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Global Debt: Quarterly Macro Update
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Developed Market Contributions to Global Growth
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Increased Volatility as a Result of EM Tensions

For the second quarter of 2018, the global debt team believes that the economic outlook for the next 9 to 18 months has not changed materially, but that the risks have changed as a result of EM (Emerging markets) political tensions and the potential for a full-blown trade war between China and the U.S.

The team believes that the individual shocks within EM are not material, but that the rapid succession of them has soured the investment climate. The negative political events started with an increase of U.S. sanctions on Russia that were followed by negative political developments in Turkey, Mexico, and Brazil. Additionally, the emergence of the right wing/left wing coalition in Italy had a negative impact on European assets. Although market growth continues to remain on track, with U.S. growth picking up materially, EM growth has not seen similar increases as a result of these negative political shocks.

Additionally, trade tensions have been escalating. One of the immediate impacts of this escalation was a kneejerk reaction that caused depreciation in the currencies of the impacted countries, including a 7% depreciation in the Chinese Renminbi. This combination of increased U.S. growth and a slowdown across other regions has left global growth at a high plateau. As a result of this, there has been a decline in the value of non-U.S. risk assets, with U.S. risk assets maintaining their value.

Despite these tensions and shocks within EMs, we continue to believe that global growth will remain robust, albeit at a somewhat slower pace. We expect that growth will slow to the 3.6% to 3.7% range for this year, but the composition of growth will shift as European growth stabilizes. We also believe that the domestic European economy will remain stable and that the recent slowdown was related to a mini cycle in trade and its associated investment and inventory cycle. In addition, industrial production in emerging markets is expected to improve as industrial production in developed markets is close to decade highs. From an asset valuation perspective, these conditions have left emerging market fixed-income assets at historically cheap levels vs. developed markets assets.

Developed Market Growth

While we expect that global growth will remain around its historical average, most major developed economies in the world are actually growing above long-term potential growth levels. Unemployment rates are at historical lows in the United States, Japan, and Germany, and are declining steadily in the rest of Eurozone. Additionally, investment growth is picking up as economies reach full employment and workers are getting more difficult to find. The wounds of the global financial crisis of the 2008-2009 are to a large extent healed and we are now in a more normal business cycle expansion.

At the beginning of the year we saw a moderation in growth mainly in the Eurozone and Japan. We believe that this can be explained by one-off factors, weather being an example. Now these sectors are cooling off to a more trend-like growth. The latest data suggest stabilization toward the end of the second quarter.

When we look at the U.S. economy and service sectors, on the other hand, we don’t see a slowdown. Domestic drivers of growth remain intact. Jobs are being created, incomes are rising, and consumer confidence is around historical highs. The U.S. economy is going strong, with high levels of consumption and investment.

Trade Tensions and Regional Implications

A key risk for the global economy is trade tensions. The risk is a hit to consumer confidence that could alter the investment outlook, and thus we are watching the developments in this area closely.

Although Asian economies did quite well at the beginning of the year, contributing the most among all regions to world growth in Q1, we now expect Asia will settle to a slightly lower growth path. This expectation is mainly predicated on slowing growth in China, a longer-term trend we expect will continue, given a cooling off of the cell-phone cycle, tightening financial conditions, and the uncertainty of a full-fledged trade war. India, the second largest economy in the region, is still on a recovery path, while the rest of South Asia remains steady.

While the initial impacts of U.S. tariffs on China are estimated to be limited, risks have been tilted to the downside with new tariffs under consideration. The direct impact of proposed and recently imposed tariffs is estimated to shave off about a 0.4%-0.5% from China’s growth, a number that can be easily mitigated by domestic policies from the Chinese government. We have seen a relaxation of monetary policy and more responses are likely to come, including increases in fiscal spending. However, the indirect impact of tariffs on the global supply chains could put a damper on business confidence and investment. Regardless, most of the Asian economies have strong external fundamentals and resilient domestic demand that would help them ride out this period of uncertainty.

Potential for Delayed Growth in Latin America

Economic growth in Latin America was downgraded, mostly because of unexpected hits in Brazil and Argentina, the two countries emerging from recession. Argentina’s central bank was forced to tighten its monetary policy and go to the IMF to preserve financial stability. Currency weakness notwithstanding, most central banks in the region face weak underlying inflation trends and are likely to be watchful of the risk of increased inflation, but remain on hold. Overall, the prospects of the region living up to its potential for high levels of growth have most likely been delayed to next year.

This quarter, Latin Americans went for the polls in two of the three largest countries in the region. Mexico’s election of left-of-center president has the potential to compromise the structure of the country’s macroeconomic framework. But unlike Mexican voters, Colombians rejected their leftist choice for president, thereby preserving policy continuity.

Portfolio Implications

Despite increased political shock in many EM countries, we expect that global growth will not experience a significant slowdown. Additionally, if trade tensions do not escalate much further, we believe the global economy will resume its trend, which is around its long-term historical average.

To adjust our portfolio to changing EM market conditions, we will continue to favor EM country rates, but we will shift our focus to the countries that are offering high real yields and steep yield curves, such as Brazil and India. In foreign currencies (FX), we will shift our exposure more to EM FX and somewhat decrease our exposure to DM FX such as the euro and yen. Our portfolio will change the least in credit, where European financial subordinated debt continues to be the most attractive sector of global credit markets, followed by EM high yield credit.