Until last year, JPMorgan had at least clear explanations for this, largely from fiscal tightening in Europe and the US and fading productivity growth in EM. This year, though, growth has collapsed even more, to a 1.6% pace in H1, with even fewer explanations aside from the Japanese tax hike.
The forecast remains that growth rebounds to over 3% from this quarter on, but as investors, we need to investigate the risk scenario that we may instead be in a, say, 2% growth world. The trending behavior of forecast revisions, and thus surprises, would suggest there is more down than upside risk on growth assumptions, even as surveys do not confirm this.
This is not to say that we can eliminate upside risk of growth rising to a 4% handle, as the 1990s US experience similarly saw steady up grades in the second half of the cycle, after downgrades in the first.
With the consensus steadily projecting 3% US and global growth, this view should be in the price and instead a 2% growth pace should thus be a surprise that requires asset repricing. JPMorgan sees two broad drivers of weak growth – weak demand and/or weak supply – and both have similar market implications: they favor income over growth assets.
Weak demand would essentially reflect unfinished post-crisis balance sheet delevering by households, banks and governments. The market impact would be relatively easy to judge as it is very close to, though not as bad as, what happened in Japan post its leverage boom and bust over twenty years ago.
Economic growth in Japan fell to less than 1% above population growth, deflation set in, bond yields fell, credit spreads went to nothing, and equities saw no capital gains throughout. We have argued here that low growth keeps both volatility and policy rates low and is thus bullish for risk assets. But growth can become so low as to depress earnings and to create deflation, inducing investors to prefer bonds, as happened in Japan.
If indeed economic agents continue to delever balance sheets, then monetary policy has no further impact on growth, as we learned in Japan. Only fiscal policy, supply side reform, and/or time can redress growth. G4 central banks would indefinitely delay rate hikes; bond yields would fall again; the search for yield would intensify; equities would at best perform on par; Value and income stocks would outperform.
A weak supply side, from low labor supply, a low supply of new capital, and low productivity growth, is an alternative driver of a 2% growth risk scenario. And indeed, we have seen these forces at work already in this cycle. JPMorgan’s economists have lowered their estimates of potential global growth by 0.5% since 2008.
Taking out the effect of the growing share of EM, which has higher potential, the drop in global potential is over 1%. So far, this did not prevent global asset price inflation. If we continue to see lower growth than what we expect and it all seems due to a fall back in potential, then we create neither price deflation nor inflation.
It will, though, significantly reduce the return on capital, and with that, equilibrium real interest rates. In the US, it would likely keep fed funds well below 2% for years.
What do we do about these risks? Both weaker demand and supply have in common that they would boost income assets – better yielding fixed income and income stocks again growth assets, primarily cyclical stocks.
In JPMorgan’s mind, it should boost the currencies and assets issued by countries that pursue better supply side reform. For the moment, this analyst thinks it should still support an OW of EM assets, as they are better yielding and better valued, would escape the threat of fast Fed tightening, and at least this year have relatively better macro momentum.