The US has reignited geopolitical tensions with Iran, even as the trade war with China goes on. While there are signs of a broader global economic recovery, central banks have little room to manoeuvre if growth stalls again.
SINGAPORE (Jan 10): About a year or two ago, market observers were predicting that a global recession was just around the corner. This was due to the fact that the US, the world’s largest economy, was in the late phase of the economic cycle. Coupled with the heightening trade friction between the US and China, the chances of the global economy going south were high.
As a result, some market observers warned that a global recession could hit us as soon as this year. Others reckoned that a global recession could happen next year, though there were a handful who were convinced that this might occur later, in 2022.
But given certain positive developments in the last few months, it now appears that a recession could be averted or at least delayed. Market observers are confident that the global economy could continue expanding this year, albeit slower, despite the risks and uncertainties.
This optimism is partly driven by the continued strength of the US economy, underpinned by consumption. “While the industrial sector has gone into recession, its diminished importance to overall GDP and the continued resilience of the US consumer means we expect a soft landing for the global economy in 2020,” Romain Boscher, Fidelity International global chief investment officer, wrote in a 2020 Asean outlook report.
Jeff Schulze, investment strategist at ClearBridge Investments, shares a similar view. “While we expect the contraction of the manufacturing sector to marginally worsen due to the ongoing trade tensions, the consumer side of the economy should remain strong enough to avert recession,” he wrote in a Jan 8 commentary.
The progressive resolution of trade tensions between the US and China – which is obviously positive for global trade – is also driving optimism. US President Donald Trump announced last year that he will sign the first phase of a trade deal with China on Jan 15. Under the deal, China will commit to buy US$200 billion ($270 billion) in US goods, including at least US$40 billion in agricultural products. In return, the US will begin to remove some of the tariffs it has levied on Chinese imports.
“A US-China partial trade deal should be sufficient to reduce uncertainty and reignite a modest recovery in capital spending and trade,” Maybank Kim Eng economists Chua Hak Bin, Lee Ju Ye and Linda Liu wrote in their 2020 outlook report.
On the other hand, KGI Securities warns that the Phase One deal does not signal the end of the trade war. “The Phase Two trade negotiations will be much tougher. Trade tensions have spilled over into the technology sector, and it’s going to be a long and bumpy road. Besides, we think that the next battlefield could be the finance sector as China is opening up its capital market in 2020,” stated KGI Securities in its Jan 9 report.
In any case, the major central banks around the world have become accommodative in the second half of 2019. The US Federal Reserveslashed the Fed fund rates by a cumulative 75 basis points (bps) to between 1.5% and 1.75%. The European Central Bank (ECB) cut its deposit rate by 10 bps to a record low of negative 0.5%. Also, in November, the ECB restarted its bond purchases at a rate of 20 billion euros ($30 billion) a month. Meanwhile, the People’s Bank of China reduced its loan prime rate by 5 bps to 4.15%. This low interest rate environment should in theory provide a cheaper cost of capital that will spur economic activity.
As such, the International Monetary Fund has projected the global economy to grow 3.4% in 2020, up from 3.0% in 2019. Nomura is less bullish, forecasting world GDP to “hold steady” at 3.1% this year. In Singapore, DBS Group Research has forecast the local economy to expand 1.4% in 2020, compared to the 2019 growth of 0.7% in the Ministry of Trade and Industry flash estimates.
This positive outlook helped to lift equity markets to their respective year-end highs in 2019. The MSCI All-Country World Index was up 25.5%. In the US and Europe, the S&P 500 and MSCI Europe indices surged 29.7% and 21.7%, respectively. Japan’s Nikkei 225 and Hong Kong’s Hang Seng index climbed 22.9% and 12.2%, respectively. Similarly, the Straits Times Index gained 6.1%.
Wilful and reckless Trump
That said, the global economy could face several challenges. For one, geopolitical concerns have spiked early this year. On Jan 3, the US authorised a drone strike that killed Iran’s top security and intelligence commander at Baghdad International Airport. In retaliation, Iran fired a series of rockets at two US-Iraqi airbases five days later. At press-time, there was some rhetoric of de-escalation, but Trump was seen by many commentators to have crossed a line with the brazen assassination of a top foreign leader in another country.
“What most of the American public and much of the American political elite fail to comprehend is that the US has committed far more crimes against Iran than vice versa. The US has wilfully and recklessly created an enemy for no reason other than its own misguided actions,” says Columbia University professor Jeffrey Sachs.
Investors sought safe-haven assets in response. Gold prices surged to breach the US$1,600 an ounce level – the first time since 2013. Crude oil prices have also rallied given Iran’s status as a major oil producer and member of the Organization of Petroleum Exporting Countries. The Brent and West Texas Intermediate crudes were up as much as 4% and 3.4%, respectively, on Jan 6 compared to the start of the year. However, both crudes have since retraced those gains and fallen below their prices at the start of the year. Equity markets turned red across the board on Jan 6, but have since rebounded.
