Late cycle rebound

Global growth stands at an important inflection point. Are recession concerns overdone? Could central bank easing, lower geopolitical risks and China's fiscal action prompt a rebound in demand?

27 Nov 2019

Evan Brown

Head of Multi-Asset Strategy

Dan Heron

Senior Investment Strategist

Ryan Primmer

Head of Investment Solutions

The global economy stands at an important late cycle inflection point. But late cycle does not mean end cycle. We continue to view short-term recession fears as overdone. Rather, we expect a moderate growth reacceleration in early 2020 as geopolitical risks abate, China's growth slowdown stabilizes and as the lagged impact of looser monetary policy globally feeds through to demand. Lower USD borrowing costs also herald an important easing of financial conditions to emerging markets that is likely to be positive for global demand growth.

The global demand slowdown in 2019 has been largely driven by global industrial production and trade as the negative impacts of the US/China trade dispute have increased. But global manufacturing lead indicators are now turning and we expect these tentative signs of improvement to become more definitive in the coming months. Key to the moderate demand pickup we expect is the delayed boost to economic activity from the significant easing of global financial conditions. Over the past year, the US Federal Reserve has performed a sharp policy pivot from the tighter stance and rhetoric of late 2018 to its current more accommodative position. Recent statements support our view that the Fed is now more likely to let US growth and inflation 'run hot' than it is to tighten policy early and risk a sharp downturn. We do not see the US Federal Funds rate rising in the near term.

Exhibit 1: Lead indicators suggest global manufacturing growth is rebounding

This line graph represents key indicators that suggest global manufcaturing growth is bouncing back

Source: UBS Asset Management, Refinitv, as of November 2019.

Importantly, the shift to looser policy has not taken place only in the US, but has been broad based across both developed and emerging markets. Absent any extraneous demand shock, we see this supporting growth throughout the early part of 2020 as the boost from lower rates feeds through more powerfully to manufacturing. We also expect consumption growth to remain resilient in 2020, underpinned by low unemployment and solid wage growth. Should growth falter, we believe that calls for fiscal stimulus to play a greater role in the overall policy mix will grow louder in a number of major economies.

Despite GDP at its lowest level since 1992, the one major central bank whose policy stance has not moved to unequivocally loose is the People's Bank of China (PBoC). The five basis point cut in one-year bank lending rates in early November is evidence that the PBoC is not ignoring the growth slowdown. But its modest nature perfectly reflects the difficult balancing act it faces between conflicting cyclical and structural goals. This does not concern us unduly. With the full monetary and fiscal policy toolkit at their disposal the Chinese authorities are able to turn to other measures alongside interest rates to influence the rate of demand while rebalancing its drivers. We expect Chinese growth to stabilize as these policy actions take effect and there is scope for further stimulus measures if necessary.

Exhibit 2: US monetary policy is loose

This line graph shows the US monetary policy loosened

Source: UBS Asset Management, Macrobond as of October, 2019

Geopolitics represent both risk and opportunity. Brexit and the US/China trade standoff were the headline geopolitical stories of 2019. However, the probability of a worst case scenario on both issues has clearly diminished. We see sufficient goodwill in the most recent US/China rhetoric to suggest that some of the previously announced tariffs could be cancelled rather than just postponed. Such an outturn could provide much needed support to global corporate confidence.

Twelve months ago we said that global growth fears were overdone given the likely resilience of developed world labor markets. We therefore entered 2019 with a positive view on global equities that has since been well rewarded. We continue to see short-term recession concerns as exaggerated and there are major opportunities from a tactical asset allocation perspective in an extension of the business cycle and a stabilization of growth prospects relative to what is priced into markets. We expect some sharp rotation within risk assets.

Given our belief in a modest demand rebound, we currently favor the more growth sensitive equity markets of the eurozone, China, Japan and emerging markets. US equities have enjoyed a sustained period of outperformance in a global context. We understand the tactical argument that the more domestically focused US indices are less exposed to near term trade war concerns. However, as 2020 progresses we see a mix of both cyclical and structural factors coming into play. In particular headlines around the US presidential election and potentially dramatic changes in US economic policy will likely prompt bouts of volatility that may disadvantage US equities over their international peers. Still, investors must weigh the probabilities of one candidate having the full legislative backing to generate truly transformational change.

