Financial Markets Look Ahead: 2019
2018 ended with a spike in volatility and a broad decline in the markets — the S&P 500 was down nearly 10% in December alone. The S&P 500 ended the year at 2506 — with a small “consolation” uptick at the end — from the low of 2346 made on December 24. Some called this a probable recovery, but has anything changed at a macro level, or is this just a hope? In this piece I’ll examine various macro trends that may influence the markets in 2019.
In the United States, the government shutdown, which is ongoing, is certainly impacting market confidence and with the President digging into his demand for a border wall, I expect the present shutdown to remain in place for some time still, and more importantly, such prolonged impasses will likely take root every time a new issue crops up. A tenuous relationship between Democrats — who take control of the House on January 3— and the President will serve to further impede any meaningful policy decisions. Additionally, any adverse findings by the Mueller investigation involving the President or his family members will lead to policy paralysis.
Beyond the United States’ internal political concerns, trade discussions between the US and China appear to be proceeding well, and it is likely that some solution will be announced in early 2019 for no other reason than that the stakes are high for both the US and China. With regards to the trade war itself, we shouldn’t lose sight of the fact that this war is in reality just scratching the surface of the more secular challenge of the US’ global hegemony by China. This undeclared, longer-term war is evident in the battle for 5G telecom supremacy, which has most recently manifested itself in the US’ insistence that its key allies avoid purchasing Huawei equipment, and with the recent arrest of Huawei’s CFO in Canada. In this context, I am skeptical that any truly meaningful agreement on trade will be reached between the US and China; only a band-aid solution will be presented. That said, I still hold the opinion that the market corrections seen globally in 2018 were not primarily driven by the ongoing trade war.
In the United Kingdom, a vote on the draft Brexit agreement with the European Union is yet to be held. At this point, there are three potential outcomes: 1. The British Parliament votes to approve the draft agreement negotiated with the EU, leading to a more orderly exit; 2. The British Parliament votes to reject the draft agreement negotiated with the EU — the so-called “hard Brexit”. This would severely hinder day-to-day life in the UK (and the EU) as existing agreements would no longer be valid, with no new agreements in place; and 3. There may be a second referendum on whether to exit the EU. Any cancellation of Brexit arising from a second referendum will be tailwind to the markets (although unlikely to benefit the underlying economy), but ultimately, whether a second referendum is a good idea is a matter of perspective. Some might argue that given the last vote was so close, and considering everything we’re now learning about the real, on the ground impact of Brexit — especially in the context of the recent evolution of the global economy — a second referendum will better capture the sentiment and desires of the British citizenry. On the other hand, the purpose of a referendum such as the one regarding Brexit is to gauge public interest in major, era-defining changes to a country’s path. In that context, a follow on referendum — while averting near-term economic pain — can be seen as undermining the very fabric of British democracy. As of this writing, the odds of a second referendum are looking good and increasing.
The European Central Bank (ECB) will formally end its multi-trillion dollar bond-buying program at the beginning of this month, finally ending its quantitative easing program. It will, however, moderate the effect of the unwinding on the economy by reinvesting cash from maturing bonds for an extended period of time. On the fiscal side of things, Italy finally agreed to a budget with the EU after several weeks of tough negotiations.
France, which is facing its own difficulties with balancing its budget, announced a tax on US technology firms with the goal of raising €500M a year starting January 1, 2019. Interestingly, France has decided to go it alone on this tax, as there was no unanimity within the broader EU community. As of this week, Austria is strongly considering a similar tax of its own. What this means for the longer-term stability of the Union remains to be seen, but it has to be said that when economic pressure builds up, even the torch bearer of the union looks the other way and decides to act in isolation.
Globally, what really spooked markets — especially emerging markets — in the second half of 2018 was not only the continued monetary tightening by the US Federal Reserve in early 2018, but also its bullish outlook and indications of further rate hikes. Consequently, the US Dollar moved out of emerging markets and into the US, resulting in a steep decline in several emerging market currencies, beginning with Argentina and Turkey before cascading onto Asian economies. The table below highlights how the US Dollar strengthened against key currencies globally in the middle of 2018.
