From the US/China trade war to challenges in Europe, we consider hazards on the horizon for the year ahead.
Markets started 2018 full of optimism. The US economy delivered stellar performance – buoyed by US president Donald Trump’s tax cuts, which propelled a surge in growth and corporate earnings – while the US unemployment rate hit an almost 50-year low. An upward drift in inflation was gradual, so there weren’t any big surprises from the US Federal Reserve, which hiked interest rates in line with its guidance.
However, some US government foreign policy initiatives proved disruptive throughout the year. Undeterred by the threat of higher costs for US consumers and businesses, the US ramped up trade tensions. It seems there is considerable political appetite among the US electorate, across both Republicans and Democrats, for a review of US trading relationships, with China very much the target of trade war rhetoric and US tariffs.
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US trading aggression hit the Chinese economy at a point when growth was already slowing rapidly in response to tighter fiscal policy from the Chinese government. Emerging markets have thus been hit by a double whammy of slowing growth in China and higher US interest rates, which has raised their borrowing costs.
Europe has been caught in the crossfire. Although early tensions between the US and the EU over automotive tariffs have dissipated for now, demand in Europe has been battered by a downturn in global trade.
Strong growth in the US economy did not trickle down elsewhere as it has tended to do in the past. The US economy, equity market and dollar were relative bright spots in an otherwise dismal year for global markets.
Fading fiscal benefits
Significant US economic outperformance is unlikely to persist in 2019. As the chart shows, the fiscal stimulus that provided an intense sugar rush for markets in 2018 is expected to fade in the coming quarters, and overall GDP growth is expected to moderate to less than 2% by the end of 2019.
US tax cuts might have generated more lasting effects worldwide through increased business investment, but in the face of great geopolitical uncertainty, firms are currently deferring investment. This has been most starkly in evidence in Europe and Asia, but there are increasing indications that capital expenditure intentions are fading in the US itself. This is particularly disappointing because the global economy desperately needs stronger investment to revive growth, lift productivity and real wages, and in turn ease many global political difficulties.
One solace for markets may come from the Federal Reserve. The recent decline in the oil price and the strength of the dollar in 2018 are likely to keep headline inflation at close to its 2% target. JPMorgan Asset Management expects the Federal Reserve funds rate (the rate at which deposit takers lend to each other overnight) to edge closer to 3% by mid-year, but it also expects the Fed to demonstrate that it will be considerably more hesitant and data-dependent in making its interest rate calls in the coming months.
Fiscal stimulus may be fading in the US, but policymakers in China have put their collective foot firmly back on the accelerator to see off the impact of slowing exports. The Chinese government faces the difficult balancing act of sticking to its ‘quality over quantity’ agenda and reducing excesses and leverage in pockets of the Chinese economy, while maintaining a sufficient level of growth to support employment. Easing measures will be targeted and smaller in scale than they were in 2008, but we expect growth to remain supported in the region of 6%.
Stable growth in China is likely to support neighbouring Asian countries, but elsewhere in emerging markets growth and earnings are likely to continue to moderate in reaction to the tighter policies deployed in 2018 to defend currencies.
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European corporates are plagued not just by geopolitical uncertainty but also by political challenges at home. At the time of writing, there is still considerable uncertainty about prime minister Theresa May’s ability to get her Brexit deal through the UK parliament. Our baseline assumption is that the threat of either another referendum or a general election will eventually bind the Conservative Party together and that her deal will be passed.
Beyond Brexit, challenges for the EU remain. Critical European parliament elections are due in May, and the risk is rising that Eurosceptic alliances will take a greater share of the vote. Such an outcome may leave investors sceptical about the longer-term prospects for EU integration as well as the EU’s ability to provide meaningful leadership in the next downturn.
Meanwhile, the stand-off between the EU and the Italian government looks set to continue, and Italy is likely to be placed under an ‘excessive deficit procedure’. However, such a procedure is not a particularly rare occurrence in Europe. France, for example, has been in equivalent monitoring for 15 of the past 17 years.
We don’t expect Italy to question remaining in the euro, but the zone’s third-largest economy is slowing sharply as credit conditions tighten. A more lacklustre pace of growth and political fragilities could limit the European Central Bank’s ability to lift interest rates in the second half of the year in line with its current guidance. If that’s the case, negative interest rates will weigh on the profitability of Europe’s banks for some time yet.
In aggregate the domestic eurozone economy looks fine for now, and wages are rising, but ongoing weakness in global trade is likely to deter firms from hiring in much the same way that it is causing them to scale back their investment intentions. External weakness is beginning to infect domestic strength. However, the recent collapse in the oil price is supportive for Europe as a region, so European growth is likely to hover at just above 1.5% for much of 2019. That will be enough to cause a sizeable narrowing in the performance of the European and US economies during 2019.
Asset class outlook
GDP growth convergence in the developed world will coincide with a narrowing of the relative earnings growth of equities.
In the US, margins are likely to be slowly eroded because of a combination of higher tariffs, wages and debt servicing costs. What’s more, the US’s technology sector advantage has faded somewhat, with investors fretting about the sector’s structural earnings potential, particularly in light of increased regulatory scrutiny. An outperformance of the US stock market of the scale seen in 2018 looks unlikely, so regional diversification makes sense.
That said, given that 73% of FTSE All-Share index earnings are made overseas, a positive Brexit outcome is likely to result in sterling gaining value, which will hit repatriated earnings and large-cap UK stocks, even if they look attractive from a dividend yield perspective.
Valuations are no longer terribly lofty anywhere – at least on a forward price-to-earnings basis. Valuations in emerging markets are compelling, but investors’ appetite for risk will need to increase before they become comfortable returning to emerging markets. A more hesitant Federal Reserve will help. The ideal backdrop for emerging markets would be one in which US economic growth slows to 2% but stabilises.
Fixed income, meanwhile, faces several challenges investors should navigate carefully. At this stage in the cycle, when investors should be (and are) thinking about reducing risk in their portfolios, it is natural to head towards the shelter of fixed income. However, at this juncture investors must be careful about where in the fixed-income universe they head.
The challenge is most acute for UK investors. A good Brexit outcome may be good news for the UK economy and coincide with a bounce in growth in 2019. However, it will pose significant challenges in terms of generating asset returns. That’s because a stronger sterling will probably drag on the FTSE large caps while a faster pace of interest rate normalisation will weigh on government bonds.
As US growth differentials fade, the market is likely to pay more attention to some of the structural challenges facing the dollar, such as ever-rising US government debt and the US’s large current account deficit. The dollar is broadly likely to nudge lower against European and emerging currencies by the end of 2019.
The shift against sterling is likely to be most stark if our prediction about the Brexit outcome proves correct. Sterling can be expected to appreciate significantly if Theresa May’s Brexit deal does get passed through the UK parliament, but only when the Bank of England acknowledges that interest rates need to move more swiftly will we see the full extent of upward pressure on the currency.
Navigating a market cycle is a bit like flying a plane. The dangerous bits – the parts you really need to get right – are take-off and landing. The current economic and market cycle may be getting closer to its destination, but be wary of overreacting to political noise and opting for dramatic shifts in allocations – policy decisions and sentiment can change quickly.
Those who adopt the brace position will lose sight of the controls and the ability to make the most of opportunities that present themselves in a period of market turbulence.
Karen Ward is chief market strategist for the UK and Europe at JPMorgan Asset Management.
This article was originally published in our sister magazine Money Observer, which ceased publication in August 2020.
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