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Midyear Market Outlook

Global Growth Should Improve if Trade Disputes Don't Worsen

Robert W. Sharps, CFA, President, Head of Investments, Group CIO
Justin Thomson, Head of International Equity
Mark J. Vaselkiv, Chief Investment Officer, Fixed Income

Executive Summary

  • While challenges to global economic expansion are evident in slower earnings growth, the risk of a recession in major markets appears limited.
  • Widening trade disputes and populist politics have created notable downside risks, which could endanger hopes for an earnings reacceleration in late 2019.
  • Monetary expectations have shifted dramatically since the beginning of the year, with the Federal Reserve now seen as likely to cut interest rates.
  • Secular disruption continues to favor growth and the technology sector, but investors are becoming more cautious and some established firms are fighting back.

Heading into the second half of 2019, senior T. Rowe Price investment leaders remain cautiously positive about global economies and financial markets, but they warn that political risks—in particular, escalating trade disputes—could trigger renewed volatility and further impede growth.

To a certain extent, market behavior in the first half of 2019 seemed to reflect two contradictory perceptions, argues Robert W. Sharps, chief investment officer (CIO) and head of investments:

  • Falling bond yields and an inverted U.S. Treasury yield curve—a situation in which longer‑term yields move below short‑term interest rates—appeared to signal growing economic pessimism.
  • On the other hand, the relatively strong equity gains seen in the U.S. and many emerging markets in the early months of 2019 seemed to suggest hopes for an earnings reacceleration later in the year.

On the positive side, market expectations for monetary policy shifted dramatically in the first half. Investors now lean toward the view that the U.S. Federal Reserve is more likely to cut interest rates rather than raise them further, according to Mark Vaselkiv, CIO, fixed income.

On the negative side, hopes for a trade deal between the U.S. and China deteriorated in May, and the Trump administration briefly threatened to impose tariffs on Mexican goods. Trade fears contributed to persistent strength in the U.S. dollar, keeping emerging market (EM) currencies under pressure, notes Justin Thomson, CIO, equity.

“A lot depends on a resolution of the trade war and on the emergence of green shoots of improving global economic and earnings growth,” Sharps says. “If we get those things, we could see the U.S. equity market make new highs. If not, expectations for 2020 clearly will need to come down.”

Opening Quote To a certain extent, market behavior in the first half of 2019 seemed to reflect two contradictory perceptions... Closing Quote

Global Growth Has Slowed, but Recessions Are Unlikely

Concerns about the strength of U.S. and global economic growth returned in the second quarter of 2019. The stellar U.S. earnings gains seen in 2018 abruptly stalled (Figure 1).

While the consensus earnings forecast is for a reacceleration later in the year, to get that result “you will have to see economies begin to improve, particularly outside the U.S.,” Sharps says. However, the global economic outlook remains subdued, according to Thomson:

  • Most developed economies are growing below their potential, and earnings momentum has turned negative in both Europe and Japan.
  • In the emerging markets, the strong U.S. dollar effectively is a form of monetary tightening—unwelcome in economies still in the early stages of recovery.
  • The trade war is having a corrosive effect on business confidence and capital spending, particularly in export‑heavy economies such as Germany, Japan, Korea, and Taiwan.

Despite these headwinds, the risks of a U.S. or global economic downturn still appear limited. “I don’t see any major imbalances that would suggest a recession is imminent or even likely,” Sharps says.

The strength of the Chinese economy remains a key variable. Slow growth in late 2018 led Beijing to ease credit and boost spending, but the results may not have been as positive as Chinese policymakers desired. “If there is one thing that would make us change our generally cautious stance [on global growth], it would be if China increases stimulus again,” Thomson says.

Opening Quote If there is one thing that would make us change our generally cautious stance [on global growth], it would be if China increases stimulus again. Closing Quote
— Justin Thomson
CIO, Equity

(Fig. 1) U.S. and Global Earnings Growth Has Stalled
Cumulative Growth in Earnings Per Share by Region
December 2013 Through May 2019

Sources: Standard & Poor’s (see Additional Disclosures) and MSCI (see Additional Disclosures). T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved.