The US stock markets, which had been moving up steadily — and with low volatility — since the beginning on 2016, reversed course at around the same time as the Dollar’s strengthening. By late September, the US markets had a case of the flu and towards the end of Q4'18 several indices had flirted with bear market territory. Why did the US markets react so negatively to economic data that was generally quite positive: US Manufacturing Purchasing Managers’ Index, although declining, has stayed above 53 throughout 2018 (any level above 50 indicates economic expansion). The MNI Chicago Business Barometer slipped to 65.4 in December from an 11-month high of 66.4 in November 2018. National unemployment declined throughout the year closing at 3.7% in December, reaching levels last seen in the 1960s. Can a comment from the Fed Chairman on interest rate hikes do so much damage? What happened to the so-called smart money movers? Or are there any dark clouds on the horizon that the ordinary investing public is unable to see?
In my opinion, there is certainly cause for concern, but there was no fundamental need for the markets to react with such panic. US corporate debt accumulated during a decade of easy money is slowly unwinding [further reading: 1, 2, 3]. We can expect corporate buy backs (purchasing stock using cheap debt) to slow down as rates rise. Segments of the economy such as housing are beginning to show troubling signs. Yield inversion is also indicating caution related to an impending recession. Yield inversion occurs when long-term debt yields less than short-term debt of the same quality. In normal times, long-term debt will require higher yield as there is more risk associated with it — the longer the duration of debt, the more that can go wrong and so investors will ask for a greater return. With inverted yields, investors require higher returns for short-term debt, indicating concerns around the debt issuer’s ability to repay the debt.
Yield inversion has predicted recessions in the past, but on average the recession takes 14–18 months to materialize. Also, yield inversion must sustain for a few months before we can consider it a strong signal. As I mentioned earlier, there is certainly cause for concern, but even if they do play out, they will materialize slowly into a recession, but not tomorrow. There was no need to rush like herds as if there was no tomorrow!
What does all this mean for 2019? Below are my expectations for the year.
1. We will receive positive news on the US-China trade war in Q1. Although I don’t consider the ongoing trade war to be a big factor driving the current state of the markets, I expect that both presidents will, out of their own compulsions, try and find a solution to end the current impasse. It is likely there will be some positive announcements in Q1 2019, providing near term tail winds for the markets.
2. The Fed will hold rates steady in Q1. Inflation will likely remain low — especially given low Oil prices heading into 2019 — and therefore the Fed may re-consider additional rate hikes, especially in the first quarter of 2019. They have already proven that they don’t listen to the President, so there is no need to make the same point again. Holding rates steady for now is particularly important for investor sentiment, and given the risk of a negative outcome from the Brexit vote, holding rates steady in Q1 will be very positive for the markets.
3. Emerging markets will see gains in 2019. US growth will remain subdued compared to 2018, as is reflected in Dollar price movement. A weakened Dollar will be like Oxygen for emerging economies and we’re already seeing some improvement globally. Considering emerging economies have lost a lot of value in 2018, I’m long emerging economies and US multinational corporations with majority international exposure.
4. Gold will move up slowly as the US Dollar loses strength, but not as a safe asset. I expect Gold will face a lot of resistance at the 1350–1370 levels. In the latter half of 2019, Gold may become more attractive as a safe haven asset — see the next point.
5. Eventually, the easy money days have to come to an end. The Fed will likely take steps towards quantitative tightening starting in the second quarter and markets will have to adjust to this new reality. Short term interest rates will rise, further inverting the yield curve and foreshadowing a recession. The full effect of these changes will play out in the second half of 2019 and throughout 2020. For 2019, I expect the S&P will move within the high-low band established in 2018.
6. US corporate earnings will remain subdued, but not worryingly so. I expect both earnings and guidance to be neutral to positive, but not negative. S&P 500 will likely re-test its previous highs around 2800. As I mentioned in my note from December 17, I will consider opportunistically exiting positions and re-balancing to cash, with the view that a recession is likely.
7. With the expected improved sentiment in emerging markets along with the Dollar moving lower, I expect Crude Oil to make a comeback and a price level of 75 dollars is not beyond reach in the first half of 2019.
8. On Europe, we’ll have to wait for Brexit to play out and the dust to settle.
Disclaimer: Nothing in the above text constitutes advice or recommendations of any kind (financial, tax, legal or otherwise). An investment in any security is subject to a number of risks, and discussions of any security or basket of securities published above does not contain a list or description of relevant risk factors. Always conduct your own independent research and consider your risk apetite prior to making investments.
