such as cloud computing, internet retail, social media and online gaming. These themes have been sector tailwinds throughout the cycle and remain intact. But for EM investor flows, capital expenditure, exports and ultimately the broader equity market, tactical risk remains from potential further escalation in trade restrictions. As we have seen over the past two years, these have episodically given way to portfolio capital outflows and weaker returns for EM overall; and this is unlikely to change after the upcoming U.S.-China talks. Though we continue to see underlying supports for growth-oriented sectors within the emerging world (both from the structural shift toward consumption and digitization and from recent monetary stimulus), we therefore remain more cautious for now on the EM equity complex as a whole.
Between lower oil prices, a strong dollar, a weak global auto market and the twists and turns in U.S.-China trade negotiations, the manufacturing sector in the U.S. has been hit from all angles over the past year. We believe one of the key reasons why the U.S. economy has outperformed its global peers over the past year has been its reliance on the services sector, making services-related activity all the more important to the economic outlook as manufacturing continues to falter.
On the heels of the weakest ISM manufacturing PMI reading since 2009, the nonmanufacturing index fell to 52.6 in September, led by a drop in new orders and business activity, and the weakest employment reading since 2014.
While demand will likely remain under pressure, consensus earnings expectations within services industries are holding up far better than goods-producers, and have been a good place for investors to position their portfolios over the past year as global growth has slowed down (Exhibit 6). Higher and more stable inflation in the services sector (+2.3% versus -0.5%) should remain a tailwind for revenue growth, and helps explain why service providers have more stable margins than goods producers, adding an additional buffer to earnings. This will be key if global economic conditions don't start to improve on a more consistent basis and is worth watching.
As manufacturing activity remains under pressure, the outlook for the services economy will be right near the top of our watchlist heading into 2020. While not our base case, continued weakness in the sector could begin to call the U.S.-consumer-driven growth story into question, since services account for 84% of private employment in the U.S. According to the ISM report, a 52.6 reading on the nonmanufacturing index is consistent with real GDP growth of just 1.4%. But for now, we maintain a preference for equities over bonds, especially high-quality U.S. large caps, and believe considering selective exposure to services can help investors manage risk in their portfolios as concerns over tariffs and manufacturing remain front and center.
Exhibit 6: Earnings for Services Industries Holding Up Better Than Goods.
Note: Data represent the Goldman Sachs S&P 500 Services and S&P 500 Goods indexes. *Consensus Earnings per Share (weekly data). Sources: FactSet; Bloomberg. Data as of October 2, 2019.