The Outlook: December 2018 economic commentary

Commentary
 


Looking ahead to 2019 – a happy new year?

It is the season when economists and financial market analysts make their predictions for the year ahead. Precise forecasts belie the complexity of the global economy and almost always turn out to be wide off the mark. As the 19th century American novelist William Gilmore Simms once quipped, “Economists put decimal points in their forecasts to show they have a sense of humour.”

Nevertheless, consideration of the broad economic trends and geopolitical events that are likely to impact financial markets is still a valid exercise. Such analysis provides a valuable input into the portfolio construction process and can help guide necessary asset allocation changes if developments do not pan out as had been anticipated.

Brexit outcome is key for UK investors

For UK investors, the crystal ball is particularly murky at the current juncture, clouded by the uncertainty of Brexit. At the time of publishing, Theresa May was still struggling to get her deal through parliament. Given the ruling by the European Court of Justice that the UK can unilaterally revoke Article 50, and signs that parliament is reasserting its authority, it might be argued that the probability of a no-deal Brexit has fallen somewhat. However, the situation remains fluid and highly uncertain. As we wrote in our October 2018 commentary, the eventual deal/no-deal outcome is likely to have binary repercussions for UK financial markets and, via the impact on the pound, a big influence on the sterling performance of unhedged overseas holdings.

Slower, but more balanced, global growth

For global markets, however, a bigger consideration will be the interplay between the economic performance of the major economies and their respective monetary policies. 2018 was a year of US exceptionalism which saw growth in the world’s largest economy accelerate on the back of the Trump tax cuts, while growth in most of the rest of the world, notably in China and Europe, slowed. In 2019, the US economy is set to shift down a gear, as the boost from fiscal stimulus fades and the lagged impact of tighter monetary policy takes its toll.

The performance of the eurozone economy has been disappointing in 2018, as export demand has softened. Weakness in the Italian economy is likely to persist, not least as concerns over Rome’s budget plans undermine sentiment and keep borrowing costs elevated. However, some of the recent downturn in the region has resulted from transitory factors, notably disruption following the introduction of new vehicle emissions tests, along with the ‘gilets jaunes’ protests in France. Consequently, some bounce-back in activity going in to 2019 should be forthcoming.

In China, the slowdown is likely to continue as Beijing seeks to rebalance the economy and the imposition of US tariffs curb exports. However, the extent of the deceleration in 2019 should be contained as the authorities appear likely to introduce more fiscal and monetary stimulus in a bid to balance the negative impact of softer external demand.  

Less supportive monetary policy

With the current post-crisis expansion in the US economy getting somewhat long in the tooth, it is not surprising that fear of a looming recession is starting to frighten investors. Recessions are often triggered by central banks raising interest rates too aggressively in their bid to contain growing inflationary pressures. With the US yield curve close to inverting – a development which has preceded recessions in the past, see our July 2018 commentary – there is understandable concern that the Fed will ‘overdo it.’

However, there are grounds for optimism on this front. Fed officials have sounded more dovish of late and indicated that further rate hikes will be dependent on the strength of incoming data. If there are signs that the economy is slowing too sharply therefore, the Fed is likely to take a break from hiking further.

More generally, inflation trends through 2019 also suggest that central banks will not be under pressure to raise rates aggressively. The recent weakness in the oil price, if sustained, will weigh on headline inflation. And, even though tightening labour markets across the developed world are putting upward pressure on wages, core inflation remains muted. Against this backdrop, real interest rates in the main regions are likely to remain below levels that have typically ushered in recessions in the past.

This said, interest rates are only one aspect of monetary policy, and 2019 is also likely to see the combined balance sheet of the G4 central banks (the US Fed, European Central Bank (ECB), Bank of Japan (BoJ) and Bank of England) shrink in year-on-year terms. The Fed is already winding down its holdings of government bonds built up during its post-crisis quantitative easing (QE) programme, and the ECB recently confirmed it will terminate its own QE purchases by the end of 2018. Although the BoJ is still buying assets, the pace of expansion has slowed, as it has prioritised targeting the level of bond yields rather than the absolute quantity purchased.

The gradual reversal of central banks’ great policy experiment provides an added level of uncertainty to the current phase of policy tightening. Inflating asset prices was one of the transmission channels through which QE was seen boosting the economy, so it is perhaps not surprising that investors are getting nervous as balance sheets fall back.

The risk of a trade war

Elevated levels of event risk are also likely to make for volatile markets in 2019. Indeed, the direction of markets during 2019 will, in large, partly depend on developments regarding the Trump administration’s trade policy. President Trump has delayed the threatened imposition of 25% tariffs on Chinese imports until 2 March 2019, to allow time to negotiate a trade deal.

Nevertheless, it is difficult to see how Beijing can meet all of President Trump’s wide-ranging demands, which include a $200 billion reduction in the bilateral trade deficit and greater protection of intellectual property. In the absence of a deal, the escalation in the trade war is likely to further undermine global equity markets. However, President Trump’s desire to avoid further stock market falls and economic weakness ahead of the 2020 presidential election provides an incentive for Washington to give ground. Aside from relations with China, a pending decision on possible tariffs on EU autos will also be key.

A happy new year?

Investors go in to 2019 facing extreme levels of uncertainty. The economic cycle is in its late stage and recession risks in some of the world’s major economies are rising. A slowing global economy and waning impact of US tax cuts will translate in to softer profits growth, and rising labour costs threaten to squeeze margins. Real interest rates in the major economies are unlikely to rise to levels that have triggered recession in the past, but the current cycle is complicated by the wind down of QE. Brexit and the Italian budget saga represent downside risks for Europe, while US trade policy is a threat to the global economy and financial markets.  Against this backdrop, cautious investors will understandably look to adopt more defensive positions, raising allocations to cash and short duration government bonds.

However, it should be acknowledged that, if the feared downside event risks fail to materialise, there is scope for 2019 to provide better investment returns than those of 2018. The expectation of more balanced global growth and a pause in Fed rate hikes as the US economy slows hold out the prospect of a weaker US dollar, which would be a plus for risk assets, most notably in emerging markets.

The pull-back in equity markets in 2018 has left valuations looking more attractive, with forward price-earnings ratios for the major regions currently at multi-year lows. Moreover, in contrast to this time last year, when talk of global synchronised growth and US tax cuts had market participants in a euphoric mood, recent surveys suggest investors are more bearish than they have been in years.

As a result, although late cycle considerations might cap gains in 2019, there is potential for upside surprises. Investors are not expecting a happy new year, but it might not turn out to be as bad as they fear.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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