There is scope for Chinese equities to rerate higher as capital markets open up to international investors and we see capital flows increasing in the wake of the inclusion of onshore Chinese equities in MSCI's widely followed emerging market (EM) equity indices. There are also strong arguments for wider EM equities, which we see as the major beneficiary of a global demand bounce, any US/China trade truce and of the cut in USD borrowing costs.

A modest rebound in global demand suggests to us that there will be at least some upward pressure on longer-dated government bond yields given the very low growth and inflation assumptions reflected in the 10yr government bond prices of developed countries including Japan, Germany and Switzerland. With monetary policy likely to remain loose even in the face of improving data, we see developed world nominal yield curves steepening. Our favored market for this view is the US, where we are long the UST two year and short the UST 10 year in a yield curve 'steepener' to exploit this scenario. Given relatively high nominal and real yields Chinese bonds stand out to us as the one genuinely attractive major sovereign bond market. Inclusion in major bond indices is likely to see additional structural downward pressure on Chinese yields.

Credit also offers some compelling opportunities to play a cyclical uptick. As with EM equities, we see a rebound in global manufacturing and lower USD funding costs as being supportive for emerging market credit in general. Against this backdrop, both local and hard currency EM yield spreads over US Treasuries appear attractive vs. US investment grade and US high yield.

The maturity of the cycle, residual geopolitical risks and some crowded positions across asset classes raise the prospect of intermittent bouts of headline and intra-market volatility in 2020. In a lower growth environment, returns from risk assets are also likely to be lower than investors have enjoyed for most of the last decade. Given this backdrop, we believe that staying flexible and nimble to exploit asset allocation opportunities as and when they arise will be important in 2020 and beyond.

Asset class attractiveness

Traditional asset classes and currencies

This chart shows relative asset class and currencies attractiveness. For equities, the Eurozone, Japan and China are attractive, Australia is unattractive, and other markets are neutral. For fixed income, China is rated the most attractive, followed by US long end, emerging markets in local currency and emerging markets in USD. In currencies, the most attractive is the Japanese yen, followed by the euro, British pound and emerging markets currencies.

