The year may be drawing to a close, but it is not clear that Annus Horribilis for investors will end. The projection of the 2017 synchronized growth upturn into 2018 hit the shoals of the business cycle. The fiscal stimulus gave the US an adrenaline rush, lifting growth to an average annualized pace of 3.8% in Q2 and Q3, but many models, based on market prices, warn of increased risk of a recession. Other economies have already faltered. Germany, Japan, Italy, Sweden, and Switzerland contracted in Q3, and the flash France's December flash composite PMI fell below the 50 boom/bust level. China's economy appears to be slowing, but because of the dubious quality of some of the economic data, it is difficult to know the extent.
The still fresh scar tissue from the Great Financial Crisis means that the end of the business cycle would trigger high anxiety over the possibility of another credit crisis. The leveraged loan market, the growth of passive investment, and student loans have been touted as new equivalents of the subprime mortgages. US Treasury Secretary Mnuchin recently attributed the increase equity market volatility on the Volcker Rule and high-frequency trading. After the WWII, US policymakers were also fearful of a return to depression-like conditions and policies were pursued at home and abroad to avoid it. Growth and rising living standards were also understood as the best bulwark against the spread of Communism.
It is not only the business cycle that makes this period so difficult. Indeed, the political challenges are arguably even more daunting. Since 2016, the US has emerged as a revisionist power, insisting on reversing the country's globalist strategy. Could one even imagine another US President in the modern era that would proudly call himself the "Tariff Man?" In the following thirteen days, the S&P 500 dropped nearly 13.5%. Three things the US is doing are sources of instability: its trade policy, the unilateral withdrawal from the treaty with Iran, and the oil boom.
The US trade policy itself has three dimensions, and they will each likely intensify in 2019. The US-Chinese trade talks are set to reach some conclusion by March 1. It is difficult to see a meaningful agreement in such a short period. Lighthizer who is leading the US negotiations recognizes this, but what it means for the threat to increase the 10% tariff on $200 bln of imports from China to 25% and/or imposing a tariff on the remaining imports from China is not clear. China is likely to make more concessions, and there is some low hanging fruit. At the same time, it is clear that the problem is more in China's operational policy than declaratory policy - what it does rather than what it says.
In 2019, the US will also turn its trade attention to its Europe and Japan. Previous Administrations expressed various levels of frustration over the years with European and Japanese trade practices. The tensions were constrained by the Cold War and WTO. However, this administration has little time for ideological rivalries and is primarily interested in economic competition. In this sense, we have suggested that Trump is the first post-Cold War president. Despite a new trade agreement between the US, Canada, and Mexico, which appears to be mostly the old NAFTA plus some modernizing elements that had been negotiated in the Trans-Pacific Partnership (from which the US withdrew) and enhanced domestic content rules, Canadian and Mexican steel and aluminum continue to face tariffs on national security grounds.
The World Trade Organization itself is under threat. On the one hand, the Trump Administration argues that the rules are not designed for non-market economies like China. On the other hand, it is blocking the appointment of appellate judges, without which the important conflict resolution mechanism breaks down. There are normally seven judges, but it now down to three, which is the minimum for a panel to hear an appeal. This will slow things down and bring them to a halt one has to recuse themselves. The issue will come to a head as the term of two of these judges is over at the end of 2019. Studies of WTO decisions finds the US wins more than 80% of the cases it initiates, which is better than most countries and brings the most cases as well.
The US withdrawal from the Iran Treaty speaks to the increased element of American unilateralism rather than isolation. In addition to the balance of power politics in the region, between Israel and Iran and Iran and Saudi Arabia, the US decision impacts foreign companies who also do business in the US, and this includes SWIFT, the international payments platform. While some commercial ties are disrupted, the fact that Belgium-based SWIFT will respect the embargo is particularly frustrating for Europe, who chafe under what BusinessWeek recently called the Tyranny of the Dollar. The increased weaponized of access to the dollars rather than the "currency wars" over nominal foreign exchange levels, which captures the imagination of analysts and journalists, is an increasingly important exercise of US financial statecraft and projection of power but fuels a desire for an alternative.
The US has not reached "peak oil." Output is projected to rise in 2019. Exports may reach two million barrels a day. The simple geological fact of the existence of shale fields does not explain very much. Instead, the US carbon "revolution" is driven by technological change, which is ongoing and lowering the cost of production, access to cheap capital, which speaks to the depth and breadth of US capital markets, and a certain attitude toward the environment that is not universally shared even in the US, where New York State, for example, bans fracking.
