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Has the Global Economy Reached "Peak" Peak?

In 2017, the global economy rode a wave of synchronous growth, low inflation and low volatility. But Investment Management Chief Global Strategist Ruchir Sharma says five trends could make 2018 a very different environment. 

2017 will likely be remembered as the year investors rode a wave of favorable trends: Global growth synchronized, inflation remained persistently low despite tightening labor markets and low volatility in both developed and emerging markets set a tone of unusual calm. 

While Sharma believes that we may have more months of euphoria ahead, his takeaway for investors is to be aware of the exit door in regard to illiquid investments.

But according to Ruchir Sharma, Head of Emerging Markets and Chief Global Strategist at Morgan Stanley Investment Management, these trends may be poised to turn.

“2018 could end up being a year marked by a confluence of peaks in many respects,” says Sharma. “Despite above-trend global economic momentum, there are some cyclical and structural signs that point to peak growth.  Record lows in global unemployment rates point toward peak employment.  The recent jolt of volatility may signal the end of peak calm. And all of this is coming at a time when liquidity is peaking across the world.”

Sharma’s top five trends for the year focus on these peaks and detail how each could shape markets and economies in 2018 and beyond.

Trend #1: Peak Growth

Sharma mentions that while current global economic growth is referred to in boom-like terms, the global economy is growing at a pace of merely 3.5 percent.1 While this is the fastest pace since the great financial crisis of 2008-2009, it is below the average of the postwar “miracle years,”2 he argues, and it may also be peak growth for three reasons: commodity prices, low global investment and weak population growth. 

“In terms of commodities, you have to look at countries like Brazil and Russia, which have gone from slumps of negative economic growth to now registering positive economic growth this year.  However, the question is, can commodity prices go higher from here?  So although we’re seeing a boost from commodity-producing economies, it could be limiting.”

A lack of global investment may also hamper further growth. “Investment levels in the U.S. and Europe are relatively low, largely because the world's manufacturing has shifted to China,” Sharma says. “So now China is heavily overinvested, and the Western world is underinvested.”  Sharma says we're likely to see a rebalancing in the coming months, with investment activity picking up in the Western world but slowing in China as the country moves toward a more consumption-oriented economy.

Finally, he points to a slowing in the population growth rate, which he calls “Peak People.”

Trend #2: Peak People

Sharma points out that from 1950 to 2005, there was an explosion in the working-age population growth rate, averaging roughly 2 percent a year.  But since 2005, the rate of growth has dropped to an average of 1 percent.3

“The two drivers of economic growth are increases in the labor force and increases in productivity,” says Sharma. “From 1950 to 2008, the postwar miracle period, the global economy experienced an unprecedented boom that coincided with an increase in the working-age population. Although the current economic conditions are considered boom-like, global economic growth today is nowhere close to what we experienced over that period. And it's likely, I think, to slip further because this trend has been going down, and it's a trend that’s very hard to reverse.” He points to a telling comparison between the mid-1980’s—where only two countries saw shrinking populations—versus today, where 38 countries have that distinction. 

As a silver living, Sharma says this trend has resulted in falling unemployment rates, which calms some fears about automation replacing workers in developed nations. “The unemployment rate today is close to a 40-year low,” Sharma says. “Even emerging markets are seeing about as low a level as we have seen since data was captured.”

Trend #3: Peak Positioning

Sharma also points out that investor optimism has driven cash levels worldwide to record low levels on both the institutional side and retail side. “My favorite new phrase is ‘Illiquidity is the new leverage.’ The size of financial markets has grown so big that the tail is now wagging the dog,” Sharma says. “In 1980, before the start of the great era of financialization, the value of global stocks and bonds was similar to that of global GDP. Now the global value of stocks and bonds is three and a half times larger than the global economy.4 This has major consequences in terms of economic activity.”

