Global Slowdown: Preparing for a Recession

Includes: IXJ, KXI
by: Russ Koesterich, CFA

There's been a spate of data lately showing a slowing global economy, including disappointing June manufacturing figures out of the United States and Germany, and most recently, weak second quarter gross domestic product growth in China.

It's no wonder, then, that many investors are wondering what's behind the slowdown, whether it will continue and what they should consider doing if it grows worse.

The most obvious culprit driving the slowdown is the ongoing crisis in Europe, which is hurting both U.S. manufacturing and Chinese exports. However, there are other idiosyncratic factors dragging down growth in China and the United States:

  • China: In China, slow growth can be blamed on the lagged impact of last year's monetary tightening, government efforts to dampen the local real estate market and a falloff in investment activity thanks to an apparently so far successful longer-term economic restructuring away from investment-led growth toward consumption-led growth.

  • The United States: The United States is still suffering from the debt overhang and the bursting of the housing bubble, long-term causes of the country's weaker growth. And in the shorter term, the consumption growth the United States experienced in late 2011 and early this year hasn't been sustainable as slowing income growth, partly a result of slowing government transfer payments, has caused consumers to pull back. This is a big problem for an economy 70% driven by consumption.

But despite the slowdown, I believe that growth will continue in both China and the United States. I expect the Chinese economy to stage a modest rebound later this year, as the impact of monetary easing and fiscal stimulus starts to be felt, and to maintain an 8% growth rate in coming quarters. Meanwhile, assuming the United States can figure out later this year how to avoid falling off a fiscal cliff, I expect growth there to stabilize at around 2%.

In fact, I still believe that there's a 60% chance that the global economy as a whole will experience continued slow growth, and avoid a recession, in 2012. This means, however, that there's a roughly 40% chance of a more significant global economic slowdown later this year. A European banking crisis or U.S. fiscal tightening would most likely drive such a recession.

If things do get worse, investors may want to consider opting for these five portfolio moves:

  1. Less equity exposure

  2. A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (NYSEARCA:KXI) and the iShares S&P Global Healthcare Sector Index Fund (NYSEARCA:IXJ)

  3. Less credit exposure in the fixed income section of their portfolios

  4. A smaller allocation to commodities

  5. A higher weight to dollar-denominated assets

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.

Health care companies are subject to extensive government regulation and their profitability can be affected by restrictions on government reimbursement for medical expenses, rising costs of medical products and services, pricing pressure, and malpractice or other litigation.

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