Recession inevitable

Matthew Peter, Chief Economist

Slowing rates of economic growth in the second half of 2018, a correction in equity markets, falling earnings expectations, a spike in volatility, a blow out in credit spreads, an inverting US yield curve, fed funds futures priced for a Fed rate cut, trade wars, US government shutdown, Brexit, European populism and the extended length of the current economic cycle has pushed many commentators to expect the onset of an economic recession. Recession seems inevitable.

A key concern is the drop in global manufacturing, with the JP Morgan Global Manufacturing PMI dipping to 51.5 from a recent high point of 54.4 at the start of the year and just below its long-term average of 53.7. Nonetheless, the measure continues to signal expansion in the sector, albeit at a slower pace than over 2017 and the first half of 2018. The manufacturing slowdown is also broadly based across countries. However, the US, the euro area (including Germany) and Japan continue to post levels above 50 (i.e., expansion in the sector), with only China (of the majors) slipping below 50 (i.e., contraction).

The slowdown has been reflected in the real economy data with the annual rate of growth in global industrial production (ex-construction) falling from around 4.0% at the start of the year, to 2.7% in November; around its post 2011 average of 2.6%, on a three-month moving average. As is typical, the slowdown in global manufacturing has been associated with a slowdown in global trade. Annual growth in global merchandise trade has slowed from its high point early in 2018 of just above 5% to just below 4% in November, on a three-month moving average.

Financial markets have also deteriorated sharply since September. The MSCI World (local return) equity index is down around 11% from its September high point, having flirted with a bear market at the end of 2018, US investment grade corporate credit spreads have blown out by around 40 basis points (bps) and high yield spreads have risen by 140bps. Precipitating the sell-off in equities was sharp climb in interest rates as the Fed raised the fed funds rate by ½ percentage point (ppt) by mid-year signalling (and executing) a further ½ ppt increase in the second half of 2018, in addition to a reduction in the Fed’s balance sheet that was on automatic pilot.

The slowdown in global manufacturing and trade has two possible sources: (i) the impact of US/China tariffs and (ii) the impact of the drop in oil prices. If either of these two catalysts stabilise then the growth rate in global manufacturing and trade will stabilise. The New Year has seen the twin developments of a recovery in oil prices and a US/China cease fire on tariffs. Saudi Arabia (and OPEC) appear to be driving the price of oil back towards US$90/bbl and the prospects for an agreement between the US and China look promising. If these two problems resolve, much of the ongoing downward pressure on global manufacturing and trade will abate. Perhaps more important to the health of the global economy is the health of the global consumer. Here, the news has been mostly positive, with growth in real consumer spending holding up well in the US, euro area, the UK and China, supported by improved balance sheets and robust labour markets.

What of financial markets? In our view, the current correction in equity markets is a welcome reassessment of risk and its impact on the real economy via wealth effects and higher earnings yields is not large enough to undermine consumer spending and investment. However, the risk of an overshoot in equity and credit markets is clearly present. Yet, recent events indicate that central banks still have the ability to stabilise asset markets with both the Fed and the Peoples Bank of China stepping in to quell market fears.

A greater risk is a significant earnings disappointment. Currently, the market is factoring in earnings growth of around 7% over 2019, down from a projected growth rate of around 22% in 2018. Our current forecast for 2019 economy-wide corporate profits growth is 6%, not too distant from S&P 500 forward earnings estimates. The forecast is based on average annual wage growth of 3.3%, growth in nominal unit labour costs of 1.5% and growth in sales revenue of 4.4% (in line with nominal GDP growth). Therefore, we do not anticipate a sharp disappointment to expected earnings.

Global recession is not inevitable. Underlying fundamentals remain healthy and policy makers still have the power to calm investor fears and help limit market volatility. However, risks are rising. Trade wars, Brexit and another bout of financial market pessimism could tip us over the edge.

Table 1: Financial market movements, 3 – 10 January 2019

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,596.6

6.1%

US

2.74%

18.9 bps

US Dollar Index (DXY)

95.54

-0.8%

Nikkei 225

20,163.8

0.7%

Japan

0.02%

2.1 bps

USD-JPY

108.43

0.7%

FTSE 100

6,942.9

3.7%

UK

1.27%

8.0 bps

GBP-USD

1.275

0.9%

DAX

10,921.6

4.8%

Germany

0.26%

10.2 bps

EUR-USD

1.150

0.9%

S&P/ASX 200

5,795.3

2.9%

Australia

2.32%

14.2 bps

AUD-USD

0.719

2.6%

Source: Bloomberg

 

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