10 January 2019

Happy New Year!  I am back at work for the first time since releasing my blog in mid-December. Did I miss anything??!! In a word, it’s been crazy! In September, we published our 2019 Global Strategy Outlook entitled “Turning (Even More) Defensive”, in which we warned that the year ahead would be characterised by low returns, heightened volatility, and at least one market slump of over 10%.

As all of these have now transpired, it is worthwhile identifying and evaluating the causes of recent turmoil in order  to outline a road map for the next 12 months. First of all, financial markets have been spooked by the prospect of a recession in 2019. Is this likely? In our September report, we pegged the chance of a global downturn at 40% in 2020. In other words, a meaningful risk, but not our base case, and not occurring until 2020. Nevertheless, we indicated market volatility would escalate in 2019, as investors began to anticipate the next downturn. Our thinking remains the same. We expect global growth will decelerate in 2019, especially in the USA, but recession is a 2020 story. Secondly, inconsistent communication by the US Federal Reserve cast doubt about American monetary policy. What lies ahead for the Fed and other G4 central banks? And, the prospect of trade wars appears to have already taken its toll on global trade, casting doubt on the longevity of this aged economic cycle. What lies ahead for trade, and especially the outlook for China’s near term growth? What are the implications for markets in the coming 12 months?

Global Recession: More Likely a 2020 Story

As the saying goes, Economic cycles do not die of old age. Almost always, recessions are the result of an acceleration in wage growth and inflation, combined with a monetary policy mistake as central banks raise interest rates too much in an attempt to curb price pressures. To be sure, some of these traits are emerging, especially in the USA. And, while I anticipate a sharp slowdown in US economic activity in 2019, underlying support remains intact for yet another year for the aging expansion.

First of all,  fundamentals for consumer spending, representing over 70% of the American economy, remain healthy. Employment gains and accelerating wages are boosting incomes, which are now receiving additional support from falling energy quotes. The Chart above illustrates that consumer confidence is near an all-time high, and that Christmas spending activity was  buoyant.

Prior to recessions, capital spending often booms, producing over-capacity after demand cools. The Chart above illustrates that US capital spending has been healthy in 2017/18 — but by no means booming following disappointing results the two prior years — in part in response to the 2018 corporate tax reform. However, new orders and survey evidence point towards much slower gains in business investment ahead, as the impact of tax changes fades and worries about trade wars escalate. Meanwhile, residential investment has declined in 5 of the past six quarters, as interest rates rose. However, while this will remain an area of weakness, with housing starts still well below levels normally expected at this stage of the economic cycle,  collapsing residential investment will not lead the economy into recession — as  has happened often previously.

Decelerating US activity will result primarily from the fading benefits of 2018’s fiscal stimulus and a continued negative contribution from net exports. Overall, GDP growth will cool to  below 2% in 2019 compared to 3% last year. Moreover, growth will be even more imbalanced: combining strong consumer spending and worsening external imbalances, and rising twin deficits.

In addition to decelerating US growth, unmistakable evidence is emerging of continued economic weakness in both Europe and China (see Chart above). In my past blog entitled “Europe: Slipping Towards Recession?“, I projected that European growth was cooling towards its meagre long-term potential of 1.25-1.5%. However, riots in France, Italy’s fiscal woes, German political transition, and Brexit all point to downside risks to this forecast. Likewise, trade tensions already are adversely impacting Chinese industrial activity (PMI is now below 50). My earlier  blog “China: Slowdown Just Beginning” describes that trade is only one of the issues China confronts, and the slowdown is just beginning (more on this later).

Overall,  while the global economy will avoid a recession in 2019, world-wide activity will decelerate this year, led by the USA. In addition, US economic imbalances — e.g. the twin deficits — will become more evident. Meanwhile, as US grow slows in line with other regions, global activity will be more synchronised than in 2018.

Policy Mistakes: The Fed, Oil and Inflation

As hard as they try, recessions normally are the unintended consequence of central bank efforts to battle inflation risks late in the economic cycle.  Fortunately, however, I believe the recent sharp decline in oil quotes has reduced inflation risks, and 2019 price gains will likely to be lower than expected. If true, pressure on central banks will be reduced, and the likelihood of monetary policy mistakes and recession will be more limited.

To be sure, inflation risks remain, especially in the USA. The Chart  above illustrates low unemployment has led to accelerating wage gains (from 2% to above 3% in recent years) and rising core inflation.  In recent months, however, both US headline and core inflation have been lower than expected. Oil is one reason. In November, energy prices rose only 3% YOY compared to 9% the prior month. If oil prices remain below $50pb, I project headline inflation will decline towards 1.5% in coming months. I expect these declines also to feed through to core inflation, which will remain below 2% for most of 2019, despite higher labour costs.

