“Looking towards 2019”
As 2018 ends, the world’s biggest economies continue to show signs of growth yet equity markets continue to roil in the uncertainty surrounding the growth outlook. This disconnect between evidence of growth, growth prospects, and equity markets’ concerns on weaker growth ahead relates to views that a range of issues could undermine growth. The issues include; increasing international trade tensions, high debt levels, and risk the US Federal Reserve raises rates too aggressively. While there are risks to the global economic growth outlook, the risk of this growth being derailed in the near term seems comparatively small.
To look forward I have had to look backwards. Looking back to our update at this time last year we noted some potential ‘Black Swan’ events:
- Lame duck Trump
- A coup in North Korea
- Prime Minister Jeremy Corbin
- Italian election troubles
- Blood bath in Latin America.
To a degree, all the above (excluding a coup in North Korea) have been a feature of the 2018 landscape. Trump will continue to seek relevance abroad, Jeremy Corbin could still become Prime Minister with the increasingly likely ‘Bremain’ or hard exit from the EU, Italy is a mess, and Latin America will struggle with a high USD$.
Victor Yeung, Investment Committee member, comments on the geo-political issues in his 2019 Outlook and writes that;
2018 has been unusual, as geopolitics became a dominating factor in market performance. The escalation of trade disputes between China and the US since 2Q 2018 has affected both the capital markets and the real estate markets. MSCI Asia Pacific has been down 11% year-to-date and 17% from its peak in January.
The market seems to be relieved that China and the US have reached a 90-day “truce” on December 1 at the G20 Summit over the trade dispute. Under the truce, the US agreed not to raise tariffs on USD 200 billion of Chinese goods from 10% to 25% and China would import more US goods whilst the two sides would try to negotiate on the trade issues over the next 90 days. Markets have reacted positively on the truce. However, the positions of the two governments seem to remain far enough that concluding a deal is far from certain. Thus, failing to reach a trade deal following the 90-day “cool-down” period is a potential market-impact event for 1Q2019.
One major trend emerging from the rising geopolitical tension is the reversal of globalisation. It is increasingly clear that Trump’s “America First” policy has led to what looks like a restructuring of US’ relationship with other countries that may be perceived as pressuring other countries into renegotiation of trade deals and formed multiple bilateral relationships. Such trends have impact on the global economy and markets. Trade rows and rising global tension are giving continuous pressures to MNCs to restructure their global supply chains in order to cope with the increasing trade tensions.
In the US, GDP growth looks set to continue at annualised growth of 3.5% underpinned by strong consumer spending. Consumer spending looks set to remain strong with forward readings like high consumer sentiment, high consumer confidence, strong wages growth, strong employment growth and lowest unemployment rate since 1969. The October ISM reports for manufacturing and non-manufacturing were both slightly weaker however both remained in strong expansionary territory. These factors should support US economic growth despite the softness in housing activity and business investment spending.
The fear (for investment markets) is that the US Fed may continue to view the combination of above trend economic growth and low spare capacity as potential higher inflation threat, causing it to hike rates beyond neutral. The recent dovish comments by Jeremy Powell calmed investor nerves. A rate hike on December 19 is probable and the Fed dot points suggest at least another 2 hikes in 2019 taking the rate to 3%. There is nothing to suggest that the Fed is doing anything other than returning rates to neutral, whatever that level is. The Fed is data dependant and is watching closely to ensure the economy can cope with higher interest rates, but not to restrain it, inflation is not a significant threat. The rise in interest rates will cause some pain for Corporate America, particularly those with high levels of debt. If the Fed does become more dovish and leaves rates unchanged post December 19 due to subdued data, then combined with an already flattening yield curve could signal a recession. Either way, equity markets will need to adjust…..or continue to adjust.
In Europe the ECB has confirmed the withdrawal from Quantative Easing as expected. This is despite GDP growth weakening. The weak GDP read is expected to be temporary as Europe’s labour market continues to tighten. Wages are starting to lift in some countries. The ECB is sticking to its plan and is still looking to increase interest rates in the second half of 2019. German and French economic growth has slowed, Italy is messy, and Brexit adds uncertainty.
