After ending 2018 with weaker momentum, the global economy is set to slow further in early 2019, given lingering trade uncertainty, a continued slowdown in China, and the lagged impact of tighter financial conditions in late 2018. However, financial conditions turned sharply from headwind to tailwind in the first quarter. Developed market central banks turned dovish, China continued to provide stimulus, and trade tensions eased — as President Trump delayed planned increases in tariffs and telegraphed his desire for a deal that could remove tariffs that have been recently implemented.
While we expect global growth conditions to deteriorate further in the near term, we think they will bottom later this year, and we still see low odds of a recession. The risk of a policy mistake from overzealous tightening looking forward has vanished since the Fed put its hawkish stance on hold in January and emphasized patience on interest rate policy and increased flexibility on reducing the size of its balance sheet. At the March meeting, the Fed went further, ruling out additional rate hikes in 2019 and announcing that the balance sheet run-off will slow in May and end in September. The fed funds futures curve is suggesting a high probability of a cut by year end.
Meanwhile, China continues to increase monetary and fiscal stimulus, putting its deleveraging campaign on hold. The European Central Bank (ECB) also pleasantly surprised markets by launching a third round of targeted longer-term refinancing operations (TLTROs) at its March meeting and signaling that it intends to leave rates steady for an even longer period. With inflation in the developed economies remaining low—at or below central bank targets — central banks in these markets can afford to pause on policy normalization and focus instead on stabilizing growth.
In emerging markets (EM), central banks have moved to an easing bias after having raised rates in 2018 when inflation risks were elevated due to high oil prices and currency weakness. This new dovish stance was made possible by a decline in oil prices from six months ago, an easing in the uptrend in food prices and a rebound in EM currencies. This led to more benign trends in inflation, especially among oil importers. Thanks to these positive developments, EM growth is likely to stabilize and recover in 2019.
After being an island of strong growth in 2018, the US economy is on track to slow this year due to the fading of the fiscal stimulus, the lagged impact of prior rate hikes and the strong dollar, and the effects of weaker growth outside the US. Growth in Q1 may be especially weak for idiosyncratic reasons (such as the government shutdown and winter storms), but it should improve thereafter. The labor market remains strong — despite the March disappointment — with solid wage growth underpinning consumer spending. US business confidence was mixed in February, with the ISM Manufacturing Index1 falling to a two-year low of 54 but the ISM Services Index rebounding to a red-hot reading of 59.5. The recent inversion of the yield curve, especially if it deepens and/or is sustained, raises risks for a downturn in 2020.
The Eurozone economy remains anemic, eking out a 0.8% annualized growth rate in Q4, led by weak business and consumer confidence and soft exports. The big drags on growth were Italy (-0.8%), which fell into technical recession, and Germany, which barely avoided it, posting annualized growth of 0.1%. However, growth held up in France (1.2%), strengthened in Spain (2.8%) and was solid in the Netherlands (2.0%). In the UK, economic activity slowed to 0.8% due to a big decline in investment spending and a drag on trade due to ongoing Brexit uncertainty and slowing global demand.
Growth in 2019 may be undermined by geopolitical and political risks, especially Brexit and the US/China trade standoff. In the UK, there is still no consensus in Parliament about how to move forward on Brexit. With the March 29 deadline looming, Prime Minister Theresa May was forced to request more time, and the EU has granted a conditional extension to May 22 or April 12. A “hard Brexit” still seems unlikely, but it remains the default option. It would be a nasty shock to Pan-European economies and financial markets if it were to happen, with negative global spillover. A high probability of a US/China trade deal appears to have been priced in by financial markets, so they have been set up for disappointment if talks collapse. For now, both the UK and US/China situations remain risk scenarios and are not our base case.
Investment Outlook: Central Banks Refill the Punchbowl
It has been a wild couple of quarters for risky assets, with Q4 and Q1 shaping up roughly to be mirror images. So, what explains the market’s recent mood swings? Slowing US and global growth, Fed intransigence in tightening monetary policy, continued tension on the US/China trade front and a US government shutdown all spooked markets in Q4.
Market declines accelerated in the second half of December, leading to a situation in which stocks and other risky assets priced in a too-high probability of a global recession, in our view. The selling reached a climax on Christmas Eve, and equity markets staged a powerful rally that has so far lasted through Q1.
The key catalyst for the rally was an abrupt shift from hawkish to dovish rhetoric on the part of the Fed and progress on ratcheting down trade tensions. The end of the partial government shutdown on January 25 and recent economic data also calmed investors’ fears about a potential US recession. While investors’ sentiment has clearly turned more positive, concerns about slowing global growth remain a risk.
While markets may need some time to consolidate or pull back after such a robust first quarter, we think stocks should remain in an uptrend over the next few quarters. Several factors could underpin this move, including a further dovish pivot by the Fed and ECB, and reasonably attractive equity valuations.
Stock valuations have rebounded along with the markets so far this year but are still reasonable, giving scope for further multiple expansion — which is common late in the business cycle. A US/China trade deal and a UK/EU agreement that avoids a “hard Brexit” could also provide further fuel for the rally if all goes as expected. On the flip side, either could be a source of major disappointment and downside risk in the unlikely event that a “hard Brexit” does occur or US/China trade talks collapse.
Investors will likely keep a close eye on the performance of corporate earnings, which have slowed dramatically from last year’s robust pace, and expectations for 2019 continue to decline for all regions. Globally, expected earnings growth has slid to 5%, with more downside possible, due to tougher year-on-year comparisons, tighter financial conditions, weakening GDP growth, lower commodity prices and slowing tech demand.
However, there are early signs that a more dovish monetary policy is starting to work through the system from China to Europe to the US, manifesting itself in an easing of financial conditions and the potential for a trough in global growth. Indeed, 12-month forward earnings expectations for emerging markets and the US are showing signs of bottoming and are likely to improve in the second half of 2019.
1This index based on a survey of over 300 manufacturing firms and monitors employment, production, inventory, new orders, and supplier deliveries.
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