We are less than two months into 2016, and yet we have seen markets recording their worst weeks for many years. The recent volatility begs the question whether these setbacks will ultimately lead to another global economic recession.
Investment reporter Valentina Romeo speaks to M&G fund manager Stephen Andrew and Axa Wealth head of investing Adrian Lowcock to understand why a recession is unlikely to happen anytime soon.
Andrew argues there are not “exhaustive analyses” to prove we are heading towards a recession and despite the slow pace of US growth, economic data from the Federal Reserve proves the country is not on the brink of a crisis.
Lowcock adds although saying China’s slowdown remains a worry for many economies, risk alone will not lead to a recession, especially in the UK.
How big is the risk of global recession?
There is a saying in finance that markets create their own propaganda. This means if markets are down, investors focus on the economic evidence that supports this. Recently, this “evidence” has come from global manufacturing data, which has been weaker, but investors have ignored the services side of economies, which have been stronger. Services in the major economies account for 75 per cent of GDP and even in China are now believed to represent over 50 per cent.
In Europe, the weak euro, low oil price and easy monetary policy, together with continued signs of less fiscal austerity, are resulting in falling unemployment and a pick-up in many of the peripheral economies. In Japan, however, the government has recently reduced its GDP forecast for the year. Abenomics has yet to deliver the expected amount of structural reform but, on the positive side, wages are increasing.
When it comes to the emerging economies, there continues to be huge divergence between commodity importers and exporters. Most of the attention is currently focused on China and whether it is headed for a hard landing. The Western media continues to focus on the wrong statistics, which show its economy in a poor light. While manufacturing and fixed asset investment continues to slow, services continue to grow.
A different world
For investors, today’s world is miles away from that of previous regimes, so it is hard to make sense of. Between 2000 and 2008 we were in a regime of increased leverage but since 2009 we have seen the opposite. The effect of a deleveraging regime is slower demand, slower growth and lower inflation globally. In such a world it is difficult to be sure of the business cycle investors should expect.
In a cycle where rates and economic growth stay low, there are reasonable prospects the upturn will be longer and steadier (although slower), which should allow interest rates to remain at levels low by historic standards and, even when increases occur, these will be modest. As a result, valuations in asset classes such as equities can remain at higher levels as the discount rate used will be lower than in previous cycles.
The catch for this is that because growth and inflation rates are expected to stay low, markets will be extremely sensitive to small changes in either of these numbers. Weaker growth can lead investors to fear a fall into deflation.
Areas of divergence
A key area of divergence is in monetary policy between the Anglo Saxon economies of the US/UK and Europe/Japan. For investors in the US, rising rates have historically resulted in the market P/E de-rating. At the moment, however, earnings growth there is not strong enough to counteract this de-rating. Rising rates have also impacted currency markets and been a negative factor behind capital leaving the emerging world.
On the other hand, Europe and Japan should remain favoured by continued easy monetary policy. Both markets continue to offer investors upside outside of a global recession and are expected to outperform.
There is also divergence between developed and emerging economies. While the recovery in the developed world progressed in 2015, economic growth in the emerging economies slowed. Russia and Brazil, two of the largest developing economies, are already in deep recession, with little sign of an imminent pick-up in growth. Emerging economies today account for around 50 per cent of world output at purchasing power parity, so developments there are much more significant than 20 years ago.
What hope for growth?
Today’s market turmoil has led investors to question whether unconventional central bank policy will actually deliver sustainable economic growth.
Looking at markets on a longer-term perspective, there have generally been two main drivers of serious bear markets: recession and aggressive tightening of monetary policy. Neither of these outcomes looks likely and perhaps a more balanced appraisal of the recent sell-off is that it was valuation driven. It certainly occurred at a time when there was less valuation support for the market than in other pullbacks in the post-crisis period. While the recession risk for the global economy in 2016 cannot be dismissed entirely it remains a low probability.
In this scenario, investors need to keep a level head and look to exploit market falls as opportunities to selectivity top up equity positions if exposure is light. While markets should recover from these levels, volatility is likely to continue until investors believe the end of unconventional monetary policy will transition into sustainable economic growth. At present, markets are fearful and this could persist until either economic data causes investors to reassess or there are signs of a policy shift that is supportive of markets.
Graham O’Neill is director of RSMR