Global Economy Cycles From Repair to Expansion

In what was probably the most-anticipated 25-basis-point increase of all time, the US Federal Open Market Committee marked the end of a chapter in the evolving epic of the global economy. In many ways, it was anticlimactic: This could shape up to be the slowest pace of monetary tightening in history, and at levels already priced in by the bond markets.

Nevertheless, it comes at a critical moment for the world economy. As developed and emerging markets “oscillated between repair and recovery modes,” global growth has for years been elusive, says Chetan Ahya, co-head of global economics at Morgan Stanley. In fact, 2015 was the fourth straight year in which global GDP growth, estimated at 3.1%, fell short of the 30-year annual average of 3.6%.

Looking to 2016, investors should expect a similar storyline, as developed markets shift gears, from repair to modest expansion. Emerging-market economies are no longer in decline, but continue to struggle. Morgan Stanley’s emerging-market economists are calling for a modest 4.4% improvement in GDP in 2016, compared with an estimated 4% in 2015.

For investors, the plot thickens: Across the globe, “returns across asset classes have been unusually high relative to their levels of volatility,” says Morgan Stanley Global Strategist Andrew Sheets. Going forward, the trade-off between risk and return won't be so easy.

The Fed's rate increase—the first in more than a decade—is the start of what Morgan Stanley economists expect to be an unprecedented period of tightening. Moving slowly and deliberately, US policy makers will weigh the effects of this move before any further incremental increases in the second half of 2016. They will also likely leave their reinvestment policy unchanged until later in 2016, having learned a lesson after the Taper Tantrum of 2013.

The US economy should take this rate bump in stride. Consumer balance sheets appear to be in good shape, and 80% of household debt is locked in at fixed rates.

Globally, the picture is mixed, as growth now hinges on the resilience of domestic demand in developed markets, the outlook for China, and the impact of US monetary tightening in dollar-dependent emerging markets.

Whereas the US dollar typically weakens at the start of a monetary tightening cycle, Morgan Stanley is forecasting a stronger greenback through 2017, largely due to divergent monetary policy—while the US is tightening, many other major markets are either staying their course or still easing. As a result, the dollar should continue to strengthen against most major currencies.

“For the first time since the early 1990s, monetary policy will likely decouple across the Atlantic,” says Elga Bartsch, co-head of global economics. Look for the UK to start reining in its monetary policy in mid-2016. Elsewhere in Europe, quantitative easing will likely continue into 2017. China may move in the other direction, as it contemplates the possibility of deflation.

The last five years have been fraught with challenges, but ironically, investors looking to take on incremental risk didn't necessarily have to shoulder additional risk. Assuming Morgan Stanley's long-term forecasts are met with average levels of volatility, investors are looking at a much flatter efficient frontier. Translation: “We think 2016 will be the year where credit outperforms equities on a risk-adjusted basis,” Sheets says.

Historically, equities outperform at this stage of the cycle. That may not hold true this time. Chalk it up to weaker growth, looser central bank policies and larger credit-risk premiums. Debt-funded deals and share buybacks have resulted in wider (relatively speaking) spreads for US investment-grade bonds; as this activity subsides, spreads could narrow.

Slow but steady economic improvements tend to favor high-yield bonds. “The proverbial 'best house in a bad neighborhood' award goes to US high yield, where we see base case total returns of 5%,” says Sheets, adding that credit selection should be a source of significant alpha in nearly all global markets.

While the strategists recommend that investors reduce their exposure to equities, they see some opportunities—namely among the past year's losers. In Europe, “expensive defensives” may be richly priced, but the opposite is equally true for lower-quality names, including those in energy and mining. “European 'junk' has never been cheaper or more unloved,” Sheets says, “which leads us to overweight value, such as materials and energy, where we feel further earnings-per-share downgrades are now arguably discounted.”

The same can't be said for most emerging markets, where a strengthening dollar and weak oil prices continue to work against investors. “While emerging-market valuations are 'cheap,' they are not so extreme that one can ignore still-poor fundamental trends, in our view,” Sheets says. 

Historically, equities outperform at this stage of the cycle. That may not hold true this time. Chalk it up to weaker growth, looser central bank policies and larger credit-risk premiums. Debt-funded deals and share buybacks have resulted in wider (relatively speaking) spreads for US investment-grade bonds; as this activity subsides, spreads could narrow.

For more Morgan Stanley Research on the global macroeconomic and strategy outlook for 2016, ask your Morgan Stanley representative or a Financial Advisor for the full reports, “Global Macro Outlook: A Slow Slog Back” and “Global Strategy Outlook: The Lower Frontier” (both issued Nov 29, 2015). Plus, see more of our Ideas.