Europe and Japan are likely to benefit even more from lower petrol prices. In Europe, core inflation has remained steady at 1% — well below the ECB’s target — while headline inflation registered 1.6% in December. Lower oil quotes should keep both price indicators in a 1-1.5% range this year. Meanwhile, Japanese inflation is less than 1%, and cheaper oil will produce downside risks to price projections.

What does this mean for monetary policy? Outside the USA, it is now quite likely that monetary policy will remain on hold again for all of 2019 in Japan, the United Kingdom, and Euroland (although we still maintain a December ECB rate hike in our forecast).

Most importantly, the decline in oil prices will take pressure off the Federal Reserve; thereby limiting the risk of a policy mistake that could lead to recession. To be sure, the Fed’s recent communications have been poor. In particular, after signaling a dovish tilt in November, Chairman Powell appeared more hawkish during his 19 December press conference. Minutes of recent Fed meeting, however, reveal a more dovish, flexible approach to monetary policy. In September, I forecasted three Fed rate hikes for this year. Now I expect only two: likely in June and December.

President Trump’s criticism of the Fed is troubling. On the one hand, it is ironic , as the Trump fiscal stimulus contributed significantly to the need for higher interest rates, and increased the risk of a Fed policy mistake. In addition, the President’s intervention may cast doubt on Fed independence, and whether the Fed’s pause may be the result of political pressure.  Such uncertainty will surely contribute to further market volatility  in the period ahead.

China and Trade Wars: The Pain is Already Evident

The third cause of recent volatility has been the prospect of a Sino-US trade war, and especially the consequences on China’s growth outlook.  The earlier Chart illustrated that China’s manufacturing sector is already feeling the pain prior to the tariff hikes planned for March 2019. In my previously China blog, I estimated that 25% tariffs would reduce China’s GDP growth by 1% over two years.

Perhaps even more worrisome, however, is the toll the conflict is already taking on global trade. In particular, the export-led Asian economies have experienced a sharp deceleration/decline in foreign sales in recent months. Unless a resolution is quickly found,  economic risks will escalate throughout Asia (Chart above).

To be sure, Chinese authorities will continue to attempt to offset these risks through stimulative economic policies. As I have described in the past, however, China’s economy  also confronts headwinds posed both by deleveraging and the transition towards consumer and service-driven growth. Therefore, stimulative macro-policies should cushion the impact of the trade dispute, but not at the expense of these other important objectives.

So far, the results are mixed, at best. Using stimulative monetary policy may impede progress on deleveraging. Indeed, the Chart above illustrates that bank loans are still growing 13%, suggesting a continued rise as a percent of GDP (deleveraging is only getting started). Allowing the currency to weaken, likewise, runs counter to the goal of reducing dependence on exports and promoting consumer spending and services. The following Chart illustrates that after years of successful restructuring, the transition to consumption and services has stalled since 2016.

Preferable would be to use fiscal policies to stimulate household incomes directly — the recent income tax cut and the proposed VAT reduction represent progress. The following Chart illustrates that both retail sales and fixed investment are slowing sharply. However, the recent upturn in FAI suggest that infrastructure spending may have been funneled through state-owned enterprises, which is a highly undesirable throwback to past resource misallocation.

While it may take some time, I do expect the US and China will reach a trade deal this year. The slowing US economy and President Trump’s wish to point to a political achievement this year will lead the Administration to compromise. Good short-term news (politically expedient), but will leave important issues unresolved.

Strategic Implications

• The US dollar will be the story of two halves. The USD will appreciate in H1 2019, as the US economy outperforms. As America slows and markets focus on the twin deficits, the USD will fade in H2.
• As the gap between American and European growth narrows, US bonds will outperform.  US minus German bond spreads are 50bp wider than a year ago – US represents relative value.
• A more flexible Fed, weaker USD, and an eventual trade compromise will lead to an outperformance of Emerging markets.

• In September, I suggested that US equity returns would be modest, as the S&P 500 remains this year in a 2400 to 2900 range, as rising interest rates and slowing growth provide headwinds. Following the recent correction and bond market rally, however, equities are at their cheapest level (relative to fixed income) since the sell-off in 2016 (above chart). In a volatile, range-bound market this year, I have been buying the current dip! Beware of the sharp deceleration in EPS growth that will become evident in the upcoming earnings season!