Australia’s major trading partner, China, continues to see GDP slip lower. The trade war with the US will hit China’s growth rate eventually. We have seen the Chinese and US exporters bring forward their production and we are now seeing that start to roll-off. The data will have a few sharp adjustments before settling again. Concerning for China is the fall in retail sales growth to 8.6% y-o-y from 9.2% in September. While China is seeking to stimulate the economy, it won’t be to the extent of which we have seen in the past and not enough to fill the gap from weakening export trade. Much will depend on China’s ability to boost retails sales. China’s growth rate looks set to grind lower in 2019 barring any unexpected reduction in hostilities in the trade war with the US. The recent detainment of Huawei CFO in Canada has not helped the situation.
Victor Yeung comments that: One market indicator to watch will be the strength of the Chinese Yuan in early 2019, especially if interest rate increases are slowing down in the United States. It is therefore likely that the Chinese government will continue its stance of selective easing, especially regarding lending to private enterprises. We may see more Required Reserve Ratio (RRR) cuts in 2019. Nonetheless, a re-run of large, 2009-style easing as and or large-scale relaxation of property sector policy curbs are improbable.
Slowing debt and investment growth in China leads us to think that several commodities will remain under price pressure, particularly iron ore and coal.
In 2019, Australia’s domestic economy is still robust, but we are mindful that trade friction and economic slowdown in her trading partners can affect Australia. Market consensus has expected the Australia economy to grow 3.3% in 2018, the highest growth since 2013, then slowing to 2.8% in 2019 and 2.7% in 2020, with CPI inflation staying at 2.0%-2.3% level.
At the heart of Australia’s improving growth story is the strength of the labour market. The unemployment rate fell to a six-year low point of 5.0% in September and October. While wages growth is still rising only slowly, pockets of more rapid wages growth are developing and are likely to spread. Strong labour market conditions are encouraging the household sector to spend even in the face of weak housing and high household debt, the saving rate has dropped.
The soft AUD$ is assisting the export sector which has been strong. In fact, the trade surplus was $3b in September. Business investment is improving, and a healthy Federal Budget surplus is likely to fuel large spending commitments in the lead up to the federal election.
Given the challenging situation, the Reserve Bank of Australia is likely to maintain its policy rate at 1.5% level at least until late 2019.
The last few months has seen markets adjust rather sharply, down about 13% in early December from its highs and in half the statistical average time. But is it just a little turbulence as I indicated in last month’s update? Marcus Padley (professional investor) has summed things up well and I paraphrase some of his thoughts below:
- Slowing US Growth. The realisation the growth is not indefinite at 2018 levels, which must be adjusted for, is not a catastrophe.
- The yield curve in the US is inverting. A sign of slowing growth meaning markets think long term interest rates are going to be lower than current rates. This would only happen if inflation fell and growth slowed.
- Inflation is still benign. This is despite a decade of accommodative monetary policy. The recent fall in oil prices is keeping it down.
- Trajectory of US Interest rates. Could be flattening out.
- The fear of trade war escalation. The issue could obviously escalate. Its unclear how Trump will play this when it comes to his re-election.
- Peak earnings. Earnings growth in 2018 was driven by Trumps tax breaks. Thus, earrings growth will drop this year in the US but there will still be growth, this is a positive and we should be impressed.
- Those tweets add volatility. The tweets add significant and unnecessary financial market volatility. We will just have to live with it.
- The 10-year oversupply of cheap money is coming to an end. This should not be a surprise.
- The overpricing of US tech stocks. Finally, the top end of the US stock market is sobering up, but it is the froth blowing off not the core blowing up.
There does not seem to be anything like the US sub-prime mortgage cancer in the balance sheets of US companies. Slowing earnings growth is hardly terminal but markets will need to adjust. While the short-term trend appears to be down, we are assuming this is a normal mid-cycle correction. The signs of a long-term market sell-off don’t appear to be there.
One of the most obvious risks for the domestic market remains the fall in house prices. The RBA minutes suggest the central bank is comfortable with correction to date. While there is talk of the negative wealth effects falling house prices can have, the RBA remain unconcerned and feel they are ‘generally small’. No doubt this issue will be a focal point in the first half of 2019 but it won’t be the only one. Other focal points include the direction of the release of the Banking Royal Commission report, US Fed and an escalation in US-China Trade tariffs.
This information was prepared by Royston Capital, ABN 98 158 028 392 AFSL 438262. The information in this presentation is current as at 17 December 2018 unless otherwise stated.
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Sources: Admiral Investments, Alexander Funds Management (Steven Roberts); https://www.livewiremarkets.com/wires/nothing-terribly-wrong (Marcus Padley)