Financial markets could be in for more pain, but sticking to a long-term position may be worth it
- Kerry Craig says while there is uncertainty over US monetary tightening, the trade war, Chinese economic policy and global politics, the short-term volatility of the past few weeks may be fading
No pain, no gain. That’s the theory anyway, and something to remember for those whose New Year resolution was to get fit. For the markets, the question is: will perseverance reward investors battered by losses and volatility or is there more pain to come?
Fretting markets got ahead of themselves in December, fearing that a global recession was knocking at the front door despite the lack of any major signs that a material economic slowdown was imminent. Equity markets have rebounded in the first few weeks of 2019 as investors do some bargain hunting, but is this relative calm sustainable? The answer depends on a few key factors.
First, US monetary policy. The fading stimulus effects of the tax reforms against a background of already tighter financial conditions have the market discounting any further rate hikes. However, the Fed is likely to continue to raise rates this year, given that policymakers have obtained both their full employment and inflation mandates. The pace of tightening will depend on how fast inflationary pressures build and whether some of the political uncertainty diminishes.
Getting this balance right will be important for the Fed, lest it accidentally tips the US economy into recession, but it is acutely conscious of the potential for a policy error.
Another factor is whether a resolution to the US-China trade war can be found. The increase in tariffs had a limited immediate economic impact, but as the trade war has rolled on, the damage done to corporate confidence has been profound in both the United States and China. The risk that the trade war translates into a tangible downturn in corporate spending is real.
However, with markets and economies feeling the burn, there is more incentive for both sides to seek a compromise. Many questions remain unanswered following the round of talks in Beijing this week, but a steady flow of incrementally positive signals could boost market spirits.
In the interim, China has stepped up its stimulus efforts. The reserve ratio requirement will fall by 100 basis points this month, while infrastructure investment has started to rise compared to a year ago. Just how far Chinese officials will deviate from their deleveraging to maintain the country’s economic growth target will have a large bearing on investor sentiment.
The trade war hit China at an inconvenient time, as it was already trying to pivot the economy away from investment-led growth. Having to revert to stimulus is a change in direction, but recent easing of monetary policy and an increase in local government bond issuance to fund infrastructure investment suggests that there is more to come.
For example, railway investment has become a focus in China, as suspended projects have been unfrozen. China’s National Development and Reform Commission has jump-started project approvals with 930 billion yuan (US$137 billion) in planned investment since December 2018. The country has also set out plans for environmental protection and development of eco-economic zones and development of city clusters and metropolitan areas, such as the Yangtze River Delta region and the Guangdong-Hong Kong-Macau Greater Bay Area.
Finally, global politics. The euro zone continues to feel the impact of rising populism in Italy and France. Italy has come to an acceptable level of government spending and government bond yields are starting to fall, but sentiment has taken a hit. Meanwhile, the disruptive Brexit debate will soon come to a head. Washington’s dysfunction may cause investors to become more sensitive to matters that have historically not been that important for markets, such as the government shutdown. In Australia, the outcome of the federal election will have market and economic ramifications.
How these factors will play out is still uncertain and whether we will see more market pain is hard to judge. It also means that there are both downside and upside risks for markets. But the negative short-term stock blips of the past few weeks that triggered panic among investors may be fading and those really committed to their New Year resolutions and long-term position could take note.
Kerry Craig is a global market strategist at J.P. Morgan Asset Management