The impeachment of Trump could also bear a negative impact on the US economy and stock market, and reverberate across the globe. Charges against him have already been brought to the US House of Representatives and passed in a vote along party lines. A US Senate trial will be held this month to vote on whether Trump should be removed from the Oval Office.
So is the optimism reflected by market observers misplaced, given the increasing geopolitical concerns? Or is a global recession still on the cards as previously warned?
Consumption steady, industrial production bottomed
Ray Farris, Credit Suisse chief investment officer for South Asia, says he expects global industrial production to have bottomed out in 4Q last year. He also expects “some degree of recovery” to be seen in the beginning of 2020, though industrial growth will still be below trend for the longer term. This is because the demand for global goods from countries excluding China continues to outpace global industrial production.
According to Farris, US consumption, and to some extent investment, have continued to “trudge” higher. This is an improvement compared to them being “stalled” for the past six months, he says. This is important as the improvement in global industrial production will drive asset markets, which is less so for services or GDP, he explains. “We just had a very good Black Friday,” he said at a recent briefing.
Farris stresses that at some point in time, factories will have to produce more to meet increasing demand. “A lot of what is happening is the continuation of decent growth, and [this] is going to force businesses to resume a faster pace of production going into next year,” he says.
At the same time, consumption will remain strong as it will be supported by robust labour markets. According to Farris, unemployment rates in the US and the EU have been on a downtrend in the last few years, while wage growth in both regions has been on an uptrend. “So household incomes are growing. That is supporting consumption and ultimately businesses have to produce to meet consumption,” he says.
In addition, US new home sales skyrocketed in 2019, owing to lower mortgage rates, which fell by over 100 bps last year. The lower mortgage rates were the result of lower interest rates, notes Farris. “For the US, and in a sense the global economy, this is crucial because housing is much more important for the US than exports. This is just a much larger sector,” he says. “It is going to help the US economy grow.”
Fiscal stimulus to kick in
Still, lower interest rates across the globe alone will not be enough to deter a global recession. Evan Brown, head of multi-asset strategy at UBS Asset Management, says the major central banks have little to no ammunition left to further reduce interest rates. For example, each time the US had avoided a recession, the Fed had to cut an average of 550 bps, he notes. With US interest rates at 1.5% to 1.75%, “there is simply not enough room”, he says. In short, monetary policies in the form of quantitative easing (QE) are “not offering the same power that it had”, says Brown.
Instead, fiscal policy – together with easier monetary policy – will be crucial to engineer a soft landing for the global economy. Brown points out that fiscal stimulus has a direct impact on the economy, unlike monetary policy which is more dispersed. He notes that former ECB president Mario Draghi had pushed for fiscal policymakers to do their part and this was echoed by his successor Christine Lagarde.
“Central bankers are worried that they don’t have enough space to cut interest rates. It [economic impact] will have to come from fiscal [stimulus],” he says. “What is going to happen is [that] monetary policymakers will cut interest rates a little bit, engage QE and then they’ll turn to governments and say that: ‘We’ve done our part.’”
To that end, Brown believes that fiscal policymakers, who are essentially elected officials, will respond positively. This is because elected officials are incentivised to keep the economy above water in their aim to stay elected. “Elected officials will have a choice – let their economies stagnate and get thrown out of office, or really engage in aggressively in fiscal stimulus to make the sure the economies are steered out of a recession. And given that we believe in incentives, we think elected officials will engage in fiscal policy,” he says.
‘Game of Thrones’
While production and consumption could improve, on top of monetary and fiscal stimulus, trade – a real and tangible economic activity – remains at risk. DBS Group Research reckons that the next phase of negotiation between the US and China will be challenging as it involves the discussion of “thornier issues”, such as state subsidies for enterprises. Moreover, the rollback in tariffs may backpedal in future should the US accuse China of not fulfilling the terms of the deal, it adds.
Tommy Xie, head of Greater China research at OCBC Bank, sees the path towards a complete deal to be challenging. This is because there is an “understanding gap” between both countries. For a complete truce to happen, he notes that the “language” in the agreement needs to be equitable to both sides. “Do you know why the deal broke in May last year? It is because the US tried to force China to change the law. But the US knew that China did not want to change,” he said at the OCBC Premier Private Client Investment Seminar on Jan 7.
Phase One, at best, is a good compromise. Just like the final conclusion of the fight for the Iron Throne in “Game of Thrones”, no one is really happy, says Xie. “I think this sentence [best describes] the US-China situation. We now have the Phase One deal. [But when] I talk to my friends in China, no one is happy because they think a deal is not good for China,” he says. “It is a face-saving deal.”
