Weak incoming data, both in respect of profits forecasts and the global economy is in sharp contrast to the strong performance of risk assets such as equities and corporate credit during 2019. Conflicting narratives can certainly create angst but in this case reflect investors’ belief that central banks have acknowledged the slowing global economy. We would concur that easier financial conditions means relief from negative economic surprises may be in sight by mid-year. Despite having risen sharply in the first few weeks of the year, on balance we believe global equities now have the prospect of volatile but still upward progress, as political events unfold.
In January, we outlined the reasons for shifting from a cautious to neutral position on global equities. Valuations had softened – and for the UK had even become cheap relative to history. We viewed central banks as highly likely in time to respond to the evident weakness in the incoming economic data. Furthermore, a fiscal response to slowing growth in China was likely to be forthcoming.
In terms of politics, re-election dynamics suggested US President Trump is under pressure to agree a deal on US/China trade this year. Similarly China is also incentivised to find a route out of the current trade conflict, given the slowing Chinese economy in recent quarters. Finally, the absence of support for a no-deal Brexit in the UK Parliament suggested a delay or a soft Brexit remained the most likely options. These factors comprised in our view 2019’s wall of worry – a wall which markets proverbially climb.
A month later, global equities have risen notably yet incoming economic and corporate data outside the US continues to be disappointing. Notably, corporate profits forecasts are still suffering from downgrades of a magnitude not seen since 2015. While we anticipate a stabilisation during Q219 the naked truth is at present there is no sign of a turn in this trend. In particular, the downgrades to emerging market equities which started in Q2 2018 have if anything accelerated during Q418.
In terms of soft economic data such as PMI surveys, while these can be misleading in terms of exaggerating the ultimate extent of a downturn at times of political uncertainty, there has been a steady flow of weak data worldwide, ex US, suggesting a meaningful slowing of activity and not just in nations exposed to Brexit. Survey data has also been confirmedby unanticipated weakness in industrial production, notably in Europe.
In addition in Italy, the recent EU downgrade to 2019 forecast GDP growth from 1.2% to just 0.2% puts into perspective the drawn-out negotiations on the precise level of Italian government spending late last year. We note that 10y Italian government bond yields have risen by 25bps following this downgrade, highlighting investor’s renewed fears of fiscal instability.
Chinese growth has continued to slow and policymakers appear at this stage to wish to avoid creating incentives for further wasteful investment in overcapacity, real estate or infrastructure. For this reason, while we expect VAT and income tax cuts in China over coming quarters to add to 2019 GDP growth by supporting the consumer and SME sectors, we are not expecting a sudden credit-led resurgence in industrial output which would move the growth needle globally.
Yet while the narrative of a US/China trade conflict creating uncertainty and a decline in business investment remains relevant, we believe for economic activity it is in fact a secondary factor to the actual and expected path of global monetary policy over the last 18m. Monetary policy may also not be the whole story but the fingerprints of higher US funding costs were all over the strength of the dollar, weaker emerging market currencies and poorly performing global equity markets in 2018.
In particular, US interest rates were rising sufficiently quickly in H118 for emerging market policymakers to unusually sound an alarm about the effect of tighter US dollar funding on emerging market growth and capital flows. For a period, these alarms were ignored in Fed rhetoric. However, while the Fed may only recently have paused rate hikes, the period of monotonically US rising rates is already some way behind us.
US 2y rates stopped rising in the summer of 2018. This suggest to us that the drag from tighter US monetary policy may already be fading and the effect of looser than expected global monetary policy may start to be felt in the real economy during the second half of 2019. This is the primary reason for the recent recovery in investors’ risk appetite in our view.
Outside the US, the Bank of England has recently followed the Fed by significantly downgrading its UK GDP growth forecasts for H119. The UK picture is however complicated by the path of Brexit. It is unfortunate but only logical for the BoE to keep its no-deal planning private at this stage – but we would expect determined action in
this still unlikely event.
The ECB has been the laggard in terms of recognising the persistence of the shortfall in activity on its own eurozone doorstep but is likely in our view to shortly do so when new economic projections are presented during March. It is also helpful for ECB policymakers that the Fed has thrown out the “autopilot” idea of steady balance sheet reduction, potentially allowing the ECB to consider a more adjustable balance sheet policy, should that prove necessary in terms of forward guidance, or even actual policy steps.
Critically for monetary policy flexibility and effectiveness, and market confidence, is the continued absence of financial stability and inflation risks. In terms of financial stability, the significant sell-off during Q4 in both credit and equity markets means that the market has already discovered weak hands, or over-leveraged and otherwise unstable positions. Interbank funding costs remained well-behaved and the sell-off in leveraged loans did not escalate into a corporate funding crisis despite a number of well-placed warnings. Leveraged loan markets have staged a strong recovery in recent weeks. (This market stress-test notwithstanding, we would remain alert to financial institutions which are paying above-market yields for short-term funding).
For inflation, inflation expectations appear very well-contained worldwide, with the risks skewed towards a further period of below-target inflation in the event of a sustained downturn and therefore no immediate constraint on monetary policy.
However, in terms of the “wall of worry” for 2019, easier monetary policy is a necessary but not sufficient condition to deliver on our original expectation of a normal year of 7-9% growth in global equity markets. The additional developments include sufficient progress in the US/China trade dispute to avoid the imposition of further tariffs, satisfactory resolution of the Brexit impasse and a bottoming of 2019 profits growth expectations at least close to current levels during H119. Ultimately and in the best case, the recent slowdown could potentially allow for the possibility of a further “time extension” to the current economic expansion before labour shortages in developed markets become sufficiently acute to create genuine inflationary pressure.
Therefore by remaining mindful of the lags between changes in financial conditions and economic fundamentals we keep our neutral stance on equities, even as markets rise while incoming data remains weak. In our view, it is too late to be overly cautious on equities. As we believe the primary cause of the slowdown in H218 was the earlier tightening of financial conditions globally, we argue the easing of financial conditions should similarly become evident by mid-2019. Added to the scope for resolution of the headline political risks during H119, on balance the risks still seem biased to the upside even if uncertainty remains relatively high.