2019: A Year For Better Or Worse?
Authored By: Calum Mackenzie | Publish Date: January 16, 2019
Authored By: Calum Mackenzie | Publish Date: January 16, 2019
It is often like that. Markets like to swing from extremes. 2018 saw a huge psychological reversal from the previous year (and for that matter, most of the previous half decade) – ‘let us look to the bright side … turned into ‘No, let us look to the dark side instead.’ Remembering this long-held market tendency, it is perhaps not so remarkable that a year of decent global economic growth, with a booming U.S. economy that saw S&P 500 earnings rise in excess of 20 per cent and during which central banks were confident enough in the outlook to tighten monetary policy ‒ also saw weak market conditions. Perhaps it is better to characterize the year as more a case of confusion than carnage – risk assets were weak, but, as we know, even bonds mostly lost value.
Part of the difficulty for so many ‒ asset managers, institutional and retail investors, and, really, just about everyone ‒ is to work out when the shift from one extreme to another is going to occur. Some extremes hang around; others are short-lived. It is sudden changes in market psychology, like the one we saw last year, that often wrongfoot.
So, is this year going to be better or worse than 2018? Will this be a continuation of looking through the glass darkly as in late 2018? Market psychology is not impervious to the flow of economic and market fact, but the interpretive process on how good or bad things are is what brings magic and mystery to markets. What will happen to economic conditions is hard to call, but predicting market interpretation vastly more difficult. With that all-enveloping caveat on the market outlook, here are four questions, the answers to which will have a bearing on what sort of a year this is. As is readily apparent, these are interlinked, interlocking questions.
Will trade stay at skirmish levels or move to actual war? We are now getting to a point where further escalation in trade conflicts could bring major economic consequences. Currently, the kind of trade conflict and policy uncertainty we have seen has impacted corporate cost structures and business investment planning, going by stock price behaviour and comments made by company managers at quarterly analyst briefings. Its impact at the global macroeconomic level in pulling economic growth down significantly is not yet clear. That said, what is apparent is that further escalation could potentially make a big difference.
That markets are down partly on trade fears and stocks of the most internationally exposed sectors/companies are down the most, may now restrain more rhetorical ratcheting up from the U.S. given stock market sensitivity. Yet, looking hard at the epicentre of the trade conflict – the U.S./China relationship, the bipartisan support in the U.S. for a hard line on China, and the difficulty the Chinese authorities will face in making significant concessions ‒ does not suggest any major easing of tensions is likely. Trade conflict may be a slow burner rather than a market destroyer, but it is unlikely to go away and, as we have commented through last year, may keep coming back to shock markets from time to time.
Will Europe and China weaken further? Europe’s economic activity levels have fallen back from the previous year, but only to what is widely thought to be trend or underlying growth rates rather than anything worse. In the absence of new shocks, there is no obvious reason to suspect much worse to come to come this year. Policy normalization in the form of less stimulus from the European Central Bank is coming, but very slowly. Of course, new shocks in the form of a poorly managed Brexit process, more Italian troubles, and a further loss of support of the political centre in the EU are all live risks. How much they will exert pressure on the markets in 2019 is difficult to take a view on. Overall, the balance of risks still tilts to the negative given the range of things that could potentially go wrong.
As for China, our view remains that though aggregate growth rates will remain on the soft side, there is enough navigation room using monetary policy to keep growth supported above a notionally minimal level of danger (greater than five per cent). While we see policy conflicts between a notional economic activity target and the desire to reduce the reliance on debt-financed investment spending, we should remember that the process of restructuring and reform has now been ongoing for a few years with some partial success. The key risk to this view that major downside risk is absent comes from the possibility that trade conflict escalates markedly. Overall, we are working with the view of the Chinese economy looking soggy at a headline level but making some progress at the ground level (i.e. a slow improvement in growth quality).
Will the U.S. soft land its economy and profits? Will rate worries return? Part of the uncertainty has been about the aftermath of the tax stimulus package in the U.S. which boosted economic growth and bottom lines markedly over the past year. What lies beyond is still a matter of conjecture. A ‘soft landing’ to economic growth rates of perhaps two per cent and small but positive growth in corporate profits (consensus is currently seeing mid-single digit growth in U.S. S&P 500 earnings per share in 2019) would be benign and well received, especially given that the market has de-rated to valuation levels which no longer look substantially extended. The complication comes from the fact that the U.S. economic expansion has been running for a very long time, policy interest rates have risen significantly from their lows, and relatively high rates of corporate leverage carry risks if activity slows markedly. Domestic political uncertainty in the U.S. is currently contributing to the bad market mood but this is, with luck, temporary.
Our view has been that U.S. late cycle risks are difficult to wish away because they are so dual-sided. If inflation pressures surface, worries over further rises in interest rates could easily return. On the other hand, if the market grows more fearful that the Federal Reserve has already ‘overtightened,’ there are obvious difficulties too. It is this uncertainty that feeds the volatility that we have been seeing and it is hard to see this go away in 2019.
Will market sentiment stay downbeat? In the way that most problems were ignored earlier, last year saw a dramatic reversal in the market’s interpretation of news flow. The change in global liquidity conditions from loosening to tightening in 2018 has clearly been the lynchpin of this sea-change in market psychology. Could those animal spirits return again? It may, but it is unlikely to last. Yes, a market rebound would not surprise at all at this time. Jerome Powell, Chair of the U.S. Federal Reserve, quite reasonably pointed out recently that the markets have been ‘ahead of the data’ in pricing in downside economic risks. If these do not materialize, there is some potential for clawback of lost ground. However, this still looks to be mostly a tactical opportunity and should be used as such. Some rebalancing to risk asset target weights is fair for well-diversified portfolios but for others less well buffered against market pain, it would be an opportunity to divest risk.
We continue to see recent market behaviour as characteristic of a transition environment that has already moved us well beyond the best times for risk assets. Even if we are not quite ready to run for the hills and take maximum bearish positions now, this year is not offering any obvious route back.
Calum Mackenzie is national investment consulting leader for Aon (Canada).