To the extent that financing was achieved based on the value of the collateral (the price of the shale in the ground), the drop in prices poses fresh new risks. If the debt servicing acts as a fixed cost, some producers will find it in their interest to produce even at a loss. At the same time, the broader economic lift from that sector, such as capital investment, durable goods orders, and manufacturing, should be anticipated to a headwind on the economy in H1.
The oil embargo against Iran and the signals from the Administration that it would not look favorably on exemptions saw oil prices reach four-year highs at the start of Q4 '18 only to collapse when six-month waivers were grants to Iran's largest customers. These waivers will expire at the end of Q1 '19, raising the specter of uncertainty. The unilateral pullout of US forces in Syria, which appeared to trigger the resignation of US Defense Secretary General Mattis, will have consequences that will likely to become clearer in coming months, but the risk is the fragile, delicate balance will shift in favor of Russia, Turkey, and Iran.
The dramatic drop in equities in Q4 '18 and the flattening yield curve spurred concern that the US was recession-bound. Many observers argue that the Federal Reserve made a policy mistake by hiking rates 25 bp in December. There is a difference between a bear market in equities (20% decline) and an economic contraction. It may feel awful as the economy slows from 4.2% in Q2 '18 to around 2.4% (New York Fed GDP Nowcast) to 2.7% (Atlanta Fed's GDPNow), but it is not a recession. Trend growth in the US is estimated to be a little less than 2%, given the labor force growth and productivity. Bloomberg survey median forecast is for the US economy to expand by 2.4% annualized pace in H1 '19 before slowing toward 2.1% in H2.
Credit growth slowed in the last part of 2018. Most of it seemed to be related to both the commercial and residential real estate market. New issuance in the high yield bond market dried up in December, and the leveraged loans were under pressure. In themselves, these might not be undesired developments, but if there are an indication of broader, less benign developments, it would be a different story. Globally, new corporate bond issuance slowed in Q4 '18 to the lowest since the Great Financial Crisis as the slide in equities made for a less hospitable environment.
Above-trend growth, near full-employment, and real Fed funds near zero gives the central bank what used to be called a tightening bias. Officials explicitly recognize that changing financial conditions and headwinds from slower growth abroad could be mitigating factors. Press conferences after every meeting increase the Fed's flexibility to act to the changing economic dynamics (data dependency). The index of Leading Economic Indicators typically falls before the onset of an economic contraction. It rose at an annualized pace of 4.4% in the six months through November. Based on the information set at the end of the year, penciling in two rate hikes in 2019 seems prudent.
The balance sheet normalization (now at its terminal velocity of $50 bln a month) is controversial, with some of the biggest opponents of utilizing the central bank's balance sheet in the first place now leading the criticism of its unwind. Part of the confusion lies with the Federal Reserve. It previously argued that it was not the buying (flow) but the holding (stock) that made the asset purchases a powerful tool. It is only reasonable, then, that as the balance sheet shrinks, many see it as tightening. They point to the drop in equities and the flattening yield curve as evidence of too aggressive tightening. In fact, until the very end of the year, Fed policy was easier than a simple Taylor Rule model would suggest.
Just like the Great Depression discovered central government balance sheets, so too did the Great Financial Crisis discover central bank balance sheets. The effectiveness is still an open question. To the extent it worked, there appeared to be diminishing returns. There are also questions about how it worked. While we recognize investors who would otherwise buy the risk-free asset was either displaced or forced to accept a lower yield, we argue that the main channel was not the material impact of buying or holding, but the signaling impact. Officials were saying "we are doing this to ease monetary conditions." Doesn't much of it seem like a confidence game in the first place? Now as the Fed unwinds the purchases, it says it is on "automatic pilot" and technical in nature. It is not a policy tool or signal.
With the Democrats securing a majority in House of Representatives and the ongoing investigation into Russia's attempt to influence the 2016 election, President Trump may feel more constrained domestically. Even though an outsider, the Republican Party embraced Trump with high levels of support. However, halfway through the four-year term, the manner of the withdrawal from Syria, Mattis resignation and trenchant letter gave a distinct impression that Trump's support within the party may have peaked.
The challenges that the US faces are serious. However, it seems to be best positioned to cope with its domestic challenges and international headwinds, some of which it is precipitating. Europe appears particularly fragile. The economy is past its cyclical peak, and deposit rates are at minus 40 bp. Forecasts for the first rate hike have been pushed out of 2019. The German yield curve is negative through seven years. Spain can borrow for three years at negative interest rates. Italy's three-month T-bill yield is below zero. The precipitous drop oil prices will dampen headline inflation, and this will bleed into the core rate.