Asset class views

Asset Class	Asset Class	Overall Signal	Overall Signal	UBS Asset Management’s Viewpoint	UBS Asset Management’s Viewpoint
Asset Class	Global Equities	Overall Signal	Slightly positive	UBS Asset Management’s Viewpoint	We expect a moderate rebound in global growth in the coming months that we do not believe is fully reflected in global equity prices. Key to the moderate demand pick-up we expect is the restocking of inventories from low levels, and the delayed boost to economic activity from the significant easing of global financial conditions. Importantly, the shift to looser policy has not taken place only in the US, but has been broad based across both developed and emerging markets. Absent any extraneous demand shock, we see this supporting equities throughout the early part of 2020 as the boost from lower rates feeds through and equities rerate against a backdrop of supportive monetary policy. Should growth falter, we believe that calls for fiscal stimulus to play a greater role in the overall policy mix will grow louder in a number of major economies.
Asset Class	US Equities	Overall Signal	Neutral	UBS Asset Management’s Viewpoint	US equities trade at a premium relative to other markets due in part to a resilient domestic economy and a lower exposure to global growth factors. But as the global demand impulse strengthens, we see these factors as more headwind than tailwind; more cheaply valued and cyclical ex-US equity markets are likely to react more strongly. Meanwhile, headlines around the 2020 US presidential election and potentially dramatic changes in US economic policy will likely prompt bouts of volatility that disadvantage US equities over their international peers given their substantial valuation premium. The long period of US equity outperformance may be drawing to a close.
Asset Class	Ex-US Developed Market Equities	Overall Signal	Slightly positive	UBS Asset Management’s Viewpoint	Given historically high equity risk premia and a greater sensitivity to improving global manufacturing demand, we prefer developed equity markets outside of the US. In Europe, recent economic data and business surveys have been disappointing but we expect the demand momentum to improve over the coming months and for European equities to rerate accordingly. In September, the ECB delivered a comprehensive stimulus package which is growth supportive and the broad based easing of financial conditions around the world will likely put a bottom under the previously bleak external demand picture. Furthermore, geopolitical headwinds have somewhat diminished in the region with Italy in a coalition government and no-deal Brexit risks subsiding substantially. These developments are also positive for European equity valuations. We remain constructive on Japanese equities. We believe they are attractively valued and supportive fiscal measures taking effect in the aftermath of the tax hike should soften the spending slowdown. Furthermore, Tokyo business investment is likely going to accelerate as we move closer to the 2020 Summer Olympics. Improving corporate governance is also a positive.
Asset Class	Emerging Markets Equities	Overall Signal	·Slightly positive	UBS Asset Management’s Viewpoint	In our view there are also strong arguments currently for broad Emerging Market equities on a tactical basis. We see EM as the major beneficiary of a global demand bounce, an improvement in global trade in the wake of any US/China tariff truce and of the cut in USD borrowing costs. After interest rate cuts across the EM universe, monetary policy conditions have loosened significantly. The stabilization of growth in China that we expect is also likely to be positive for wider Emerging Markets.
Asset Class	China Equites	Overall Signal	·Slightly positive	UBS Asset Management’s Viewpoint	We remain positive on China as policy measures continue to cushion the economy. The Chinese authorities have shown themselves willing and able to provide additional monetary, fiscal and regulatory support to help smooth the rebalancing of the Chinese economy ongoing developments. Chinese equities still trade at a small PE discount to other markets and further market liberalization could prompt a re-rating. International capital should increasingly flow into Chinese assets following the inclusion of onshore Chinese equities in MSCI's widely followed EM equity indices.
Asset Class	Global Duration	Overall Signal	Slightly negative	UBS Asset Management’s Viewpoint	A modest rebound in global demand suggests there will be at least some upward pressure on longer-dated government bond yields given the very low growth and inflation assumptions reflected in the 10yr government bond prices of developed countries including Japan, Germany and Switzerland. With monetary policy likely to remain loose even in the face of improving data, we see developed world nominal yield curves steepening.
Asset Class	US Bonds	Overall Signal	Slightly positive	UBS Asset Management’s Viewpoint	With the Fed likely to let the US economy 'run hot' before starting to tighten policy again, there is scope for the US curve to steepen. But on a relative basis the scarcity of positive yielding safe assets should continue to drive flows into US Treasuries, keeping term premiums significantly negative and limiting the scope for longer-dated yields to rise more materially.
Asset Class	Ex-US DM Bonds	Overall Signal	Slightly negative	UBS Asset Management’s Viewpoint	In aggregate, we see ex-US developed market sovereign bonds as unattractive. The ECB and BoJ have committed to low rates for some time, limiting attractiveness of these markets. Upcoming fiscal stimulus measures in Japan and modest cyclical easing in Europe may also contribute to higher ex-US yields.
Asset Class	US IG Corporate Debt	Overall Signal	Neutral	UBS Asset Management’s Viewpoint	Given the large proportion of fixed income markets with a negative yield, we believe that US IG is more attractive in relative terms. We do not have a recession as our base case and therefore think IG debt will remain well bid. That said, we acknowledge high levels of corporate debt and the potentially large number of "fallen angels" when economic growth slows down significantly and downgrades begin.
Asset Class	US HY Corporate Debt	Overall Signal	·Neutral	UBS Asset Management’s Viewpoint	Current default rates in high yield are very low by historical standards. Given the still relatively positive economic backdrop and accommodative Fed, we do not expect a material pickup in US defaults in the near-term.
Asset Class	EM Debt US dollar Local currency	Overall Signal	Slightly positive Slightly positive	UBS Asset Management’s Viewpoint	As with EM equities, we see a rebound in global manufacturing and lower USD funding costs as being supportive for emerging market credit in general. In our view, spreads on both hard and local currency EM debt relative to US Treasuries remain attractive in an environment where positive real yields are scarce. As we do not anticipate a broadening economic downturn, we do not see a major spread widening in EM. An environment of still low developed market yields and decent growth is a positive one for EM carry.
Asset Class	Chinese Bonds	Overall Signal	Slightly positive	UBS Asset Management’s Viewpoint	Chinese bonds have the highest nominal yields among the 10 largest fixed income markets globally and have delivered the highest risk-adjusted returns of this group over the last 5 and 10 years. We believe that slowing economic growth and scheduled and planned inclusions to global bond market indices in coming years should continue to push yields down during the next 3-12 months.
Asset Class	Currency	Overall Signal		UBS Asset Management’s Viewpoint	The USD has been stubbornly strong, but we see the next big move as lower. The USD is overvalued on a real trade-weighted basis. Meanwhile, US economic growth is moderating and the Fed is easing. Over time, we anticipate economies outside of the US will stabilize and investment capital will seek out opportunities in those countries, sending the dollar weaker. Elsewhere, we continue to see strong valuation support for the JPY and see short AUD as an effective hedge against ongoing China weakness in an economy where domestic household leverage is likely to constrain growth.