Opening Quote Thomson warns that the trade war is metastasizing into a technology war. Closing Quote

Trade War Tops List of Geopolitical Risks

A series of events in May—including fresh tariff hikes by the U.S. and China; U.S. sanctions against Huawei, a major Chinese telecommunications firm; and the Trump administration’s threat to impose tariffs on Mexico—helped reignite fears of an escalating trade war.

Although the U.S. and Mexico reached a deal in June that appeared to avoid tariffs, these and other geopolitical events contributed to a surge in perceived economic policy uncertainty—particularly in China, but also in the U.S. and Europe (Figure 2).

A trade deal between the U.S. and China is still within reach, but neither country may feel a need to compromise quickly:

  • With President Trump facing reelection in 2020, he may want to put off any agreement until next year, Sharps suggests.
  • Political incentives also might favor delay on the Chinese side, Vaselkiv says. Denying Trump a trade success could damage his reelection prospects, allowing Beijing to negotiate with his successor.
  • Thomson warns that the trade war is metastasizing into a technology war. This could make settlement harder, as both countries may believe that critical technology advantages are at stake.

While the direct impact of tariffs on economics and earnings growth appears manageable at the moment, the secondary effects on business confidence, capital spending, and hiring could diminish hopes for a second‑half earnings rebound, Sharps warns. “I don’t think that’s likely, but it certainly is a possible outcome.”

Trade may be the most significant political risk facing investors, but it’s not the only one. Recent elections in Europe have shown that populist anger remains a potent political force.

Europe’s moderate political parties took “an absolute drubbing” in European Union parliamentary elections in May, Thomson notes. The outcome could encourage Italy’s populist coalition to continue pushing fiscal reflation, resulting in wider yield spreads between Italian debt and German bunds.

In the UK, a heated leadership contest following Prime Minister Theresa May’s resignation could intensify pressure for a “no deal” Brexit, with major negative implications for the UK and European economies.

(Fig. 2) Escalating Trade Disputes Are Fueling Uncertainty
Economic Policy Uncertainty Indices
December 2013 through May 2019

Source: Economic Policy Uncertainty, ©2012 by Economic Policy Uncertainty.
1Global Index through April 30, 2019.

Opening Quote ...if the Fed goes with a 50‑basis point cut, I think that could really spook the markets because that would say, ‘Wow, things are worse than anticipated.’ Closing Quote
— Mark Vaselkiv
CIO, Fixed Income

Growth Fears Will Pressure the Fed

The first half of 2019 ushered in a dramatic shift in market expectations for Fed policy. By late May, futures markets were pricing in as many as three Fed rate cuts by the end of 2020 (Figure 3).

A deepening inversion in the U.S. Treasury yield curve signals growing market confidence that the Fed’s next policy move will be downward, Vaselkiv says. “Fixed income investors in essence are daring and insisting that the Fed cut rates.”

But with policy rates still at historically low levels, and with the 10‑year Treasury note yielding less than 2.20% at the end of May, Fed policymakers have limited room to maneuver, Vaselkiv adds.

“We would not be surprised to see a 25‑basis‑point cut at some point later in the year to try to calm down volatility,” Vaselkiv says. “But if the Fed goes with a 50‑basis‑point cut, I think that could really spook the markets because that would say, ‘Wow, things are worse than anticipated.’”

If the Fed has limited room to cut rates, the European Central Bank (ECB) and the Bank of Japan (BoJ) appear to have virtually none, Thomson says. The ECB’s overnight deposit rate already is negative, while the BoJ is continuing to hold interest rates out to 10 years effectively at zero.

“The glass‑half‑full view would be that all of this is highly stimulative,” Thomson says. “The glass‑half‑empty interpretation would be that [the ECB and the BoJ] have run out of bullets.”

(Fig. 3) Investors Expect the Fed to Cut Rates
Futures Markets Versus FOMC Projections of the Federal Funds Rate
As of May 31, 2019

Sources: Federal Reserve Board/Haver Analytics. T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.
1Median of participants’ forecasts in the March 20, 2019, Federal Open Market Committee Summary of Economic Projections.

Global Growth Should Improve if Trade Disputes Don't Worsen

Additional Disclosures
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