Since the beginning of the year, two major potential downside policy risks have receded, the risks of overtightening of financial conditions due to Fed and other central bank tightening and a further escalation of the tariffs associated with the U.S. China trade war. The combination has led to a strong asset market rally and reversal of the late 2018 sell-off. However macro conditions remain weak as the U.S. economic momentum seems to have slowed, following a slowdown of some of its key trading partners. This is in line with our expectations of a softer 2019, but not a U.S. or global recession. There are some signs of trade stabilization and Chinese local growth stabilization, but few of a meaningful re-acceleration of growth. This contrasts with some growth-influenced assets like equity which are again looking expensive in some developed economies – and may be cheap for a reason in some big emerging markets. I continue to worry the low volatility (amplified by central bank support) may be underpricing risks
Some Thoughts on the 2019 Outlook
2019 set to be a tougher year…
Growth momentum has weakened in the second half of 2018, particularly in European and Asian exporters, who are responding to the end of above potential growth of the last few years, which has moderated final demand growth. Tariffs, restrictions and tighter financing costs have reinforced this trend, making final harder to forecast and encouraging caution on new investment decisions, Meanwhile Fed tightening, exit from quantitative tightening and boost in available US Treasurys, have begun to increase debt service costs across a range of sectors and geographies.
Slowing final demand growth globally is not a surprise, and has been a part of our themes for the last year, but the trade disputes and restrictions have reinforced some caution from buyers and supply chains. The drivers of this slowing of growth include a) the disconnect between policy stance in the U.S,. and other major economies across fiscal and monetary policy b) the lack of structural measures to boost final demand growth, c) removal of the “sugar rush” of monetary policy support as quantitative tightening takes hold. The U.S. and Chinese central banks have been particularly focused on continuing with business as usual, with overall policy stances only partly supportive. In both cases, a relative disconnect between fiscal and monetary policy complicates the messaging, and exacerbates some of the FX pressure.
I’m off to the annual meetings of the World Bank and IMF this week, a good chance to take the pulse on global market consensus and the worries of policy makers. Global trade risks and their impact on an already decelerating global economy are likely to top the worry list – with the impact of tariffs, policy uncertainty on value chains in focus along with questions of policy and macro divergence, all of which have left many less optimistic than in the spring. Given the recent escalation of U.S. – China trade tensions, and signs of slackening in global export growth, the focus is likely to be on the downside risks to global growth, the divergence between U.S. economic activity and that of most of rest of the world.
To read the whole post with graphics, please download here. Last week many Emerging market assets came under pressure following the rise in the US 10 year yield. The sell-off was concentrated in Turkish and Argentine markets, whose FX and thus other assets fell sharply, and in USD sovereign debt more generally, but some other assets came under pressure, admittedly falling just outside recent trading ranges. The sell-off prompted a lot of questions about whether this is a broad-based crisis. I don't think it is? Rather it should be a reminder to look closely at national balance sheets, the quality of growth, fiscal space and resilience.
I’ll try to answer (briefly!) a few key questions in this post: What happened? How have affected central banks responded? How strong are EM fundamentals? Is this another EM-financial crisis (hint: probably not), What would it take for a broader sell-off? what might be the vectors of contagion if it escalated? should we be worried about pegs?
As one would expect given the portfolio effects, which are higher for hard currency debt and equity than local, some other liquid EM saw outflows including Mexico (NAFTA risk), Brazil (election), India and Indonesia (oil and some modest financial contagion) but these seemed modest and are likely to remain so unless there is a meaningful macro risks emanating from China or the U.S. These risks are likely to stay isolated, but add to some growth challenges across relevant regions. Other stronger assets caught in the cross-fire (and even some of the affected assets) may present buying opportunities.
This is unlikely to be the last such bout as investors test the resolve of the Fed to continue normalizing, the significant wave of US bond issuance is absorbed and growth rates stagnate or weaken due to the waning of stimulus and trade policy risks. Higher and rising oil prices – driven by the uncertainties about the Iran deal, continued implosion in Venezuela and profit seeking in Saudi Arabia, only complicate the outlook, causing concerns for oil importing regions and countries, and their consumption and external balance.
