Executive summary

5 minute read

Risks recede – growth on a better trajectory

Having declined for the past 18 months, global growth is expected to reach a low point at the end of 2019, before gradually improving over the course of 2020 (Figure 1).

Figure 1.  Global growth outlook (y/y)

We expect global growth to improve through 2020

While we do not expect growth to rise above potential through 2020, there is a slightly better growth outlook than we had previously expected. That said, in the context of “mid-cycle” growth recoveries, it would be considered modest.

But for asset markets, perhaps more significant than the improvement to the growth outlook is the view that the probability of a severe downturn or recession in 2020 has receded. This reflects a more constructive near-term view on the trade dispute between the United States and China.

At the time of writing, the text of a “Phase 1” deal between the US and China had been agreed by both sides. That included the US cancelling 15 per cent tariffs on about $150bn of Chinese goods that were due on December 15 and halving the tariff rate to 7.5 per cent on goods worth about $120bn which came into effect in September (while tariff of 25 per cent on around $250bn in Chinese imports remains in place). In exchange, the Chinese also cancelled tariffs that were due to be implemented on December 15 and agreed to substantially increase their imports of US agricultural, energy and other goods and services over the next two years, as well as tighten laws on technology transfer and intellectual property rights. 

The agreement of a Phase 1 deal marks the first time that tariff rates have been reduced between the two economies since the dispute began in 2018.

Should this truce persist, it is expected to improve sentiment globally, reversing the sharp slowing in business investment seen across many major economies. It should also prevent the past weakness in the manufacturing sector (which is very sensitive to developments in international trade) spreading more widely into the much larger services sector.

However, as we saw through 2019, any truce in the trade war could prove to be fragile, with the potential for any number of factors related to the geopolitical and economic relationship a potential trigger for re-escalation. Moreover, we continue to expect strategic competition between China and the US will be an important factor in global economic developments for many years to come, irrespective of who occupies the White House.

Alongside the recent de-escalation in trade tensions, there was also a material easing in global financial conditions in 2019 (Figure 2).

Figure 2.  Global financial conditions

Significant easing in conditions in 2019 will support growth in 2020

With the Federal Reserve cutting interest rates by 75bp since July, and many other developed and emerging market central banks also easing policy, monetary conditions are back to their loosest in several years. Broader financial conditions have eased even more, with the decline in interest rate term premia, tightening in credit spreads and the rally in equity markets.

That easing in financial conditions should boost global growth by around ¼-½ of a percentage point in 2020, offsetting some of the effect of the increase in tariffs during 2019.

When taken alongside the smaller negative direct effect of tariffs on growth and the expected improvement in sentiment from a more positive trajectory (talks are already being scheduled to start discussing Phase 2 of the US/China trade deal), we expect growth to pick up to a little below potential by the end of 2020. 

With growth expected to remain below potential in 2020, inflationary pressures, which have been muted, should also remain contained. That makes it highly unlikely we will see the major central banks tightening policy during 2020. However, the likelihood there will be a further easing in policy is also limited, particularly for those economies that are close to their effective lower bound.

In our central scenario we expect the Federal Reserve and other major central banks will be on hold in 2020, but with growth below potential, inflation below target and the risks remaining tilted to the downside, we expect most will maintain an easing bias. In some jurisdictions, such as Australia and New Zealand, we expect a further reduction in interest rates in 2020.

With growth prospects improving and the downside risks from the trade dispute receding, we have a moderately positive outlook for risk assets in 2020.

Analysis of mid-cycle recoveries (defined as non-recessionary growth slowdowns that subsequently reversed) since the 1990s shows that, on average, equity markets perform strongly in the growth recovery, while government bonds tend to mark time (Figure 3). This likely reflects the improved corporate earnings and sentiment associated with the better growth outlook, and the fact that central banks have not wanted to immediately choke off such a recovery with higher policy rates.

Figure 3.  Equity and bond performance in mid-cycle recoveries

This is similar to the environment we expect to see in 2020, albeit with a somewhat less rapid improvement in growth compared to the historical average. At the asset class level, we prefer to be overweight global equities and (to a lesser extent) credit, with a broadly neutral view on government bonds (Figure 4). 

Figure 4.  Asset allocation summary

In terms of equity markets, while valuations at the broad country index level are generally around or above their long-run average, we see scope for those to move somewhat higher given the high equity risk premia implied by historically low discount rates.

Moreover, equity funds have seen substantial outflows over the course of 2019 (Figure 5), with bond and money market funds seeing significant inflows. Some reversal of this in the early part of 2020, particularly from retail accounts, could be a material catalyst for a move higher in equities.

Figure 5.  Global mutual fund and ETF flows Significant equity fund outflows in 2019 

In terms of fundamentals, we do not expect re-rating to do all the heavy lifting in 2020, with earnings growth expected to improve following a very weak 2019.

Looking across the major regions we prefer to be overweight Japan, which should benefit from both the recent fiscal package and the fact that it remains one of the cheapest markets in the world.

At the more thematic level, we think there are interesting opportunities both in tech and other sectors for businesses that are able to effectively incorporate the use of sophisticated data analytics into their business models. The shift to 5G mobile technology is also likely to produce winners and losers, with those that provide the components and services to telecoms companies arguably in a better position to grow revenues during the roll-out and launch of handsets.

We have a broadly neutral asset allocation view on government bonds. With the balance of risks still tilted to the downside, government bonds should remain an important part of a multi-asset portfolio, given their risk-reducing properties. That said, the sharp decline in yields during 2019 makes valuations challenging in many markets.

We see US Treasury yields as relatively attractive at this stage, with a German bunds at the other end of the spectrum (Figure 6). We also prefer a slight overweight in Italian BTPs, which remain cheap compared to other European government bonds, and given the reduced near-term domestic and European political risk.

Figure 6.  Real 10y government bond yields Real yields calculated using current CPI inflation

We have a broadly neutral view of developed market corporate credit, both high yield and investment grade. In both cases spreads are narrow by historical standards, supported by the relatively benign economic backdrop and easy monetary policy.

Indeed, with the search for yield driven by negative interest rates in Europe, credit has been a major beneficiary in 2019. However, there has been increased differentiation, particularly in high-yield credit, with poorer credits materially underperforming. If growth improves, as we expect, those risks should remain contained, but we do not expect to see much of a tightening in high-yield spreads in 2020.

We prefer to be overweight emerging market debt – both hard and local currency. These asset classes are highly influenced by global factors. A more favourable global growth backdrop, alongside accommodative monetary policy in the US, as well as scope to ease policy further at home, should see decent returns in 2020. 

Finally, we are slightly overweight the US dollar, with a preference for long Japanese yen and short euro and Australian dollar. While the US dollar tends to underperform in an environment of improving global growth – particularly if that results in a narrower growth differential between the US and the rest of the world – we feel the potential for a relapse in geopolitical risks in 2020 favours a slightly more defensive currency allocation.