HOLIDAYS are a good time to think about what’s going to happen in 2019.
Investors went through the toughest December in history.
So, they entered the new year feeling rather more unsettled about the 2019 outlook. Looking back, world stock markets were hard hit by a global economy that has begun to slow down, had gotten less support from central banks, and begun to face serious trade concerns. Since its recent high in late September 2018, MSCI World Index had declined by some 15% in highly-volatile trading, including December’s last week of wild swings.
Contrast this against 2017 when virtually all asset classes clocked in gains, following unusually low volatility. Indeed, the key factors which investors have to balance – expected returns, price volatility (or variance) and underlying correlations (i.e. covariance) all moved in tandem to deliver a really “dream” year.
However, 2019 presents a rather different picture in an environment where monetary authorities are expected to reverse quantitative easing (QE) and the Fed raising interest rates, in addition to valid concerns over growth in Europe and China. What’s worrisome is that investors’ frame of mind has since converged downwards, where occasional rallies bring out sellers instead of looking to buy on dips in the face of the withdrawal of easy money.
While hoping for the return of calmer times (not reflected in the wobbly first week of 2019), the likely outcome in the year ahead will be framed within a trifecta of growing uncertain economic prospects, continuing unsettled markets, and added instability arising from central banks being less able to counter geopolitical developments.
Given that investors and markets have been shielded for so long by central banks’ monetary largesse, it is prudent for investors to protect themselves by: (i) unwinding some of the excesses that had developed in the past year (including investment products that over promise), and be more aware of continuing bouts of unsettling volatility that at times, can be quite unrelated to economic fundamentals; (ii) building adequate defences into portfolios in the face of enhanced difficulties in finding good hedging investments in increasingly distorted markets.
Bear in mind, bonds are less than stellar right now. The shift in Fed policy from QE to QT (quantitative tightening) will tend to drive down bond prices, while the impact of a global trade war will hurt growth and lift inflation; and (iii) reassessing the longstanding mantra of holding more cash at this time – in order to be able to gain protection and earn a decent income; also, offers the opportunity to take advantage of indiscriminate sell-offs and volatile trading markets that inevitably will occur.
After a rotten October and a limp November, US S&P 500 fell 15% in value between Nov 30 and Dec 24. Despite an astonishing 5% rise after Christmas, the index finished the year 6% below where it started. As I see it, the unsettling and volatile markets have set up some key conundrums to be reckoned with in the course of 2019.
Bond market pessimism: At last year’s close, the US$14 trillion US government bond market (whose 10-year bond benchmark is the most widely watched) rallied, bringing down yields (as prices rise) as investors anticipate US growth to slacken from its stimulus-induced high. Ten-year yields fell to a low of 2.63% over the past month.
Still, analysts expect the yield to average at 3.44% by end 2019, according to a recent Bloomberg survey. For most, the pressing question remains whether the flattening US yield curve will really invert – a historically reliable harbinger of recession to come, whenever short bond yields rise above longer-dated bonds. The spread on 3-month and 10-year Treasuries has fallen to a mere 0.15%age point, down from 0.86 percentage point at end-September.
This is near levels seen in December 1994 and June 1998 – but then, the spreads didn’t turn negative. The late January 2019 Fed meeting should provide further guidance.
QE ends in Europe: Prospects for Europe will be shaped by European Central Bank’s (ECB) decision to end its multitrillion euro bond buying programme that it began in 2015. ECB’s purchases certainly depressed yields and its absence will certainly exert some upward pressure, even though its portfolio will be maintained at �2.6 trillion. Outcome in the market will depend on resumption of eurozone growth, resolution of global trade tensions, a messy Brexit or intransigence of Italy’s populist government, as well as the direction of German bond yields.
These factors tend to feed on each other, leading to a potentially different than expected dynamics – one likely to be challenged by forthcoming major European elections featuring populist expansionary fiscal policies.
Quo vadis US stocks: Has US stocks peaked? Strategists see two options: (i) there will be a “last hurrah” followed by continuing sell-off as recession hits; or (ii) peak has passed & prices will drift downwards as was past experience a year before recession sets in. Macro-risks abound and are well known. Mis-steps by the Trump administration have added to the sense of unease. In the end, what really matters is corporate earnings growth – expected by analysts to rise 8.2% in 2019, against up 20.5% in 2018.
The S&P 500 is today trading at 14.15 times earnings over the next 12 months, implying stocks are as cheap as in 2013, the last time this index traded at that level, according to FactSet. Furthermore, JP Morgan has already priced in a 60% chance of recession within a year in its S&P 500 forecast.
So, the index will continue to test investors’ nerves. One thing is sure: the coming year is likely to be bumpier than investors have become accustomed to.
Yuan to slide?
