Shifting the global balance: Emerging markets could be poised to replace the U.S. as the main engine of global growth as current trends normalise

From

Martin Currie, a Legg Mason affiliate manager, present their view on the world economy in 2020.

In the U.S., economic activity has been waning, principally caused by trade tensions with China.  There are “green shoots” in the negotiations, but as the tensions have escalated and tariffs have affected supply chains and product price inflation, the economy has slid closer to recession.

It is likely that the Federal Reserve will continue to provide liquidity to the U.S. dollar, funding markets and cutting interest rates further to stimulate activity, which should boost the economy in 2020. It is also possible that President Trump might seek a large tax cut for middle-income Americans to garner support for his reelection.

This would underpin equity markets, with consumer sectors set to benefit the most.

The U.K. is now looking very likely to exit the European Union at the end of January with a withdrawal deal in place. Brexit certainty should bring with it a relief surge of economic activity, leading to European macroeconomic indicators bottoming out and rebounding, particularly the manufacturing PMIs.

Sectors such as autos, insurance and capital goods could do well as a result. We should also see some better performance from those companies with a U.K. domestic focus, as many are trading at appealing valuations versus their own history. But we do need to see a resurgence in capital investment in Europe to ensure that productivity and corporate earnings rebound to drive stocks higher over the longer term, in our view. Some fiscal stimulus may be required by countries such as Germany, which currently find themselves bogged down in a technical recession.

We expect emerging economies to see stronger domestic growth in 2020 and once more become the main engine of global growth. Yet there are risks in the form of international trade disputes, public protests and uncertainty within post-Brexit Europe that could leave investors seeking refuge in safer assets. We believe many emerging market economies will see an uptick in growth in 2020. In some cases, such as Russia, South Africa and Turkey, this represents a rebound after years of subdued growth. In most emerging economies, however, growth has remained intact and should expand further on the back of widespread interest rate cuts made throughout 2019.

Australia

The Australian economy retains viable options to boost growth given low government debt and a fiscal surplus. Fiscal stimulus is likely to be far more effective than monetary easing in boosting activity and incomes.

Economic growth is benefiting from the low Australian dollar, strong commodity prices and strong population and employment growth; however, disposable income growth is stubbornly low because of the high tax take.

The current uncertain global and political environment has caused weaker recent growth data.

High household debt, restrictive household lending, falling investment income and falling iron ore prices pose tail risks. Government tax cuts, the recent interest rate cuts by the Reserve Bank of Australia (RBA) and easing of residential housing credit restrictions are positive for the economic outlook.

While index equity valuation levels are fair to high, this hides a large divergence between premiums for defensive/quality/growth assets versus cyclical/value assets. This dispersion has parallels to past turning points such as the global financial crisis and the tech bubble.

Europe

European economies have been struggling with demand weakness spreading from the automotive industry into wider manufacturing. The magnitude of the PMI declines now mirrors 2001-02 and 2014-15, with the malaise spreading to Asia and North America. Producers, distributors and purchasers have been reducing inventories for sometime, which has helped depress growth. As this ends, it should lead to stabilisation in the first half of 2020 and hopefully improvement after the summer.

It is important that the synchronised global slowdown is brief, otherwise we will need to see emergency interest rate cuts to offset a global recession under which circumstances equities will suffer.

The U.K. general election may help break the Brexit deadlock and therefore create a material investment opportunity. This relies on the composition of the next government: for equities, the best result would be a decent Conservative majority. Under this scenario we would expect U.K. domestic stocks to materially outperform as the new government takes fiscal action to stimulate the economy, corporate investment levels improve as uncertainty is removed, and risk premiums fall.

The more complex the general election result, the more likely that Brexit will be delayed, Sterling will weaken, and the FTSE will materially outperform domestic equities.

2019, like 2017, has seen unusually low market volatility. With central banks coming to an end of their rate cutting, we are likely to see a return to higher levels of volatility. In recent years, equities have been boosted by slower economic growth due to the central bank dovishness; however, a global recession would likely see equities materially de-rate. It would be hard to have accelerating earnings forecasts when GDP growth and inflation are likely to be below 1%.

Asia

In Asia we view the bottoming of earnings expectations, coinciding with basing-out of global PMI data, as near-term market catalysts. Valuations, especially asset-based metrics, are supportive. The ratio of earnings upgrades to downgrades in Asia has been exhibiting signs of stabilisation and may have already bottomed – any modest improvement in the underlying business environment will filter swiftly into this ratio and drive stock prices higher. Several factors are causing this stabilisation and could act as potential catalysts for more sustained improvement:

  • Coordinated monetary policy relaxation within the region and globally, combined with increasing adoption of more supportive fiscal policy measures;
  • The U.S. dollar has strengthened steadily since the end of Q1 2018, amid a deceleration of global economic growth. This is typically not supportive of Asian stock prices, so a dissipation of the dollar appreciation impetus would likely be a positive for Asian stocks.
  • Stable or lower energy prices. Strong energy prices are a tax on growth for Asia given that most countries in the region are net importers.
  • Easing of trade tensions between the U.S. and China – tensions between these two countries will be a persistent feature for many years to come; however, a workable trade agreement, including a de-escalation of the tariff regime, would be an obvious positive for the business environment.

Emerging markets

Throughout 2019, the direction of emerging markets was dictated by each new development in the U.S.-China trade negotiations. No one has given up hope that good sense will prevail, but with only limited resolution to date, trade concerns will remain front of mind for investors in 2020. Against this backdrop, we expect emerging market investors will look to secular growth sectors such as health care, education, cloud computing and clean energy as sources of relative strength within the asset class.

At a regional level, China’s policy objectives in recent years have been as much focused on the sustainability and quality of economic output as they have been the absolute level of growth. We expect this trend to continue in 2020 and would not be surprised to see growth slip below 6%. This still leaves China as one of the highest-growth economies and we believe Chinese equities will continue to attract increasing interest from global investors. Of particular note, China is implementing corporate bankruptcy policies that are very recognisable to western investors.

Meanwhile, India is introducing far-reaching labour reform policies; this is a necessary condition for India’s emergence as a regional manufacturing powerhouse. Enactment of these policies is not guaranteed, but they could be attractive for global manufacturers while also reducing costs for local manufacturers and creating the right incentives for smaller companies to scale up. All of this would enable more workers to enter the formal economy.

Elsewhere, 2020 looks set to be a challenging year for politicians in Latin America as populist demands and ideological divisions are likely to set a tricky path for progress. The incoming government in Argentina is stepping into the midst of a currency crisis and facing demands for wealth distribution from a disillusioned populace. Dissatisfaction with the level of wealth distribution was also behind recent riots in Chile and has forced the government to back down on proposed price hikes in public services. On a more positive note, Brazil looks well placed to drive through pension reform, a keystone in building future confidence in the country’s public finances.

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