Sharma points out that if you examine the long-term trend from 1950 to today, the U.S. stock market is currently running about 25 percent above its long-term trend.5 His concern is that if markets correct for some reason and return to their long-term trend, it could be enough to tilt the U.S. economy into a recession.

“This is the magnitude of the wealth effect at play,” says Sharma. “The rising stock market may have contributed somewhere between a half and 1 percent of the GDP growth rate in 2017.6 And that is just in stocks. People are heavily invested.”

Trend #4: Peak Liquidity

Sharma mentions that we’re also at peak liquidity as central banks begin unwinding their balance sheets.  “Before the start of the financial crisis, the four major central bank balance sheets held about $4 trillion in assets. Now, it has exploded to nearly $18 trillion,”7 he notes. But he also points to the contraction that may be coming in the second half of this year.

“It’s been a very interesting experiment,” Sharma says. “The unwinding of this central bank experiment has already begun in the U.S. (Fed), but it has been countered because the European Central Bank (ECB), Bank of Japan (BOJ) and People’s Bank of China (PBOC) have been quite aggressive in their balance sheet expansions over the past couple of years. But by the end of the year all of the central banks will likely begin to see a contraction in their balance sheets.”

Trend #5: Peak Calm

Finally, Sharma sees signs that record-low levels of volatility may be coming to an end. “Until recently, the 12-month trailing volatility for global markets has been the lowest ever recorded.8 In the past year that’s been justified because economic growth volatility and inflation volatility have been so low.  But this trend is very much against the nature of markets,” he comments. 

“In any typical year9 the U.S. stock market has seen a 10 percent correction,” Sharma says. “Last year the maximum drawdown was barely 3 percent. And for emerging markets it's even more staggering.” He notes that even during the bull years of 2003 to 2007, emerging markets would typically see a 20 percent correction every year. Last year the largest drawdown was barely 5 percent.10

Sharma believes that as interest rates rise, so too will volatility.  “When interest rates rise, there's always some trouble. But there's usually a lag of about two years after an interest-rate tightening cycle begins,” he says. “Given the fact that the Fed began increasing interest rates at the end of 2015, by the middle of this year we should expect to see a rise in volatility based on this historical relationship.”

While Sharma believes that we may have more months of euphoria ahead, his takeaway for investors is to be aware of the exit door in regard to illiquid investments.  “Remember, illiquidity is the new leverage,” he says. “Think about how you might be positioned if the tide turns.”

Sharma also encourages investors to keep an eye on emerging markets: “Many emerging markets are still in the early stages of what appears to be an upturn after a long economic adjustment. There's barely an emerging market in the world today where the current account deficit is more than 3 percent of GDP,11 which is very different from what it was four years ago during the taper tantrum.”

He points to what he believes to be some breakout stars in Eastern Europe; long-term stories like Indonesia, the Philippines and India; and overlooked companies in emerging markets, which have the potential to benefit from early stages of the cycle such as financials and consumer cyclicals.

FOOTNOTES 

1 MSIM EM Research, JP Morgan Research, IMF, World Bank as of February 2018.

2 MSIM EM Research, IMF, World Bank, United Nations (Miracle years refers to the period from 1950-2008) as of February 2018.

3 MSIM EM Research, United Nation Population Database (Working Age Population refers to people between 15-64 years of age as per UN definition) as of February 2018.

4 MSIM EM Research, BIS, Mckinsey, WFE, IMF as of January 2018.

5 MSIM EM Research, Bloomberg as of January 2018.

6 MSIM EM Research, GS Research, JPM Research, IMF as of January 2018.

7 MSIM EM Research, Federal Reserve, European Central Bank, Bank of Japan, People’s Bank of China as of February 2018.

8 MSIM EM Research, MSCI AC World Index, as of January 2018 (based on data going back to 1988).

9 Based on data from January 2018 going back to 1988.

10 MSIM EM Research, using data going back to 1988 as of January 2018.

11 MSIM EM Research, Haver Analytics, IMF, as of February 2018.

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