I wrote earlier about some elements of the consensus macro view and some risks to those views (and my own). A key part of tracking consensus (and identifying out of the consensus views), is keeping track of the questions investors and others are asking each other. I'll plan to gather some of these on an ongoing basis through the year to track the evolution of concerns and identify what consensus might be missing.
Key dilemmas remain mostly focused on policy choices and whether any policies might upend the macro resilience and market performance. Could this resilience fade? What would be the trigger? As typical queries are most prevalent on U.S. and Chinese policy, geostrategic issues, especially in the Middle East and North East Asia.
Global growth: is this the best we can get? What does that mean for asset returns? Will this pace of global growth be sufficient to create enough jobs in populous EM/Frontier countries o will it exacerbate political stresses and reinforce price pressures?
Impact of US fiscal policy: questions include the impact of the policies on U.S. and global demand, including the relative performance across sectors, across regions (especially in areas like New York, New Jersey and California) most vulnerable to the non-deductability of state tax, the impact on external balance and U.S. capital account? When would we worry about US debt finance ability?
Monetary policy transition (in terms of leaders and policy stance): Will the Fed/others overtighten to compensate? What credits are most vulnerable? Will the new board members shift policy? Many countries want to lag the Fed and would appreciate the weaker currency that may result, will they be able to do or will limitations of macro prudential measures call for a different trend?
Trade trends: Will any of the many trade agreements set in motion changes in supply chains? Are countries like Brazil finally opening up? Will measures increase the costs of compliance with different regulations (digital trade, localization , cybersecurity). Other policies (fiscal and monetary) are likely to have more effect but could the questions on the rules defer/front-load investment? Is there a new round of investment protection coming?
Valuation: Are US equities really expensive or are there drivers/buyback trends that justify valuations ? What about knock-on effects? is the credit downgrade cycle over in commodity producers?
China's policy space: Chinese authorities have plenty of tools to use but will doing so cap growth and undermine asset performance? Will Chinese corporate, government and quasi government bonds find buyers at a reasonable price? What will be the drivers of growth beyond 2018? Will Chinese export growth further undermine transpacific trade?
Europe risks? is Brexit irrelevant aside from the UK? Are the European banking systems and sovereigns solid enough? Has there been enough deleveraging? How concerning are signs of overheating in Eastern/Central Europe? Is the convergence story back on? Will Europe shift over to more domestic demand?
What’s going on in Saudi Arabia/the Middle East? Lots of questions about the Aramco IPO, the divergence between economic reforms and political approach. What is the strategy from the Saudi/Abu Dhabi nexus? What is the U.S. strategy in the region? Will the market absorb the planned bond and equity issuance (the latter is likely to increase significantly in 2018)? Will any pegs break in the next two years (watch Oman). Is the GCC completely irrelevant as a body? Will regional SWFs continue to turn inward? What are the new investment rules in the wake of the Saudi anti-corruption measures? Will the Qatar blockade just fade away as the country adjusts (and recent data suggests its a vey slow bleed) and other countries continue to trade with the country (see UK and French economic and military coordination).
Like many people I’ve spent a lot of time over the last week at “2018” Outlook events, reading and writing outlooks. At the risk of adding to the deluge, its worth a few reflections about the status of consensus and where triggers might diverge.
Almost everyone I've spoken to over the last few months is upbeat and sees a continuation of the “synchronized global expansion,"* benign liquidity conditions and pricey valuations getting even more pricey after gains. Some countries and sectors look less resilient, but the general view is quiet positive.
Some are a little worried about 2019 or H2 2018 or Q4 2018 when the effects of balance sheet adjustment might begin to be more priced and when questions escalated on what might be the new drivers of growth. In this context, regulatory uncertainty especially around trade and investment policy might reinforce recent investment trends, as some corporations and households hold off on spending.
Rachel's musings on macroeconomic issues, policy and more.