The US-Iran tensions could also send shocks to the global economy and financial markets. Jeffrey Halley, senior market analyst at Oanda for Asia Pacific, warns that prices of crude oil and precious metals will continue to climb higher. Equities will also take a hit, especially in imported energy-dependent Asia, he adds. “The chances of a significant top-side squeeze in oil prices have risen dramatically,” he wrote in an emailed commentary on Jan 8.
Fitch Ratings says it expects attacks between the US and Iran to continue. But it reckons that this will be carried out at a level “carefully calibrated” to avoid forcing the other side into full-scale military action. “We believe that both the US and Iran will look to avoid a full-scale military confrontation.
Such an outcome would carry a huge cost for Iran, given that its economy is already struggling and that the US has overwhelming military superiority. On the US side, it would be a politically risky tactic for Trump in an election year. Nonetheless, both the Iranian and the US positions are fluid and hard to predict, and miscalculations could lead to a spiral of provocations, making attacks harder to escape,” said Fitch in a Jan 7 commentary.
Fitch says in the absence of an all-out conflict, the upside risks for global oil prices will be limited. This is because the market looks well-supplied in view of continued production growth in the US, Brazil and Norway, it explains. This is addition to a “sluggish” global economic growth, it adds.
However, in the case of “more destabilising outcomes”, Fitch says a “serious” disruption to global oil and gas supplies, including through the Strait of Hormuz, could occur. “Such scenarios are likely to result in a substantial increase in global oil prices and could trigger a significant loss of export receipts for sovereigns in the Gulf region, although Oman’s export infrastructure is geographically less vulnerable,” it says.
What about US politics? Assuming Trump survives the impeachment process, and does not win a re-election, Eli Lee, head of investment strategy at Bank of Singapore, says the economic outlook will depend on the Democratic winner. “If it is someone from the left side of the spectrum, be it [Elizabeth] Warren or [Bernie] Sanders, I think it will be worse for the economy. [But] if it is someone like Joe Biden, who is a centrist, then he would be seen as a continuation of the [Barack] Obama legacy,” he said at the OCBC Premier Private Client Investment Seminar on Jan 7.
Still, Lee says he expects Trump to win a re-election. This is because it is “very difficult” for an incumbent US president to lose a re-election, unless the economy slips into a recession. He notes that former presidents George Bush Senior and Jimmy Carter were the only incumbents to lose in a re-election as the US economy was in a recession. “So if Trump had lost I would assume that the economic recovery was derailed. That is a bad thing,” says Lee.
EM equities to shine
So which asset classes could likely outperform in 2020? Luke Barrs, EMEA Head of Fundamental Equity Client Portfolio Management, says Goldman Sachs Asset Management is overall “constructive” on equities. In particular, he sees opportunities in emerging markets (EMs) and Japan as particularly compelling. This is because positive earnings are expected to continue this year, which should continue to drive performance in equities, he says.
“We believe equity valuations remain reasonable and for those companies that are aligned to key secular growth trends, there remains significant long-term potential. In particular, those aligned to three, interlinked mega-trends: Firstly, the exponential acceleration of tech innovation and disruption. Secondly, socio-demographic shifts such as the economic empowerment of women globally and the rise of the millennial consumer. Thirdly, environmental sustainability,” he wrote in an emailed commentary on Jan 9.
DBS also says it favours EM equities over developed market equities. “With macro uncertainties stabilising, we see emerging markets (EM) outperforming developed markets (DM). The one-year price-earnings (PE/one-year) growth ratio is attractive at 0.8 times for both 2020 and 2021 for EM, followed by Asia excluding Japan. EM stocks are just starting to outperform DM while EM currencies are strengthening,” it said in a Jan 6 report.
In particular, DBS prefers the Hong Kong, China and Singapore equity markets. It notes that the CSI300 Index has the lowest PE/one-year growth ratio at 0.8 times. It also notes that the HSCEI has the most attractive 2020 PE of 8.4 times with a high 4% yield. The Hang Seng Index offers a high 3.9% yield and low 2020 P/E of 10.6 times. Singapore has the best 2020 yield of 4.2%, strong 2020 EPS growth of 8.1% and reasonable PE/one-year growth ratio of 1.7 times.
Aurèle Storno, lead portfolio manager at Lombard Odier Investment Managers, however, concedes that a tricky crossroads has emerged given the lower interest rate environment. “We note that emerging debt presently offers the best compromise because it is comparable to corporates from the yield/risk point of view, but offers significantly higher yield that is potentially competitive with equities,” he said in a 2020 outlook report. “However, shifting assets towards credit and emerging debt comes with a correlation risk to risky assets, and a consequent lack of diversification in major market shocks.”
