Looking into 2019 and attempting to make sense of the year ahead, I am reminded of the old expression that economists exist to make weathermen look good! With that in mind, and the fact that almost no investment strategists called the events of 2018 (except for the perma-bears, but as they say even a stopped clock is right twice a day), it is with much trepidation that I try to highlight some of the scenarios we see unfolding in 2019.
Right at the top of any list has to be the action of central bankers, for liquidity is a major driver of asset prices. Less liquidity, ceteris paribus, means that asset prices will remain under pressure. The view currently of our team is that the Federal Reserve will raise rates in December and possibly early in the New Year as well, but then will pause, as they review the data. The spread between the US 10 year and 2 year treasury is almost negative, an event which has predicted most previous recessions. There is currently much debate around this spread differential, with some arguing that it is different this time as the 10 year is driven by both global and local US investors and hence is not a pure US story anymore, so one should take the spread differential with a pinch of salt. However, there are a number of investors that say this spread has predicted most previous recessions and as such should be taken seriously. Our view on the subject is that it is possible that it does not signify a recession, but it probably does indicate a slowdown in growth and if that is the case, it is more likely the Federal Reserve will pause and this will probably calm markets in 2019.
The Federal Reserve is clearly not the only central banker in town, with the European Central Bank also forecast to tighten liquidity in 2019, but at the moment this does not seem very likely. Italy looks very fragile, due to the weakness of its banks and prodigal government; riots in France have led to growth being curtailed; and a change of leadership in Germany happening at the same time that trade wars are impacting on the German economy. The Bank of Japan is also unlikely to start tightening due to poor growth numbers recently and inflation that is still nowhere near its target. The Bank of England might be the exception, if a hard Brexit happens, as it tries to curb inflation pressures from a weaker Sterling.
So on balance in the developed world, central banks might not be tightening aggressively in 2019. However, we don’t see massive increases in liquidity either, so liquidity remains unsupportive for risk assets.
In the same breath that central banks take their foot off the accelerator in terms of rate hikes, the reasons behind this are not hugely bullish, for it is slowing growth that might make them hesitant to increase rates. The US is predicted to slow in 2019 as the sugar rush from tax cuts and fiscal spending starts to fizzle out. Europe could do better, if a trade deal between the US and China is finally agreed, as the Europeans are collateral damage in the tariff war between these two super powers. Europe is one of the most open economies in the world and as global trade has slowed in 2018 this has hurt European growth. The car market has also been weak due to legislative issues over clean air emissions, but this too could improve in 2019, as more cars are approved for sale.
Asia, including China, could also improve, as the Chinese have been trying to get their economy to grow. They have once again increased fiscal spending and have encouraged bank lending to pick up, after months of trying to cut back on credit, especially in the shadow banking sector. Emerging markets should be a beneficiary of stronger Chinese growth in 2019, but sustainable growth will still be predicated on a weaker dollar, as credit growth in Emerging Markets is highly reliant on the dollar for global flows back to Emerging Markets.
There still remains the possibility that trade relations between the US and China could improve, which should be bullish for global growth in 2019. Our view, as we have been saying all year, is that trade wars will remain very fractious as it is not really a trade war, but a tech war, and the US remains fearful that China could overtake them in terms of the growth in intellectual capital, especially in technology, so an easy fix on trade wars still seems a long way off. However, should the US start to slow in 2019 as we expect, the US might be more inclined to try and find a solution to the ongoing trade battle.
Inflation globally is still very low, despite some regions of the world being at or close to full employment and this has remained a conundrum for most investment strategists around the world. It would appear that people might be employed, but despite full employment pricing power still remains very weak for labour, possibly due to the fact that the types of jobs that people have today are in the gig economy, or working for the likes of Amazon which are semi-skilled and therefore not very highly paid. Throw in robots and AI and the demise of labour unions and we see that inflation remains low. Inflation expectations have also fallen and this could continue into 2019, especially if oil prices (which have collapsed) stay low.
On the valuation front, after an ‘annus horribilis’ for all asset classes (except the US), the silver lining is that assets are cheaper than they have been in years. Investors are spoilt for choice in terms of where they can invest. The US has been the stand out bull market over the last few years, but the same cannot be said for almost every other market with Europe being notably cheap and emerging markets even more so.
Looking into our crystal ball (said with a large pinch of salt), we would expect equity markets to perform better in 2019, with assets outside the US perform-ing better if slowing US growth leads to weakness in the dollar. At this stage we are not worried about an ensuing bear market, but rather see the current market behaviour as a de-rating of valuations, as opposed to a deterioration in fundamentals. Central banks might have tightened, but we expect less tightening in 2019; global growth is slowing, but it is still growing and inflation remains a non-event. Valuations favour the brave and earnings globally are still growing. We expect 2019 to be a year in which fundamentals matter more than liquidity and in this environment we should see active stock pickers outperforming passive funds. We continue to believe that bonds are expensive, but could see emerging market bonds and convertible arbitrage funds have a good year, given excess yields on the former and embedded optionality in the latter. Hedge funds should have a good 2019, if volatility remains at elevated levels.
(As an aside, Brexit is impossible to call, as Mohammed A El-Erin (of Pimco fame who called the 2008 Global Financial Crisis) has said recently – there are five different scenarios for Brexit and none of them have a strong enough conviction to be a base case scenario!)
Weekly comment: Weekly Comment – Joanne Baynham, 131218