global perspectives

    Declining growth regime: here we go

    Declining growth regime: here we go
    Florian Ielpo - Head of Macro, Multi Asset

    Florian Ielpo

    Head of Macro, Multi Asset

    In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we analyse the market consequences of a period of declining growth. 

     

    Need to know:

    • Our Growth Nowcasting indicators have started to indicate a period of declining growth
    • Such environments usually weigh on market valuations initially, leading to a temporary decline in expected earnings
    • The “declining growth regime” needs further confirmation for this new risk to start impacting markets; we are not there yet and sentiment remains in the driving seat for the moment

     

    Major economies are slowing down. For a second month in a row, the macro data collected for our Growth Nowcasters indicated that we have likely entered a period of “declining growth”. This regime is a key input for our long-term asset allocation, as it could potentially embody some of the worst periods of return over the last 70 years. However, indications that we are entering such a regime initially tell us little about its durability and the likelihood of it turning into a genuine recession. July has been a kinder period for investors so far, but it's important not to lose track of fundamental developments. At this stage, as we have discussed in previous weekly updates, sentiment remains the dominant driver of market moves but the macro situation could come back to the forefront in coming weeks.

    Chart 1 shows two key pieces of information gathered from our World Growth Nowcaster. The Nowcaster aggregates about 200 economic time series into a signal that fluctuates between 0% (growth very likely to be much lower than its long-term level) and 100% (growth very likely to be much higher than its long-term level). The underlying macro timeseries are gathered into subcomponents that match the major economic sectors driving growth cycles. Each sector receives an equal weight in an attempt to evaluate the breadth of recessionary symptoms. By doing so, this indicator aims to quickly identify the disease all investors should fear: recession.

    Recessions themselves do not matter much to investors, but they are made up of two important periods: the entry into a recession, and the exit from it. For example, the National Bureau of Economic Research (NBER) has dated the entry point for the Global Financial Crisis recession as December 2007 and the exit point as June 2009. If 2008 was a horrendous year for equities, Q1/Q2 2009 saw a remarkable recovery for risky assets, be it credit or equities. The key difference between these two periods was the direction of economic indicators, not necessarily their growth level – let’s not forget that markets are forward looking. An efficient way to capture this direction is to make use of “diffusion indices”. Such an index can be defined as the percentage of macro data that are improving. When the majority is improving (100%), then economic activity is enjoying an uptrend or if it is contracting, it is contracting progressively less. This is the essence of our “declining growth” versus “improving growth” regime approach, a key component of our nowcasting methodology. As of late, our World Growth Nowcaster has declined from 70% to 50% and its diffusion index has breached the 50% threshold, and currently stands at 41% which clearly reflects a “declining growth” state. But is this information of relevance to investors?

     

    Chart 1: World Nowcaster and its diffusion index

    Multi-Asset-simply-put-World nowcaster-01.svg

    Source: Bloomberg, LOIM

     

    To answer that question, we looked at the evolution of our World Growth Nowcaster Diffusion Index during the last four periods of declining growth: 2008, 2011, 2018 and 2020. Chart 2 compares the evolution of the MSCI World and the World Growth Nowcaster Diffusion Index. The pattern is consistently the same: when growth starts to decline, the MSCI World suffers a downturn; when dispersion starts to rise (even from low and negative levels) the MSCI World enjoys an uptrend. The timing is imperfect and hiccups have happened – in 2008, the MSCI World bounced back two months ahead of the growth recovery itself; while in 2011, a moderation of the sub-50% diffusion index was enough for markets to recover as the shock had been Europe-centric. In 2019, the market rebounded before the end of the downturn thanks to the Federal Reserve’s policy pivot in January of that year.  Finally, in 2020, as the economy was shut off “manually”, macro indicators were slow to react and the market moved ahead of their publication. However, what these four periods have in common is that declining growth (sub 50% diffusion index) resulted in a moderate (2011) to large downturn (2008) for equities and credit.

     

    Chart 2: MSCI World vs. World Growth Nowcaster Diffusion Index

    Multi-Asset-simply-put-MSCI World v diffusion-2008-2011-01.svg

    Multi-Asset-simply-put-MSCI World v diffusion-2018-2020-01.svg

    Source: Bloomberg, LOIM

     

    In this instance, investors have already experienced a 20% equity downturn (based on the MSCI World). This may give the impression that the downturn is behind us when it comes to growth-sensitive assets – the latest edition of our quarterly Simply Put outlines the extent to which our in-house analysis disagrees with that view: rates have increased by 200 bps, while equities have suffered a 20% drawdown reflecting their average duration of about 10 years.  Since the market lows in June, US rates have decreased by around 40 bps and equities have risen by around 5%. Duration is helping as the macro downtrend is now being confirmed by data. But this trend could lower earnings going forward which would have a further negative impact on equities. So far, the earnings season is showing little of this and sales growth has mainly beaten forecasts, supporting current valuations. However, the risks around a declining growth period are only just beginning – our weekly updates will continue to keep you closely attuned to how this macro risk plays out.

     
    Simply put, we have officially entered into a period of declining growth. This adds to existing central bank risk and should not be overlooked by investors – even if sentiment recovers.

     



    Macro/Nowcasting Corner

    The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

    The National Association of Home Builders (NAHB) index was lower than expected (55 vs. 65), indicating the housing market is starting to suffer on the back of higher rates. For the moment, housing starts and building permits are stable, limiting downside pressure for now. From a cyclical perspective, the PhiliFed survey showed a remarkable decline in July, coming in at -12.3 from -3.3 in June – this is yet another sign of the slower macro conditions in the US. The declining growth period is not only a European thing but is currently spreading to the US. The Conference Board’s leading index did not disagree with that: it moved lower again and is now at a level comparable to those reached in October 2007.

    In Europe, the main macro event was the European Central Bank’s (ECB) meeting. It hiked by a surprise 50 bps and unveiled its anti-dislocation tool. The ECB came to markets with a certitude: the fight against inflation means an end to the Draghi era, with the termination of explicit forward guidance and of negative rates. It unveiled its latest tool, the Transmission Protection Instrument (TPI), a weapon of last resort to contain peripheral spreads dislocations. The discretionary aspect of this is novel compared to the Draghi era: the ECB is now far from its “whatever it takes” mantra, with the deployment of this tool being conditional on a multiplicity of criteria and complexities. Transparency is gone as the ECB adjusts to this fast-changing environment by keeping all of its options opened. The surprise 50 bps hike and leaving the open door to more hikes in 2022 clearly shows that inflation is now the top priority for the ECB, irrespective of macro conditions – or so it seems.

    Chinese macro newsflow was muted this week.

    Our nowcasting indicators currently point to:

    • Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum. In China, growth momentum remains subdued, but more than 50% of data are now improving.
    • Inflation surprises will remain positive for the Eurozone but are declining elsewhere.
    • Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected.

    World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Growth nowcaster-04July-01.svg

     

    World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Inflation nowcaster-04July-01.svg

     

    World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Monetary Policy nowcaster-04July-01.svg

    Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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