In Europe, like the US, the political challenges appear even more formidable than economic headwinds. Brexit looms large. It hangs over the UK like a heavy cloud and has not put it in the best light. The problem is straightforward, but the solution is anything but. A slight majority of the UK favored leaving the EU in a non-binding referendum in mid-2016. Nearly everything else seems like spin. There does not appear to be a majority, at least in parliament, for any one style of a relationship with the EU.
A game of brinkmanship will be played out in Q1 19. The House of Commons will vote on the 500-page-plus withdrawal agreement negotiated over a year and a half in mid-January. It is widely expected to be rejected. The EC has made it clear they are not open to renegotiation. The ball is squarely in the UK's court. It can redouble preparations for an unceremonious departure with no agreement. It can return the issue to the people to get more precise instructions (second referendum).
It can, as the European Court of Justice ruled, unilaterally revoke the triggering of Article 50, which set Brexit into motion. The event market PredictIt shows wagers favor the UK not leaving the EU at the end of March 2019 68%-32% (December 22). In this scenario in which the UK does not leave, sterling would likely appreciate as investors generally thought Brexit was sterling negative and the hard the exit the more negative. The broader equity market may outperform the FTSE 100, with its international exposure. A decision not to leave the EU would alter the calculations at the Bank of England, and the risk of a rate hike in Q2-Q3 would seem to increase.
The EC itself will be in transition in 2019. The first part of the year will feature jockeying for position, shaping of slates and alliances for the European Parliament election in late May. Smaller and more radical parties often do better in European Parliamentary elections than they do in national ones. There is broad dissatisfaction with the elites, and this will be translated into strong showing by extreme parties. The challenge emanates chiefly from nationalist forces, which will likely siphon more support from the center-right. The outcome of the European Parliamentary elections will drive the formation of the new European Commission.
The outcome may be particularly important in Italy. League leader and Deputy PM Salvini, the junior partner in the coalition with the Five Star Movement, is feeling his oats and has been emboldened by stronger public support since the spring election. He is outshining M5S leader and fellow Deputy PM Di Maio. There is some risk that if the League puts in a strong performance in the EU Parliament elections, Salvini will manufacture a crisis that leads to national elections and with the hopes of becoming Prime Minister, perhaps in an alliance with his former partner Forza Italia.
The European Central Bank is also in the middle of a transition that will culminate with a new ECB President at the end of October 2019. In addition to Draghi, the terms of two other board members end next year: Praet (May) and Coeure (December). The three account for half of the Executive Board. The Bundesbank's Wiedmann had been the early favorite to replace Draghi, but this never seemed to us as the most likely outcome. He was too divisive where consensus-building was desired. Moreover, Wiedmann's ECB presidency would also require the other German board member, Lautenschlager, the only woman on the board to resign, as no country is allowed two executive members.
While given the way Europe does things, it would seem to naturally to be Germany's turn to have a national be president of the ECB. Lautenschlager may be the obvious choice, but Merkel has signaled that she will not press hard. We suspect she realizes that German interests are best pursued in the critical period ahead, not at the ECB where the thankless job of normalization has begun with the completion of the asset purchase program, but at the EC level. It is in the composition of the new European Commission that we look for German to exert its influence. Finland's Liinkanen is seen as the front-runner to replace Draghi.
Italy's confrontation with the EC over the 2019 budget has been resolved. The underlying debt dynamics have not changed. Nor are many convinced that the government's initiatives address the structural rigidities of the Italian economy, where growth is chronically too weak to reduce the debt burden. Unfortunately, the early Q4 '18 data does not show much improvement after the economy contracted in Q3.
The outlook for Germany's largest bank is rattling investors more than the bad loans at Italian banks. Spain's minority Socialist government has not passed the 2019 budget. The failure to do so by mid-January could spur national elections. The holidays have sapped Yellow Vest movement in France which erupted out of nowhere and without apparent leadership. It forced Macron to back off some of the more antagonistic measures at a cost that would appear to push the French budget deficit toward 3.4%, risking the EC's objections. Macron's unpopularity and weakness domestically undermine France's ability to project its power in Europe. German politics are influx. We suspect that the four state elections in Germany in 2019 (Bremen May 26, Brandenburg September 1, Saxony September 1, and Thuringian October 27) may determine if and how Merkel completes her term that ends in 2021.
Several EMU members, including Belgium, The Netherlands, Finland, Portugal, and Greece hold national elections in 2019. Thirteen of Spain's autonomous regions go to the polls as well. Enlarging the field, Switzerland and Poland hold national elections. Investors will be sensitive to the success of extremist parties. Immigration and poor maldistributed economic performance appear to be the most salient issues, at the risk of over-simplifying. As the year winds down, Orban's government in Hungry, despite the impressive electoral showing eight months ago, is becoming subject to "yellow vest" type demonstrations.
