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It’s always darkest just before dawn

It’s always darkest just before dawn

26-09-2016 | 5-Year outlook

Every year Robeco takes a fresh look at the outlook for the global economy over the next five years. Our analysis gives a prognosis for the major asset classes and three potential scenarios (baseline, stagnation and high growth).

  • Lukas Daalder
    Lukas
    Daalder
    Former CIO Robeco Investment Solutions. Daalder left Robeco in July 2018.
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Speed read

  • Hopes of monetary policy returning to normal in 2016 were shattered
  • Sentiment among professional investors is extremely weak
  • We continue to believe a gradual normalization is the most likely scenario

In December 2015, when we first set out to discuss this year’s edition of our annual Expected Returns publication, we were in good spirits. The European economy had surprised everybody by growing above trend, the global economy was picking up and the Fed’s first interest-rate hike had not derailed markets as many had feared. The process of monetary normalization was all set to begin.

Sure, there were issues; there always are. The ongoing decline in the oil price; positive for consumers, perhaps, but worrying for financial markets. A growing consensus among economists that increasingly high debt levels could lead to an adverse debt cycle. And the meltdown in emerging markets with the Brazilian and Russian economies shrinking significantly (by 3.8% and 3.7% respectively in 2015), plus a Chinese growth path that was looking increasingly unsustainable. But it was nothing we couldn’t handle.

Black clouds

Eight months on and our spirits are not in such good shape. The hoped for normalization evaporated after a solitary rate hike by the Fed. Falling oil prices have hit the positive impetus driving the US economy and the outlook has become more uncertain. External factors have also curbed the Fed’s desire to hike rates: uncertainty about China, financial market volatility and a major negative blow in the form of the Brexit vote. This shattered any hopes of monetary policy returning to normal, causing the UK to follow in the footsteps of the ECB and Bank of Japan and start quantitative easing. So unless we now regard QE as the new normal, it is clear that 2016 is not set to become the year of monetary normalization.

Is this just another temporary setback, or should we succumb to one of the numerous credible doom scenarios: disintegration of the European economy (Brexit, the rise of populist parties, Italian banks), Chinese hard landing (unsuccessful rebalancing of the Chinese economy, high debt), rise in protectionism (the Trump factor), loss of central-bank credibility (Japan), and the bursting of the debt bubble. After all, we’re spoilt for choice.

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It’s always darkest just before dawn

But are things really so bad? You could be forgiven for thinking they are. Our impression is that sentiment among professional investors has probably never been as weak as it is right now. This is corroborated by what the financial markets have priced in: average inflation expectations in the European market for the period 2021-2026 are as low as 1.25%. Looking at the West-German track record (renowned for its tough inflationary stance), such a five-year average is pretty rare. Possible? Sure. But likely? Well, only if you really are very pessimistic about the future. And this is exactly the point we want to make.

Pessimism is a risk in itself. There is plenty of self-reinforcing momentum in the way economies work, so a move in one direction is not easily reversed. Once growth weakens, producers and consumers become more cautious, investment, employment and consumption levels all contract, reinforcing the downward trend.

Stock markets normally hit bottom when things are at their bleakest. If earnings evaporate, companies collapse, people get fired and there is talk of ‘the end of capitalism as we know it’, that’s when the tide turns. The bad news may still continue, but the market has by then already discounted it. The bleaker the expectations, the better the odds that the surprise will be a positive one.

It’s always darkest just before dawn. And if the mood of investors is anything to go by, it is already pretty dark out there.

Baseline scenario

Despite just how tempting it is to succumb to this general feeling of pessimism, we continue to believe that a gradual normalization is the most likely scenario. Call us optimists if you like. One fact overlooked by many is that – despite low growth – labor markets have strengthened and unemployment rates in the leading economies are below their longer term averages. In this scenario, consumers with a disposable income boosted by oil price falls should play a central role. Mind you, given the underlying growth and inflation assumptions, we are not predicting anything spectacular: the global economy will grow by roughly 3%, inflation will reach an average of 2.5% for the world as a whole and 2% for the developed countries. But we are well aware of the risks in the current environment and the 60% likelihood we attach to our baseline scenario reflects this.

The table summarizes our forecast for the broader asset classes. We are not particularly positive on government bonds and have lowered our five-year expected return on AAA European government bonds to -3.5% (2015: -3.0%). Yields have dropped to even lower levels than last year, giving less of a buffer when adverse price movements occur. This -3.5% is, however, based on the German ten-year benchmark, which has almost the lowest yield out there. Our projections for the US indicate a -0.25% negative return (local currency), while peripheral European bonds also offer better value. We have increased our five-year target for developed market equities to 6.5% (2015: 5.5%), reflecting lower equity valuations worldwide.

Stagnation scenario

We have become more cautious and this is reflected in the increased likelihood we have given our stagnation scenario (from 20% to 30%). Here, we expect global economic growth to decline to 1.6%, half the level seen over the past five years. Some areas will be hit by recession, China will hit zero growth and then see a subdued recovery. Inflation will drop to an average of 1%, but would reach deflationary average levels without the contribution of emerging markets. The Western world will sink into a Japan-like scenario. Unlike the baseline, in this adverse growth scenario bonds remain the place to be, offering the only value for money.

High growth scenario

In our optimistic high growth scenario (10%), the US and the Eurozone economies expand rapidly, initially boosted by consumption and later by investment too. The global economy enters a virtuous circle and debt ratios fall. China successfully rebalances its economy and growth in Japan accelerates. Average real global economic growth will reach 3.5%. Perhaps not high compared to the 3.25% of the past five years, but if we take aging and the lower Chinese growth rate into account (6% compared to 8.5% in 2010-2015), it means growth will rise above its underlying potential. Inflation poses the main risk causing bonds to suffer and depressing stock performance somewhat, as wage and financing costs hurt margins.

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