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Global debt outlook: A more stable second half could stem the tide of slower growth

The second quarter was a continuation of the
first in both the economic data (as growth continued to slow) as well as the
market reaction to that data. Looking ahead, the Global Debt
team expects global growth momentum to keep tapering in the third quarter, but
at a slower rate since we expect greater stability in the second half of the
year.

What
did we see in the second quarter?

Global growth, as we expected, continued to
slow, and policymakers responded by moving toward easier monetary conditions in
almost every major global economy.  With
the easier stances in developed economies, emerging market central banks, led
by Chile and India, joined in the trend of easing tight monetary
conditions. 

The market reaction in the quarter was as anticipated. Those sectors that had been hurt by tighter monetary conditions in 2018 benefitted the most in this environment.  Emerging market assets performed the best in the quarter with an EM local currency bond index returning 5.6%, an EM US dollar bond index returning just over 4%, and a broad US dollar index falling by nearly 1%.1

Below, we take a deeper look at each region,
and expand upon our second-half outlook.

Developed markets

The
US economy has been slowing down, but from quite high levels. In our view, it’s
moving toward its potential level of just below 2%. Part of the slowdown is due
to the waning fiscal stimulus of last year, but uncertainty about trade and the
slowdown in the world economy are also factors. Business surveys on balance
suggest weakening confidence and business investment has slowed down this year.
We expect consumption to remain resilient, thanks to the solid job market, wage
gains, low household borrowing, and strong confidence. Inflation is below
target and will likely remain so until 2020, in our view. The Federal Reserve has
strongly signaled that it may cut interest rates, and we expect a total cut of
50 basis points in 2019.

The
eurozone’s economic weakness has continued because of its exposure to global
trade. Weakness started mainly in manufacturing and trade, while more
domestically oriented sectors proved resilient. On the domestic side, consumer
confidence has declined from the cyclical highs but nevertheless has remained at
strong levels. Credit is available and the labor market has continued to
improve. As in the US, there is domestic resilience but there is more need for
policy support given the eurozone’s more fragile recovery and higher exposure
to the global economy. We believe the European Central Bank is ready to act,
and we expect to see some modest stimulus in the fall, which could be signaled
in the summer.

Japan
also suffered from trade tensions. Economic growth surprised in the first
quarter, but its composition was not encouraging and recent surveys suggest
ongoing loss of momentum. With external risks increasing, firms have been reluctant
to increase wage growth. However, the labor market is extremely tight in Japan,
jobs are plentiful, and workers are hard to find. In response, companies have
been investing in machinery and software to address labor shortages. The tight
labor market and investment demand in domestically oriented sectors could
provide a cushion against downside risks.

China and Asian emerging markets

As
we expected, the first quarter was mired in further data weaknesses for Asian
emerging markets (EM), despite some stabilization in China. We see this as a
manifestation of global trade blues as global exports and industrial production
fell sharply. In addition, Asia is also feeling the headwinds from a slowing
technology cycle. In China, front-loading of exports before tariffs took effect
and the domestic policy easing were behind the stabilizing growth numbers in the
first quarter. However, forward-looking indicators point to the potential for
further weakness ahead for the region as global demand weakens.

The
stabilization we had expected in the second half of 2019 was rooted in our
expectation for a trade deal between China and the US. Despite the recent truce
at the G-20 meeting, the higher tariff rates as well as continued uncertainty
about a deal pose further downside risks to China’s and Asian emerging markets’
growth in the second half, notwithstanding the ongoing stimulus in China. We
see this uncertainty a key driver for weak global investment, which in turn
negatively affects Asian exports. On the positive side, we expect further
easing from China, should second-quarter data surprise significantly.

We
believe that this global backdrop, benign demand-led inflation pressures and
widening output gaps may allow room for more interest rate cuts in several
countries, such as India, Indonesia, Korea, Malaysia, Philippines, Russia, and
South Africa.

Latin America

The
EM economies of Latin America have underperformed growth expectations, and we
are therefore cutting our 2019 and 2020 growth forecasts across the board. The
disappointing slowdown has broadened from the region’s larger economies, which we
expect to see traction later, to the smaller economies. We have not materially
changed our inflation outlook, as output gaps are even wider and inflation
risks are lower. We expect easier global monetary conditions to curb exchange
rate pressures and allow all regional central banks to add stimulus.

Colombia’s
lagged economic recovery soldiers on while Argentina has been the larger
exception in the region with negative growth and double-digit inflation. Yet
these two economies are still improving from last year. We believe the bar is
now too high for the Argentinian economy not to contract this year, but we are
hopeful for a background of macro-stabilization, which we think will succeed
with the potential reelection of Mauricio Macri in the October
presidential election.

Mexico’s
growth was hurt by the US slowdown and uncertainties over domestic policy. In
our opinion, while the Mexican economy benefits from a good starting point with
low debt levels, its economic fundamentals are deteriorating with President
López Obrador (AMLO) and his heterodox policy mix. Within this context, we are
constructive because we see inflation convergence with central bank easing,
high real rates, and fiscal prudence. We do not see Mexican sovereign debt
ratings going to below investment grade, while the national oil company may be
downgraded again and removed from investment grade mandates.

In
Brazil, we are more optimistic with the approval of the strong pension reform,
and we expect the central bank to drive expansionary conditions. Economic
activity has faltered on global and local shocks that allowed a large negative
output gap, with domestic uncertainties failing to support a more benign
environment. We think traction will come, with higher growth more likely to
materialize next year. All in, decreasing global interest rates allow for more
accommodative monetary policy, which would support EM assets. The primary risk
to emerging markets is a full-blown trade war, instead of a protracted
conflict-resolution solution, leading to recession. However, we see this as
unlikely.

