Time to seek shelter?

Timing recessions is a question that economists are often tasked with, but find one of the most difficult to answer.

History is littered with examples of factors that can cause the global economy to contract. These include shocks (1973, oil crisis) structural imbalances (1929, Great Depression and 2007, financial crisis), restrictive monetary policy (1990, aggressive rate hikes) and irrational exuberance (2000, dot-com bubble). The list is as varied as it is long and should be a reminder why predicting the nature and timing of a recession is such a difficult assignment.

Recession warnings

A number of storm clouds have accumulated over the past couple of years that have encouraged some market participants to question if this decade-long economic expansion is set to end soon.

Leading the inventory of current hazards are trade wars and their implications for global growth. Fears of higher US interest rates, political and social instability in Europe, emerging market pressures and Brexit also continue to be disruptive forces.

Reasons to be optimistic

Despite the darker macroeconomic backdrop, recent data releases have been ahead of consensus predictions. US gross domestic product (GDP) expanded by 3.2% year on year in the first quarter (Q1), the strongest start to the year since 2015. Strong investment in Spain, buoyant consumer spending in France and rebounding GDP in Italy helped European growth recover. Q1 eurozone growth was twice the pace achieved in the final three months of last year. Even the Brexit-impacted UK economy grew at a relatively healthy pace helped by employment growth, wage increases, credit expansion and the weak currency.

Not all regions of the global economy have grown faster than economists’ expectations. China, the world’s second largest economy, lost momentum in April. The impact of trade wars and the debt deleveraging programme resulted in industrial production, fixed asset investment and retail sales all slowing more than predicted. However, Chinese authorities are expected to implement further stimulus measures including tax cuts, infrastructure investments and rate cuts in efforts to maintain growth within the official target range of 6 to 6.5%.

Labour market strength

The strength of the labour market suggests that the global economy will continue to grow. US and UK unemployment rates have fallen to historically low levels (rates of 3.6% in the US and 3.8% in the UK are the lowest since 1969 and 1974 respectively). Even in Europe, unemployment fell to 7.7% in April, its lowest level in a decade.

High levels of employment coupled with pay rising above the rate of inflation should continue to support household consumption growth and in turn the economy.

Monetary policy outlook

The over-tightening of monetary policy can have a devastating impact for growth prospects. Since the start of the year we have seen a dramatic change in policy expectations. The US Federal Reserve has taken a more patient stance, in a move we think will keep interest rates on hold both this year and next. We are also not forecasting an interest rate hike by the European Central Bank before the end of 2020.

The more benign rate environment has considerably reduced the risk of a central bank policy mistake developing into a recession.

Recession fears overdone

Trade wars have been grabbing the headlines and sharply moved the markets over the past few months. The recent escalation in the US-China dispute has forced analysts to reassess the prevailing view that a peaceful resolution to the dispute was inevitable.

Imposing higher US tariffs on China and the resulting retaliatory action will act as a tax on growth by reducing demand and pushing up consumer and producer prices. However, we don’t believe the dispute will be forceful enough to destabilise the global economy.

The world may have to live with higher tariffs for considerably longer than originally expected, but our view is that economic pragmatism will eventually prevail. This should finally lead to the slow removal of tariffs and this trade and policy uncertainty.

Investment implications

We will continue to be on recession watch and will monitor leading indicators for warning signs. So far few warning signs are causing us to ring the alarm bell of an immediate recession. Even the much hyped inversion of the US yield curve does not encourage us to hit the panic button. Especially after taking into account the depressing impact of quantitative easing on 10-year Treasury yields and the neutral Fed position.

This year we can expect moderating, but still reasonably robust, global growth of 3.6%, with the potential for marginal improvement in 2020 to 3.7%. We still recommend that investors maintain their exposure to risk assets. That said, returns are likely to be more subdued and volatility levels higher than we have seen over the past few years.

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