As the US and rest of the world diverge economically, what does 2019 have in store for global investors?
- Shamik Dhar says global fundamentals remain healthy for investors and the recent sell-off provides a promising entry point, but watch out for inflation
This was the year the global environment diverged as the United States powered ahead while the rest of the world stumbled. Looking ahead, tighter financial conditions, a slight dip in European growth, some idiosyncratic emerging market stumbles, the deleterious worldwide effects of a stronger US dollar and trade tensions all threaten to spill over into 2019. The question facing investors is whether fundamentals are strong enough to steady global markets and whether current asset prices sufficiently discount solid, though weaker, fundamentals and risks to the global outlook.
Global growth is still positive for developed economies. While China and Europe will slow further, the US will remain the consumer of last resort, powering the global economy. Several emerging markets, such as Turkey, have experienced weakening external funding vulnerabilities, but there has been no contagion to other emerging economies and pockets of strength persist.
Global inflation expectations are well anchored in the developed economies, lessening the chance of inflation spikes. While the Federal Reserve is likely to raises interest rates twice, there may not be a third hike. In addition, lower average employment across the G7 is not leading to corresponding wage gains and rising inflation. As a result, there’s no reason to expect a spike in long rates.
The European Central Bank (ECB) may choose to push back its first rate hike since the global financial crisis to late 2019 or even early 2020. The US dollar could creep higher, but any Fed pause or Brexit clarity in Brussels would put a halt to its march. Therefore, the worldwide market sell-off in 2018 presents an opportunity in risk assets, and bonds will remain negatively correlated with equities, allowing standard multi-asset portfolios to perform. While risk assets may not appreciate as steadily as in the recent past, the firm global backdrop will ultimately support asset prices.
Despite this, greater market volatility is in store as the risks to this constructive scenario come from trade tensions, global tightening of financial conditions and fears about debt sustainability and banking stability in Italy.
The US trade war with China is deepening. Donald Trump’s administration is honing in on China’s forced technology transfer, surveillance of foreign businesses and President Xi Jinping’s plans for Made in China 2025, a direct threat to US technological domination. These issues are unlikely to be solved quickly, so expect 25 per cent tariffs to be placed on all Chinese imports in early 2019. The US can withstand this pressure in the aggregate, but the Chinese economy will feel the pain. As worldwide trade contracts, Europe and emerging markets will be affected as their growth is more dependent on global demand.
Further, 2019 will mark the end of monetary global easing by developed market central banks and the beginning of quantitative tightening. The US has already rolled off up to US$400 billion of Treasury and mortgage-backed securities assets through to the end of November and is currently at a US$50 billion-per-month pace. Japan remains committed to extraordinary monetary policy, but Europe will mark the end of its asset purchase programmes at the end of 2018. Coupled with this, the Fed is determined to raise rates before the next recession. This withdrawal of global liquidity is bound to put continuing pressure on emerging markets with large external funding needs and high debt ratios.
Finally, the euro zone remains vulnerable to risks in the financial sector. The slow-moving train wreck between Italy and the ECB continues, and the European banks still own the sovereign debt of their home countries. In addition, European banks own the debt of other sovereigns, increasing the risk for region-wide contagion in the financial sector. As the Turkish currency crisis revealed last summer, the European banks lent heavily to emerging market companies during the time of free money. As global liquidity tightens and the carry trade reverses, those assets on the balance sheets could be marked lower, putting pressure on bank capital ratios.
The sleeping giant in all this is inflation. Even as inflation moves gently higher in most developed economies, the slope is both manageable for current central bank tightening plans and fairly benign for global economies. Should inflation accelerate, then the constructive scenario would break down quickly. A Fed with an itchy trigger finger could raise rates faster than currently priced in, leading to a sell-off in risk assets.
Any move towards convergence with US real rates would shock all asset classes. Under these scenarios, the investment regime would change rapidly, as the correlation between equities and fixed income goes positive, presenting asset allocators with very different challenges than in the days of financial repression.
The global backdrop remains solid, if unexciting and a bit worn down. The 2018 sell-off should provide investors with a comfortable entry point and an opportunity to rebalance their allocations. The key variable in this rosy view is inflation – and as long as that remains gently sloping upwards, then expect upwards, if more volatile, performance of risk assets in 2019.
Shamik Dhar is chief economist at BNY Mellon Investment Management