Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Peter Westaway, Chief Economist, Europe for Vanguard Asset Management, discusses the global economic outlook.
With the global economy in the middle of a period of structural deceleration, we believe that the outlook for both economic growth and market returns over the next few years is muted. At first sight this might appear rather an uninspiring view, but there are reasons to be optimistic.
One of the most striking conclusions in our recently published Economic and Investment Outlook is that the global economy is converging towards a more balanced, unleveraged and ultimately healthier equilibrium. We expect the growth rates of developed and emerging markets to converge over the coming years, with developed growth improving marginally while emerging growth slows to a more sustainable pace.
Reaching this equilibrium will require adjustments in key areas of the global economy – and some of them will cause concern from time to time, as China’s growth prospects are now. However, we always encourage investors to look to the long term and, on a long-term view, a more balanced and unleveraged global economy should be good news.
Sustained Fragility in Global Trade
The long-running downshift in emerging-market growth shown in Figure 1 will be driven principally by China, and this adjustment will continue to represent both the biggest risk to global growth and the most significant worry for investors. In China, investment as a percentage of GDP is almost 1.5 times what it was in the “Asian Tiger” economies when they were at current Chinese income levels, and twice the level of the US today. The rebalancing away from investment will take time and there will be scares along the way – especially as the Chinese authorities’ recent efforts at managing their economy have not filled markets with confidence.
As well as affecting investor sentiment, a harder-than-expected landing in China would have a real impact on other economies. Our analysis suggests that 6% to 7% is the most likely band for Chinese growth this year, well down from the double-digit levels of five years ago. This would likely shave around 0.6% off growth in Japan, and reduce euro zone, US and UK growth by 0.5%, 0.1% and 0.1% respectively. However, there is a non-trivial 14% risk of growth coming in below 5%, a common definition of a hard landing. Worse still, if China were to enter a recession, which is certainly not our central case, it would drag a number of other economies into recession with it, reducing Japanese growth by 2.3% and euro zone growth by 1.8%, for example.
Modest but Steady
However, although a Chinese recession is a tail risk that we need to consider, our central case is for China to grow at around 6% in 2016. Against this background, the outlook for growth in the developed markets is modest but steady and the US and European economies look set to contribute their highest relative percentage of global growth in nearly two decades.
The resilience of the US economy is a key factor in our thesis of convergence. Our forecast for long-term trend growth in the US is 2%, which we believe is reasonable given the reduced tailwinds from population growth and consumer debt. Despite full employment, there is little inflationary pressure in the US economy. We therefore expect the Federal Reserve to be cautious in raising rates, with a high likelihood of an extended pause around 1% and real rates staying negative throughout this year.
A Wide Spectrum
Elsewhere in the developed world there is a wide spectrum of likely monetary policy. The UK will probably be next to begin normalising rates, although the timing here is still a matter of debate and will depend on external factors as much as domestic data. Meanwhile, the European Central Bank and Bank of Japan are likely to be in stimulative mode for a considerable while yet. Indeed, as Figure 2 shows, the outlook for inflation in the euro zone suggests that further quantitative easing is not only likely, but necessary.
Summary: A Decent Backdrop for Investing
With developed economies holding steady and emerging markets settling at a more sustainable and balanced level, equity and bond markets should be able to make modest progress.
We have already seen in 2016 that the risks present in the global economy provide ample scope for market volatility. However, we believe there is a good chance of global equities providing annualised returns in the 7% to 9% range over the next decade. Meanwhile, although bonds are likely to produce far lower returns than they have in the recent past, most likely around 2-3% over the next decade, global fixed income will continue to act as an effective portfolio diversifier.
As such, a balanced portfolio of equities and bonds is likely to remain the most appropriate starting point for most investors.
Disclaimer
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