Russia appears intent on fostering and widening tensions in the United States and Europe. While the focus has been on Sino-American confrontation, Russia has been solidifying a sphere of influence in center of the Eurasian landmass. It has been developing alliances not just with China, but with Iran. The extent of the rapprochement with NATO-member Turkey is not clear. With the US seemingly distracted, Russia could press its interests more forcefully in 2019 in Ukraine and what it considers the near-abroad. Putin seems less fearful than many of antagonizing the mercurial American President and participated in war games with Venezuela at the end of 2018 that included the provocative deployment of two strategic bombers.
Europe is involved in another transition. The last five centuries have been dominated by the northern Pacific community. The center of the global economy has clearly shifted, and the rise of nationalism, Brexit in the west and the rise of illiberalism in east threatens to leave Europe weak and divided in an era of large states. Monetary union is incomplete. Banking union has barely begun. Fiscal union is not for this generation. Political union is not discussed. The United States of Europe sounds foreign to the ear. The idea that the French seat at the UN Security Council becomes the European seat is simply fanciful, and if the UK remains, can Europe defend having two seats for much longer?
India, which moved ahead of France in the league tables for economic size this year, will likely surpass the UK in 2019, making some conservative assumptions about growth. France and the UK are at the same level of development and have similar populations. In the past, they have often wrestled for the fifth largest economy. India will take fifth place, and France may edge above the UK for sixth place, dropping the UK to seventh. India holds national elections in probably in April or May.
Everyone recognizes that the Chinese economy has slowed. There is a tendency to project near-term trends in a linear fashion. The median forecast in the Bloomberg survey was for the Chinese economy to grow 6.2% in 2019 after about 6.6% in 2018. The risk is that it does not take into account the stimulative measures Chinese officials have signaled, including tax cuts, and long-term targeted funds for small businesses. There is also plenty of scope to cut the required reserve ratios, which remain among the highest in the world. The PBOC could cut the key one-year deposit rate that has been at 4.35% since 2015.
The trade tensions with the US have been very instructive for Chinese officials. Until the confrontation, they did not seem to be aware of the extent of their isolation. Many countries object to its trade and commercial policies. China has already made some bilateral concessions to the US. It will likely offer more. There will be other reforms forthcoming. Indications suggest financial market reform will be emphasized. Look for China to protect its flanks, and this can be done only by changing its practices. China may be fortunate that there is not a multilateralist in the White House who wants to lead a coalition against it. It has two years before that could change.
Emerging markets may come back into favor next year. Two big headwinds for most emerging markets - rising US rates and high oil prices - will lessen. Chinese stimulus and ongoing efforts to find alternative inputs and markets away from from the US will Asia-Pacific economies. Money chasing returns had left emerging markets and liked the developed equity markets until the end of Q3 18. The MSCI Emerging Markets equity index outperformed the MSCI World Index of the developed markets by about nine percentage points so far in Q4 18. We expect this trend to continue next year.
The JP Morgan Emerging Market Currency Index fell by about 12% in 2018. It appears to be carving out a low, but this does not preclude lows. The sharp depreciation in several of the large emerging market countries will likely improve external accounts but the second round effects, including the compression of domestic demand, and inflation may quickly eat away at the improved competitiveness. Regionally, Latam faces a headwind from falling commodity prices, and Eastern and Central Europe are tied to the euro. East Asia benefits the most from the drop in oil prices and China's stimulus. Mexico is always interesting. The peso is off 1.4% year-to-date, third best among emerging markets, behind the Hong Kong dollar and the Thai baht (both off about 0.25%). Our suspicion that AMLO is Lula's tradition rather than Chavez has been bolstered by the early appointments and policy signals.
The Australian dollar was the weakest of the major currencies in 2019. Its nearly 10% depreciation against the US dollar, 4.6% against the New Zealand dollar, and 4.2% against the Chinese yuan returned it to near fair value (+3.5% above the OECD's PPP calculation). Given the high household indebtedness and falling house prices, we look for easing conditions to come through rates and/or currency. The central bank is reluctant to cut rates and continues to suggest the next move, so time off, will be a hike. Australia will hold elections for half the Senate and the entire House in 2019. Joint elections likely it will be held in May after the 2019 budget is presented in early April.
The Canadian dollar was near fair value according to the OECD's measure of PPP at the end of 2017 but moved away from it with the 7.6% depreciation against the US dollar. The Canadian dollar is finishing 2018 at 18-month lows as the market prices out additional rate hikes. The dramatic drop in oil prices has ripple effects through the economy, which is highly levered. Trudeau's foreign policy first with Saudi Arabia and then with China may be faultless, but it has won it few accolades from the US. Canada holds national elections in late October.
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