Discard overblown threats of global doom and gloom
While there are concerns, key indicators do not point to an overheating US economy and therefore impending world recession
There’s no doubt that today’s world economy is slowing, with deceleration under way across China, Europe, Japan and more latterly the US. The numbers don’t lie. Equally, global growth is under threat from the expanding US-China trade war. However, are we to believe the frightening headlines predicting that a global recession is imminent? Should investors start selling their equities with the expectation that stock markets will now plummet? At Prudential, we believe the answer to these questions is no, and here’s why.
First, some pundits have said that because this is now the longest expansion in US history at over 120 months, we are “due” for a recession. But economic cycles don’t have schedules. They don’t happen in a routine way, so the length of a recovery should not be a predictor of the next downturn. As we have seen recently, central banks have quickly reacted to add more monetary stimulus as necessary, protecting the recovery and extending it.
Investors shouldn’t be nervous about investing in global equities because of the growth outlook.
Rather, we should at least interrogate what the classical cyclical indicators are signalling. If we look at four of these indicators, which historically have warned of an overheating economy and therefore a coming recession in the US, none is flashing red. In fact, three are green and only one is amber when we compare the current expansion with the previous seven recoveries dating back to 1961.
First, we note that while US GDP growth has been consistently positive over the past 10 years, it has not approached levels that suggest overheating or reached the 4%-7% year on year rates seen in previous recoveries. Indeed, US GDP growth has been decidedly lacklustre, typically 1%-3% year on year — the most pedestrian recovery since World War 2. There has not been a build-up of excess consumer demand that would push prices up and give the US Federal Reserve a reason to hike interest rates significantly and put an end to the expansion. This is the first green indicator.
Following from this is the complete lack of inflationary pressure in the current recovery. Averaging less than 2% year on year, US inflation has been lower than during any recovery since World War 2. In the past, prices have typically risen inexorably in the latter part of a recovery cycle, but at present the absence of price pressures is puzzling for economists. This is the second green indicator.
The third cyclical recession indicator is unemployment. In the current recovery the US unemployment rate has fallen from 10% to 3.6%, a 50-year low and matching the best level reached in any previous recovery. This is a classic warning sign of approaching labour market overheating, and so is flashing amber.
However, this very low unemployment rate has not fed through into higher wages in any significant way. Although US wage growth has averaged 2.5%-3% year on year over the past seven years, it started extraordinarily low and rose only very slowly, remaining at the lowest level of any previous expansionary period since 1961. Companies therefore have not experienced cost or margin pressures and so have not had to raise their product prices. Consequently, wages comprise the third green indicator.
From the above we can conclude that the classic warning signs of an overheating US economy, and therefore impending global recession, are not yet present. That is not to say there are no reasons for concern. Certainly the rise of protectionism; the potential for monetary policy paralysis (due to historically low interest rates); and high government debt levels constraining fiscal policy are among the fundamental factors that are worrying economists.
Still, investors shouldn’t be nervous about investing in global equities because of the growth outlook. On the contrary, we believe it is a good idea to remain exposed to global equities. However, this is based on the current attractive valuations of global equities. We don’t believe in investing based on macroeconomic forecasting, which is highly unreliable.
Instead, we invest on the basis of asset valuations. And if we examine current global equity valuations the very high risk premiums and prospective real yields now available from many equity markets, particularly compared with developed government bonds, make this an excellent opportunity for investors to take advantage of. Emerging-market equities are looking especially well valued.
While US equities are somewhat expensive compared with their history, our client portfolios are overweight in selected attractive markets including Singapore, Hong Kong, SA and Turkey, as well as Germany, Italy and Japan, which are all priced to deliver prospective real yields between 7% and 13% in US dollars over the next three to five years.
Although we don’t know exactly how or when these returns will be delivered over time, history has shown that current valuations should produce investor returns well above the long-term average. And let’s not forget that global equity is an excellent diversifier for any investor willing to tolerate its relatively high volatility.
• Knee is chief investment officer at Prudential Investment Managers.