Outlook

We still see global growth
momentum slowing in the third quarter, but at a slower rate since we expect
greater stability in the second half of the year. We think EM growth will
improve marginally in the second half, but at a lower level than we originally
expected in the first quarter. The slowdowns in trade and related investments
have been the primary drivers of the decline in global growth. The domestic
drivers of growth have been stable, in almost every region, despite signs of weakness
evident in declining inflation expectations. 

The US economy has been slowing
down, but from high levels, towards its potential of just below 2%. Declining
fiscal stimulus of last year, along with uncertainty about trade and lower
global growth, are also contributing factors. Lower growth in the eurozone
continues from weakness in manufacturing and trade, while domestic sectors have
been more resilient. Consumer confidence has declined from the cyclical highs
but remains at strong levels.

While the delta of change to
growth is still negative, we think there will be some stability in the second
half and an improvement in global growth in 2020. Our 2019 growth forecast is
2.8% for the countries in our investible universe, and this is a bit below consensus.
However, our 2020 growth forecast is 3.1% with the increase coming mainly from
outside the US. While global growth is weaker, it is still very much with the
global sweet spot of being at potential or slightly below providing support for
risk assets. The impact of both monetary and fiscal policy is expected to be
positive for assets.   

We expect that monetary policy
globally will continue to become more supportive, especially as the Federal
Reserve has moved toward an easing bias. 
Similarly, The European Central Bank has already announced that further
monetary policy stimulus is quite likely, and we are waiting to see which form
it takes.

In this environment, there is room
for emerging market central banks to provide monetary stimulus. EM central
banks from India to Chile have eased, and we expect other central banks to
follow. Real policy rates in emerging market countries remain high with room to
fall. The high real rates also highlight the fact that inflation remains very
muted globally, and we see little near-term risk of it accelerating in a
meaningful manner.

We expect the mix of moderate
growth with falling inflation to have a positive impact on asset prices. While
we will monitor global conditions closely, we do not expect a recession. The
positive policy environment that began in the first quarter should continue for
our investment horizon.

Portfolio implications

Due to the shift in economics and
the policy environment, the Global Debt team has kept a stable outlook for our
portfolio positioning.  We continue to
believe the US dollar will slowly decline, possibly accelerating in the second
half of 2019 into 2020 as the global growth differential to the US may widen. We
maintain our view that the medium-term trend for the dollar is lower,
continuing the decline that started in 2015, and was only interrupted in 2018
because of the large fiscal stimulus in the US. EM currencies will likely
benefit from carry while developed market currencies could benefit from
valuations.  

In our portfolios, we favor carry
from EM currencies. We increased our exposures to the Brazilian real, Indian
rupee, Indonesian Rupiah, and South African rand. We also like the Norwegian
krone. We continue to favor emerging market interest rates over developed
market interest rates. Real yields in emerging markets remain close to highs
when compared to a combination of developed market yields. Given the strong
performance in credit in the first half of the year, we are reducing our credit
exposure in both emerging markets and Europe. We look to redeploy that capital
into emerging market interest rates.

1.
Source: Bloomberg, L.P. The EM local currency bond index is defined by the
J.P. Morgan Government Bond Index – Emerging Markets Global
Diversified, which consists of regularly traded, liquid fixed-rate, domestic
currency government bonds to which international investors can gain exposure.
The EM
US dollar bond index is defined by the J.P. Morgan Emerging Markets Bond
Index Global Diversified, which is a composite index representing an
unleveraged investment in emerging market bonds that is broadly based across
the spectrum of emerging market bonds and includes reinvestment of income (to
represent real assets). The broad US dollar index is represented by the
Bloomberg Dollar Spot Index, which tracks the performance of a basket of 10
leading global currencies versus the US dollar. It has a dynamically updated
composition and represents a diverse set of currencies that are important from
trade and liquidity perspectives. An investment cannot be made directly into an index. Past
performance  does not guarantee future
results.

Important information
Blog header image: Thaï Ch. Hamelin – ChokdiDesign / Unsplash.com

Carry is defined as the profit investors gain from selling a certain currency with a relatively low interest rate and using the funds to purchase a different currency yielding a higher interest rate.

Interest
rate risk refers to the risk that bond prices generally fall as interest rates
rise and vice versa.

An
issuer may be unable to meet interest and/or principal payments, thereby
causing its instruments to decrease in value and lowering the issuer’s credit
rating.

The
risks of investing in securities of foreign issuers, including emerging market
issuers, can include fluctuations in foreign currencies, political and economic
instability, and foreign taxation issues.

The performance of an investment concentrated
in issuers of a certain region or country is expected to be closely tied to
conditions within that region and to be more volatile than more geographically
diversified investments.

The opinions referenced above are as of July 19, 2019. These
comments should not be construed as recommendations, but as an illustration of
broader themes. Forward-looking statements are not guarantees of future
results. They involve risks, uncertainties and assumptions; there can be no
assurance that actual results will not differ materially from expectations.

This does not constitute a recommendation of any investment
strategy or product for a particular investor. Investors should consult a
financial advisor/financial consultant before making any investment decisions.
Invesco does not provide tax advice. The tax information contained herein is
general and is not exhaustive by nature. Federal and state tax laws are complex
and constantly changing. Investors should always consult their own legal or tax
professional for information concerning their individual situation. The
opinions expressed are those of the authors, are based on current market
conditions and are subject to change without notice. These opinions may differ
from those of other Invesco investment professionals.

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