In the 10 years since the global financial crisis of 2007-2008 there has been a perennial fear that the withdrawal of central bank support would lead to a collapse in asset values, which had been artificially inflated by ultra-low interest rates and asset purchases. With equity markets outside the US now having fallen by 13% in US dollar terms since the peak in Q1 18 as US interest rates have risen, it is very easy to become convinced this is the start of something bigger. While experience is in general an advantage, investors should beware of the risk of being too quick to make emotive links with the run-up to the 2008 financial crisis and emerging market crises of the 1990s. Notwithstanding the recent market declines, when we look ahead into 2019 we can see scenarios which imply a continued, albeit slower, global GDP and profits expansion – and a pause or slowing in Fed rate increases.
Furthermore, time has proved that in the US case at least, asset purchases can be halted and interest rates normalised even as the domestic US stock market remains at all-time highs. We acknowledge Trump’s late-cycle 2018 corporate tax cuts made the transition away from unconventional monetary policy easier than it might have been. Nevertheless, investors have at least one case study in how to normalise monetary policy without creating economic disruption, as they consider the ECB’s next moves.
We have been cautious on equity markets on a global basis for some time, an argument based on the absence of upside due to high starting valuations, rather than a prediction of a slowdown in economic or profits growth. This is a call which has been mostly accurate over the past 12 months, with the notable exception of the US.
A benign de-rating scenario has played out over this period, with markets moving sideways or modestly lower as profits grow and catch up with market prices. Now, the question is how much further this period of muted returns on equity markets has to run. A linked question is whether the recent turmoil at the fringes of the financial spectrum, namely emerging markets, represents an early warning of a threat to the core or is merely a transient period of volatility before growth is re-established.
We believe a comparison with the period of 2004-2005 is relevant. The similarity to today is that the Fed started tightening policy after the recovery from the dot-com recession while the economy was still growing strongly. US 2y yields moved from 1.5% to 4.3% and the yield curve flattened considerably before inverting at the end of 2005, Exhibit 1.
The important point to note is that the S&P was rising throughout this rate increase cycle, even after gaining 30% from the lows of 2003. Furthermore, despite the persistent inversion of the US yield curve, US equity markets did not peak until late 2008, almost 3 years after curve first became inverted.
Admittedly, the market decline in 2008 was calamitous, taking markets back to 1997 levels – but perhaps a good example of markets remaining irrational for longer than the typical fund manager could remain bearish. Those highlighting the currently flat yield curve would appear to need additional indicators to show that a recession or sharp reduction in the availability of credit is imminent.
We highlighted an increase in the relative cost of LIBOR versus secured funding earlier in the year, typically a sign of a shortage of dollars in overseas markets. This measure – which was a highly useful symptom of stress in the financial system in 2007 – has however returned to normal levels, Exhibit 2.
One data point which might give cause for some concern is the reported slowdown in global trade. The US administration’s policy of engaging in trade conflicts has had a negative impact on sentiment and merchandise trade volumes have slowed in recent months. However, global trade volumes have lagged behind the growth rates of the pre-2008 era for most of this decade, even as the US and Europe recovered from recession. Set against this data are economic surprise indices for developed markets indicating that incoming economic data is currently in-line with consensus forecasts.
Given the one-off nature of the fiscal stimulus from US tax cuts, US corporate earnings and GDP growth in 2019 is very likely to be slower than this year. Yet consensus US earnings forecasts in 2019 are still for high single-digit growth in profits.
In addition, we detect from Fed Chair Powell’s comments at Jackson Hole indications of a second, more relaxed, phase in the Fed’s rate increase trajectory. Powell highlighted the benefits of central bank credibility obtained by firmly anchoring inflation expectations. He suggested if this credibility is in place, during an expansion the Fed could consider running relatively easier monetary policy (absent signs of a pick-up in inflation), thus reducing the risk of choking off the expansion too quickly. This wait-and-see approach allows for the possibility that data on potential improvements in growth rate of the economy may not be available in real time.
In addition to this intriguing doveish possibility, we note that US interest rates have moved a long way from the zero lower bound and are not so far from Fed estimates of the natural (nominal) rate of interest of close to 2.5%. During H2 18 although US 2y rates have continued to increase, this has been at a much slower rate compared to the start of the year. While the Fed is highly likely to go ahead with a rate increase this September, the key for us is any shift in rhetoric in terms of the outlook for the trajectory of rates during 2019.
A signalling of a slower pace of Fed rate increases would in our view reduce upward pressure on the US dollar and provide respite to emerging markets. Emerging market equity valuations are more attractive than in developed markets due to the recent run of underperformance, although not at distressed levels.
However, if dollar strength is sustained due to a hawkish Fed, this EM underperformance would be likely to continue. This is even as the longer-term reserve status of the dollar is being openly called into question, in part due to the current US administration’s policies of running larger fiscal deficits and in some eyes “weaponising” the currency through trade and sanctions policy.
EU Commission President Juncker has in recent days highlighted the oddity that EU nations pay for oil in dollars when only 2% of supply comes from the US and that the practice of buying planes in dollars should be changed. There is perhaps a greater impetus to take the initiative on an alternative world currency as China and Russia promote the same agenda, given the more confrontational US trade and sanctions policies. Over the long-term, dollar strength is not assured.
With US trade and Brexit headlines dominating the headlines we believe it is easy to lose sight of the fact that many of the negative market events of the last 6 months – higher volatility, a stronger dollar and underperforming emerging markets – could equally have been attributed to tighter US dollar funding conditions. We may be a little early to highlight the possibility of a more relaxed pace of Fed interest rate increases but if inflation remains well-contained, a self-sustaining period of growth supported by higher wages in the US for 2019 remains a possibility. For the rest of the world, if the Fed shows further signs of a switch to wait-and-see mode during Q4, the pressure on emerging markets may ease.