De-synchronised global growth – implications for investors

The global economy has become de-synchronised. While the US economy has slowed significantly the rest of the world is doing fine.

Introduction

While the US economy has slowed sharply over the last year the rest of the world remains robust. The de-synchronised nature of the global economic cycle was evident in the International Monetary Fund (IMF) recently revising down its US growth forecasts but leaving unchanged its forecast for global growth this year and next at around 5% thanks to upwards revisions to growth virtually everywhere else. This note looks at the key drivers of global de-synchronisation, whether it is sustainable and what it means for investors.

The US economic downturn

Recent US economic data has been very soft. The US economy grew just 1.3% annualised in the March quarter (or 2.1% year on year). Housing has led the downturn and this has resulted in a slowdown in manufacturing and is starting to lead to slower consumer spending. However, our view remains that the US economy is just going through a mid-cycle growth slowdown (like those of the mid-1980s and mid-1990s) with growth likely to average around 2% this year.[1] Interest rates have not been raised aggressively, and there are none of the other extremes that precede recessions such as talk of new eras, over investment, excessive speculation or major share market overvaluation. The US mortgage crisis is unlikely to lead to a generalised credit crunch dragging down the rest of the economy. It’s also worth noting that the March quarter growth data in the US is not as bad as it looks as net exports, inventories and defence spending came in far weaker than expected and should rebound.

The de-synchronised world

However, while the US has slowed significantly the rest of the world has held up remarkably well. This is evident, for example, in business conditions indicators in the US, the Euro-zone and Japan. While the US ISM manufacturing index has been in a softening trend since a peak in 2003, the Japanese Tankan business survey has remained strong and the German IFO business conditions index has strengthened (and this is indicative of other business conditions surveys across Europe). This is shown in the next chart which shows standardised index levels for each of these surveys. This is very different to the lead up to the global downturn earlier this decade when Japanese and European indicators quickly followed the US down.

Source: Thomson-Financial, AMP Capital Investors

The divergence between the US and the rest of the world reflects a range of regional specific considerations.

·       Despite rising interest rates and the strong Euro, growth in Europe is strong as economic reforms in Germany are leading to a renaissance of the German economy as productivity has improved and unit labour costs have fallen. This is spreading across Europe thanks to much improved corporate balance sheets and improving labour market conditions which are boosting domestic demand. Euro-zone unemployment is now at a 25 year low. Easy monetary conditions and improving confidence are driving strong money supply growth.

·       While consumer spending remains sluggish in Japan, exports remain strong (helped by China) and the Japanese economy is stronger than at any time over the last 15 years with strong profits & falling unit labour costs which are helping improve its competitiveness.

·       Growth in emerging markets remains very strong. Developing countries are doing well on the back of a steady move towards free markets, free trade, stronger domestic demand and easy money conditions as many of their central banks seek to limit or slow appreciations in their currencies. On average developing countries are growing around 6 to 7%pa and account for about 29% of world economic activity. While the OECD’s composite leading growth indicator for the G7 (basically Europe, Japan and North America) has slowed (reflecting the US), leading indicators for the BRICs (Brazil, Russia, India and China) remain strong – in contrast to the past relationship.

Source: Thomson-Financial, AMP Capital Investors

Within emerging markets China is continuing to grow strongly and the evidence suggests this growth is becoming more sustainable with consumer spending playing a bigger role, business investment broadening out from the Eastern provinces and inflation remaining low. Continued strength in China explains, for example, why commodity prices, including the oil price, remain so high.

More general drivers of the recent de-synchronisation include the following:

1.    The US downturn has been focused on the housing sector which isn’t very import intensive, so there hasn’t been a huge flow-on to exports from other countries.

2.    The US housing downturn is a US specific problem unlike the past growth shocks which were common across countries, eg, the 1970’s oil supply shocks or the bursting of the IT bubble.

3.    The absence, at least so far, of a generalised global slump in share markets, which is often a mechanism by which problems in the US are transmitted globally because it affects capital flows and confidence.

4.    A lack of inflation pressures, which has meant that the global economy has not had to contend with a rapid generalised increase in interest rates. This is evident in the next chart which shows growth in global gross domestic product (GDP) against the change in global inflation (ie, whether inflation is rising or falling). Normally inflation follows a pick up in growth with a lag, but that hasn’t really occurred in the latest cycle.

Source: Thomson-Financial, AMP Capital Investor

5.    A reduction in the importance of trade flows with the US for some countries. While this is not the case for Latin America it certainly is in the case of Asia, as evident in the next chart.

Source: Thomson-Financial, AMP Capital Investors

What does it mean for investors?

The de-synchronised world economy has several implications for investors:

·       Firstly, by smoothing out the global business cycle a de-synchronised global economy is likely to help extend the life of the bull market in shares that got underway in March 2003. Slower US growth will enable the US Federal Reserve to cut interest rates which will help ensure that the liquidity backdrop for investment markets will remain favourable while at the same time strong growth outside the US will help ensure that profit growth remains reasonable.

·       Secondly, it is likely to be accompanied by downwards pressure on the $US as growth in the US slows relative to the rest of the world and US interest rates decline relative to global interest rates. Right now the $US is oversold with excessive short speculative positions in the currency suggesting that it has scope for a bounce, but the trend is likely to remain down. This in turn means that the trend is likely to remain up in the $A.

·       Thirdly, continued strong growth in emerging markets, particularly commodity intensive China, will ensure commodity prices stay strong. Ongoing strong demand for commodities provides a solid underpinning for Australian resource shares which also benefit from trading on conservative price to earnings multiples compared to the rest of the share market.

Can it be sustained? What to look for

The main risk to the relatively benign de-synchronised global economic outlook would arise if the US economy were to undergo a harder landing with the housing slump spreading to a sharp downturn in consumer spending and business investment. This would have more of a global impact because consumption and investment are import intensive. While we see this as unlikely, the US consumer is worth keeping an eye on. Other risks worth keeping an eye on are protectionist developments in the US, geo-political tensions and the oil price.

Conclusion

While the US economy has slowed sharply the rest of the world is on a solid footing, and providing the US downturn remains relatively mild this is likely to remain the case. This provides a favourable back drop for share markets.

By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*