China’s yuan remains a wild card in the face of the Chinese stock market being the worst performing major market in 2018. Resolution of the trade dispute between the United States and China and performance of the Chinese economy will be central to the yuan’s fate. Consensus among banks and forex strategists is that US dollar will falter in 2019 (it appreciated 4.3% in 2018) in favour of the euro.
This is so as US growth weakens, prompting the Fed to stop raising rates – at a time when policy normalisation gets under way in Europe and Japan. In this regard, I also expect the yuan to continue to remain weak.
Disconnect for Fed
The future belongs to the United States as the Fed begins to engineer a soft landing. The Fed knows soft landings are rare and often, not painless! The challenge: to manage moderating growth while keeping inflation as low as possible, but avoids a recession.
To be fair, the economy has seldom looked stronger. But stock prices and bond yields appear to signal the onset of recession as growth in overseas economies, especially Europe and China, has slackened. This disconnect presents the Fed with a dilemma as investors get skittish.
The choice for the Fed: keep nudging interest rates higher to contain inflation and protect the domestic economy; or be sensitive to stresses abroad and in the markets by holding rates steady – even nudging them lower. This is not new for the Fed: it averted recession while raising rates in 1994 and 2015; but stumbling into downturns in 2001 and again in 2008.
At another point of uncertainty in 1998, the Fed cut rates and sustained global growth. Today’s situation is complicated by forces outside the Fed’s control: trade dispute between the two giants, and government shut-down. As of now, the Fed chose flexibility – listening patiently to the markets and staying cool!
I am reminded of the reference to 1998 as being analogous to today, when financial crisis in Asia and Russia and the near failure of a giant hedge fund prompted the Fed to cut rates. The following year, US economy took off and the Nasdaq bubble burst. As in 1998, investors were stunned by the US exposure to events abroad. So beware!
Trying to predict markets is perilous at best. At this stage of an ageing business cycle, investors have good reason for concern.
Two developments heighten this unease: (i) earnings multiple for the S&P 500 has fallen 16% from its peak in late 2017; and (ii) US Treasury yield curve has started the process to invert – 12-month yield is today higher than those of all Treasury maturities of up to seven years. Has the Fed tightened too much as a recession loiters beyond the horizon?
Still, the consensus is that recession risk remains low, with the risk being higher in 2020 than in 2019. We’ll just have to wait and see.
As the stock bull market approaches its 10th year, the recent roller-coaster ride in the market has prompted analysts to rethink their 2019 forecasts. With volatility showing no signs of abating, the common view is to lower forecasts on S&P 500, most by 5%-10% for end-2019.
No doubt, the market is desperately seeking clarity. Indeed, financial markets have since been behaving as if the next recession is around the corner. Nobel laureate Samuelson once quipped that the stock market has predicted nine of the last five recessions – so let’s not over-react.
In the end, I expect calm heads to prevail since the underlying fundamentals aren’t disintegrating as much as investors are pricing them. Current data continues to point to some bright spots across the US economy.
Of course, no one knows for certain when the next downturn will come. If a recession does come, the chances of it being mild sit at 88%. Today, writhing markets are an exaggeration. Nevertheless, I know of reputable analysts standing by their calls.
What then are we to do?
Be that as it may, at the recent annual meeting of the American Economic Association in Atlanta, a senior IMF official warned that “The next recession is somewhere over the horizon and nations are less prepared to deal with that than they should be,” in the face of a growth outlook that is being undermined by trade tensions, policy flaws and weakness in Europe, Asia, Africa and Latin America.
This is timely advice. As I see it, it is almost inconceivable that the global economy will remain healthy in the face of serious economic problems in both China and the United States, even leaving aside their conflicts over trade and technology. Europe lacks economic energy and the uncertainties associated with Brexit, French protests, German political transition and Italian populism mean the continent is more likely to be a source of problems than a solution.
What’s really worrisome is that governments will find it increasingly difficult to effectively use fiscal or monetary measures to offset the impact of the next recession.
Further, I agree that the system of cross-border monetary support mechanisms – including central bank swap facilities, has been systematically undermined rendering it rather ineffective. What’s really needed is for governments to pay particular attention to keeping their economy well-oiled and on a level trajectory, ridding it of corruption and building buffers, while not fighting with each other (as in rising protectionism, trade wars) and doing things that might accelerate growth, forcing it to take a downturn.
They need to develop better policies to help their populations adapt to cope with intensifying global competition instead. I should add that global trade competition is having a very uneven impact on the US workforce in particular, stoking inequality. The critical challenge for monetary and fiscal policy will be to maintain sufficient demand amid immense geopolitical uncertainty, increasing protectionism, high accumulated debt levels and structural and demographic factors leading to increased private saving and reduced private investment.
As I see it, it is the irony of our time that prudence requires the rejection of austerity.
Former banker, Harvard educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome.