The Investment Implications of a Diverging Global Economy

In collaboration with Valtteri Ahti, Ph.D. Chief Investment Strategist at Evli

Powell at Jackson Hole stresses heightened macro uncertainty

At Jackson Hole Fed chair Jerome Powell remarked that “We are navigating by the stars under cloudy skies.” He implied that macro uncertainty is obscuring the appropriate Fed policy rate that balances the economy, or r*. Having been humbled by the inflationary surge, the Fed is reluctant to rely on models and staff estimates. Instead, the Fed wants to see inflation truly fall and stay low.

The US economy defies doomsayers

The US economy has surprised both the markets and the Fed with its resilience. Economic growth is proceeding above trend at a healthy clip of 2.5%, despite the Fed hiking rates by 5% points in 14 months, which is the most aggressive hiking cycle since the 1980s.

Only a year ago Bloomberg economics stated that there is 100% chance of a US recession in the next 12 months. Indeed, most major banks and the Fed were calling for a recession. Ironically, it would seem the most predicted recession in history has failed to materialise.

The global economy has begun to diverge

The global economy is diverging. The US is exhibiting exceptionalism and other major economies are not looking resilient. To understand why the other major economies are faring less well than the US one has to look at how global demand has shifted and how high interest rates are having more of an effect in some economies than others.

The global rotation from goods to services hurts industrial giants Germany and China

The initial bout of post corona spending was based on buying goods. The second present phase of spending has centred around services. The shift away from goods has hurt industrial goods producing economies such as Germany and China. The rise of services has in turn bolstered service heavy economies such as the US.

The US is relatively insulated from high rates as households have locked in low rates

Interest rates have risen across the globe, but some economies are more insulated from monetary punishment than others. At one extreme is the US, where 85% of households hold 30-year mortgages. The vast majority of these mortgages are fixed rate mortgages. Hence, although the current US mortgage rate is 7.2%, the effective mortgage rate on outstanding mortgage debt is at historically low rate of 3.6%. European mortgage markets differ, but none are as insulated as the US mortgage market.

European housing and construction are also showing signs of distress, whereas US national house prices are unchanged year over year. The US housing market has been helped by a lack of housing inventory.

China’s four-decade long project of extinguishing the business cycle ends with Xi Jinping

For the last four decades, China has avoided recessions by simply stimulating its way out of them. This extravagant policy has led to China’s total level of debt hitting 300% relative to GDP, which is higher than in the US. Stimulus has taken the form of infrastructure spending. After four decades of pouring capital into ports, roads, and airports, there seems to be little sensibly left to build, which is reflected in the declining estimates of rates of return.

Unfortunately, China’s economy is in trouble with property prices falling and households deleveraging. Yet, premier Xi Jinping has decided that the time for massive government stimulus is over. This sea change in policy is a game changer for both the Chinese and the global economy.

Investing in divergence

Trading global macro divergence means going long US exceptionalism and shorting much of the rest of the World. US interest rates will remain high whilst European interest rates will come under pressure. The spread in economic growth rates and interest rates will be a tailwind for the dollar.

Stocks are less of a pure global macro play as stock markets are not representative of the real economy. Nevertheless, US stocks have more exposure to the US economy. European and emerging market economies naturally have less US exposure. Hence US stocks should outperform. Of course, US stocks are dominated by megacap stocks, the alleged magnificent seven, that are riding the AI wave that may prove to be the next bubble.

As we conclude our journey through the interesting realm of macroeconomic divergence and its ramifications for investment strategies, we extend a special invitation. Join us for our upcoming Trend Watch Series Volume 11, where our panel of industry experts will take the reins. Through their insights, analysis, and dynamic discussions, you'll gain a comprehensive understanding of the evolving global economic landscape and actionable strategies to harness opportunities amidst macro divergence.

Don't miss this unique opportunity. Reserve your spot now by registering HERE