These days the investing world seems split between two types of market participants: the believers and the skeptics.

Firmly among the believers are investors in equity markets, which have rebounded sharply from their sell-off in late 2018, supported by a dovish pivot by the Federal Reserve, hopes of a trade-war truce between the U.S. and China, and the U.S. government going back to work. Yet this rally, with the S&P 500 up almost 20% since the low on December 24, has occurred even as companies’ 2019 earnings have been revised markedly lower.

Moreover, while the equity market has rallied so far in 2019 (see Figure 1), U.S. Treasury yields have declined, reflecting a skeptical view. Equities have tended to benefit from falling yields increasing the present value of future cash flows. Bond markets, however, have started to price a Fed rate cut within the next 12 months, suggesting many investors see a downturn or recession in the foreseeable future. And a recession isn’t good news for equity markets: Historically, the U.S. stock market (S&P 500) has fallen an average of 27% (peak to trough) during recessions.¹  

Recent data releases bolster the cautious economic outlook: They indicate the global economy is slowing meaningfully, and many global growth forecasts have been revised downward as well. This is not surprising to us as we’ve expected a growing-but-slowing global economy for some time (see PIMCO’s December 2018 Cyclical Outlook, “Synching Lower,” and May 2018 Secular Outlook, “Rude Awakenings”).

As one looks forward, what are markets telling us? This is where market participants differ. The recovery in stocks suggests some have already bought into better days ahead, while fixed income markets suggest others remain skeptical.

China, the decider?

We will be discussing the near-term outlook for the global economy at our next Cyclical Forum in March, in which PIMCO’s investment professionals from around the world will gather in Newport Beach to debate key factors likely to contribute to, or detract from, growth. We will publish our comprehensive outlook on global markets and economies after the forum. For now I share a few thoughts on China, which will be high on our list of factors to discuss for several reasons, including the somewhat limited scope for upside surprises in the U.S. and Europe over the next six to 12 months.

Chinese authorities have embarked on an enormous program of both monetary and fiscal stimulus, which could lift market sentiment. For example, new credit creation surged to a record high of 4.6 trillion yuan (CNY) in January (see Figure 2), exceeding levels reached in 2015–2016 (albeit under the People’s Bank of China’s old measure) as policymakers look to stimulate the economy. Recent data out of China suggest that these measures may be bearing fruit: Chinese New Year retail sales came in at +8.5% year-over-year (yoy), January exports jumped 9.1% yoy and Chinese aggregate credit creation grew 11% yoy (credit and export data from Bloomberg). Unlike past Chinese approaches, which were more focused on demand (“shovels in the ground”), this stimulus is supply side driven, so it’s hard to know what the ultimate multiplier effect might be as there are no precedents.

In sum, the efficacy of the Chinese stimulus could be instrumental in deciding whose views prevail: the believers or the skeptics. And if the believers are right, emerging market equities – given their proximity to the stimulus and current valuations – could be well-positioned to benefit.

For more on our asset class views for 2019, read our Asset Allocation Outlook, Late Cycle vs. End Cycle Investing.

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Geraldine Sundstrom is a managing director and portfolio manager focusing on asset allocation strategies and is a regular contributor to the PIMCO Blog.