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Mid-year Global Macro Outlook: Constructive on the Cycle

As 2018 began, the global economy had reached a comfortable cruising speed thanks to a rare period of “global synchronous growth” driving both developed and emerging market economies. Now, midway through a year marked by the return of market volatility, a rise in protectionism risks and the reality of central bank tightening, investors are concerned that the global economy is a glass half empty.

While risk assets will likely hit a cyclical peak this year in many major markets, the global economy should continue growing above trend.

While markets are late cycle—and probably already in a bear market in the case of corporate credit—economic cycles and market cycles are not always in sync. In this cycle especially, markets have outperformed the economy over the last few years, but this is likely to reverse as central banks pull back their direct support to markets.

So while risk assets will likely hit a cyclical peak this year in many major markets, the global economy will continue growing above trend, as improvements in capital expenditures and productivity kick expansion into another gear.  “We often hear the argument that this expansion has been rather long and will enter its tenth year in 2019,” says Chetan Ahya, Morgan Stanley’s Chief Economist. “However, the passage of time is not the best indicator to predict when the business cycle will end.”

That’s particularly the case for this recovery, which was preceded by a deep recession, interrupted by a number of temporary crises and has been sub-par until 2016. On an annual basis, global real gross domestic product (GDP) is on pace to increase 3.9% for 2018 and 3.8% in 2019—its best showing since the initial rebound early in the cycle and several steps ahead of the long-term growth rate of 3.5%.

Global Growth: Moderating But Still Above Trend*

(Global Real GDP Growth % Y)

Source: Haver Analytics, Morgan Stanley Research forecasts; Global is Morgan Stanley coverage excluding Argentina, Venezuela, Nigeria, Saudi Arabia and Kazakhstan.

Capex and Productivity Kick In

At first glance, there are reasons for investors to question whether global expansion has run its course: Inflation, central bank tightening, the threat of trade wars and other risks are real.  On the contrary, “from the perspective of a stylized business cycle, we believe that the global economy has moved from a gradual recovery phase to a productive growth phase,” Ahya explains.

While inflation is set to rise in both developed and emerging markets, it remains in line with central banks’ targets. Meanwhile, easy financial conditions are still firmly in place. U.S. rate hikes are the most meaningful but still not likely to end the business cycle.

Capex Recovery Supporting a Revival in Productivity Growth

Source: Haver Analytics, Conference Board, Morgan Stanley Research. Note: Labor productivity data and forecasts from Conference Board, real investment forecasts from Morgan Stanley Research.

Regional Differences Are Key

With few exceptions, major global economies are expanding, even as the global cycle is maturing. Nevertheless, there are significant regional differences. On the whole, developed markets are far more advanced in their progression, but the majority of emerging markets—with the notable exception of China—are still in the early or middle stages of their expansions.

The U.S. economy is, not surprisingly, at the farthest stretch of its economic cycle. “This expansion will soon go down as the second-longest on record,” says Chief U.S. Economist Ellen Zentner. “The tailwinds that have been fueled by ‘fiscal muscle’ will subside, but GDP growth is still on the upswing.” Zentner and her team recently bumped up their 2018 and 2019 real GDP estimates to 2.7% and 2.2% respectively.

Following a relatively robust 2017, the euro area’s economic expansion is showing signs of moderating, with real GDP growth expected to come in at 2.1% this year and 1.9% for 2019. “The consumer is unlikely to provide the same support to the economy,” notes Senior European Economist, Daniele Antonucci. “But we expect capex growth to stay strong and productivity to rise gradually.” It’s worth noting that while economic expansion is winding down, Europe’s market cycle is running behind its developed market peers, offering investors potential upside as Morgan Stanley strategists note in their mid-year investment outlook.

In emerging markets, Morgan Stanley economists expect growth in China to slow moderately as a result of policy tightening and supply-side reforms. Slow is, of course, relative: GDP for this economic behemoth is still forecasted to increase 6.6% and 6.4% respectively in 2018 and 2019.

Emerging Markets ex-China to Be the Main Driver of Global Growth

(Contribution to Global GDP Growth in ppt)

Source: Haver Analytics, Morgan Stanley Research forecasts; Note that DM includes countries under Morgan Stanley coverage only. *EMXC is Morgan Stanley coverage excluding Argentina, Venezuela, Nigeria, Saudi Arabia and Kazakhstan.

Meanwhile, the moderate deceleration in China will likely be offset by improvements in other developing markets. Excluding China, emerging markets should be the main driver of global economic growth over 2018-2019.

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