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In 2019 investors should be prepared for an environment with more subdued returns from risky assets and persistently higher volatility. In this podcast Director of Investment Strategy Henk Potts discusses the key events shaping the global economy.
Sure. So it’s my job to guide clients through the turmoil of financial markets, talk about some of the risks and some of the opportunities as we see them. As we know there’s been huge amounts of volatility in markets recently that have certainly kept us very busy in that task.
Well, I think after years of positive returns and low volatility in the run-up to 2018, markets have become more challenging over the course of the past couple of quarters, with equities, fixed income and commodities all generating negative returns in many markets. And as you know, there’s no single explanation as to why we’re seeing such a broad-based setback, but a number of culprits have been put forward.
There’s the trade wars, of course, the impact they’re going to have on global growth. There’s concerns around high US interest rates. Perhaps more importantly, the potential for a policy mistake. As the saying goes, long periods of economic expansion never die a natural death, always murdered by the Federal Reserve. Alongside that, we’ve seen political and social instability in some of the key economies around Europe.
We know emerging markets have also been under pressure of course, that’s due to country-specific issues. The slowdown that we’ve seen taking place in China alongside the stronger US dollar. And, dare we say, and we’re going to mention it today I’m sure, Brexit continues to be very disruptive. And all of that, you could argue, has created this toxic mix of uncertainty, unnerving investors and encouraging them to take a more defensive stance.
But I suppose what we should remember is when you do get dramatic market movements it can create opportunities for investors, particularly if there’s a mispricing of risk. Markets, as we know, tend to overreact. There’s a potential for a relief rally once the emotional dust has settled. Investors are able to once again focus on the fundamentals and that’s probably what we’ve been seeing over the course of the past few weeks.
But I think it’s absolutely vital that we prepare clients for a bumpier road ahead. We don’t see a recession, but we do see moderating global growth in the future, deceleration in earnings growth as well during the course of 2019 and therefore, I think investors should be prepared for an environment with more subdued returns from risky assets and persistently higher volatility.
We still expect, for example, high, maybe single-digit returns coming through from equity markets, which is probably higher than you’d expect from other asset classes, but with significantly more risk. So the world around us has been changing, investors need to adapt to that change.
Well, a no-deal Brexit would have dramatic implications, of course, for the UK economy and for financial markets. We’ve done some research that suggests that sterling would come under pressure, maybe fall by somewhere between 5 and 10%. I think you could also expect inflation to surge up quite dramatically. If you look at UK CPI today it’s very low, just above 2%. Potentially we’d see it above 3.5% as you see the imposition of tariffs, the effect of course on a weaker currency.
Think about unemployment as well. UK unemployment’s very low today, just above 4%. We can maybe see it going above 6% over the course of the next couple of years. So I think we could see lower business investment, lower household investments coming through, reduced domestic consumption, and that would certainly weigh on growth. So we could see growth maybe coming in at six-tenths of 1% during the course of this year, then slowing once again as you look out to 2020, with growth of maybe just one-tenth of 1%. So a significant fall.
And all of that, of course, sounds very dramatic. What we should remember is that it’s nowhere near as bad as some of the predictions we saw out of the Bank of England under their disruptive, under their disorderly Brexit. They were talking about significant contractions in GDP between 2019 and 2023.
So how do you expect the Brexit negotiations to play out?
Well, that’s of course the big question for markets. What we do know is, of course, Theresa May has won that vote of no confidence which means she goes back to the day job of trying to sort out Brexit. I think she’s focusing on two strands. Number one, trying to get new concessions from the European Union. Number two, trying to develop this cross-party consensus about how to take the Brexit process forward from here.
The concern is, of course, that she’s not likely to make a great deal of progress because the European Union’s already suggested that they wouldn’t be prepared to open the withdrawal agreement, and developing this cross-party consensus is always going to be difficult. You’ve got these varying political agendas taking place across Westminster at the moment, the Labour leadership potentially pushing for a general election so that’s going to be hard to come through in terms of consensus.
I suppose the positive is the market’s decided to take this very much within its stride, believing of course the risk of a no-deal Brexit would be the most damaging to the UK economy, the most disruptive in terms of financial markets still looks unlikely to happen.
Inextricably it feels like we’re moving towards a material loosening of that marked headline date through an extension of Article 50, which of course would need unanimous agreement from the remaining EU 27. That, of course, would give more time in order for a deal to be negotiated, but we should also appreciate of course it brings in some other options as well, the potential for a general election, a renegotiation, or indeed of course a second referendum.
So it’s still all to play for despite the fact that headline date is looming very large.
Well, there was a significant pick-up in economic activity in the United Sates during the course of last year. So we saw growth move from just 2.2% during the course of 2017, getting up to 2.9% during the course of last year and actually comes into this year, I think, with some pretty good momentum. You’ve got robust household consumption, you’ve got strong business investment, you’ve got the impact of that fiscal stimulus, the sugar rush put in place under the Trump administration.
Perhaps we should step back and think about the US consumer, not only the driving force of course behind the US economy, some would say behind the global economy, the US consumer’s in great shape today, benefiting from very low levels of unemployment.
The US economy created 2.6 million jobs during the course of last year. US unemployment’s down at 3.9% today. Compare that to October 2009 when it was close to 10%. Alongside that, we know that wages are growing at a faster rate than inflation, the tax cuts have been boosting disposable income. Business investment still remains very strong. You’ve got this friendly White House towards corporates that have been reacting to that.
And alongside that, you’ve got the stimulus package, the cutting of taxes, the ramping up of government spending as outlined under the second budget from the Trump administration, so putting more government money into security, into defence and into defending the border. And these are efforts that will continue I think at least in the short term to boost the economy.
So we remain pretty positive about the growth prospects of the US economy, particularly during the course of this year. I think we can see similar growth, maybe 2.9% during 2019, but we should recognise that if growth does continue through mid-2019 it would become the longest period of expansion on record. The fiscal stimulus will gradually fade, higher interest rates of course you’d expect to eventually start to weigh on the growth of the US economy. So as you look out to 2020, you start to see conditions normalising a little bit, growth going back to round about 2%.
Well, remember the Fed began hiking interest rates back in December 2015 from near zero. They’ve now hiked rates nine times, taking rates up to 2.25, 2.5% showing they were determined to normalise policy. I think they remain under some pressure to continue to do so.
You’ve got a strong growth profile that we’ve been talking about when it comes to the US economy, those tight labour markets of course pushing up wages, but also the objective from the Federal Reserve, but you see it from other central banks about the need to have some ammunition for the next time there’s an economic downturn.
But I think also alongside that, you should remember inflation expectations still look reasonably benign at least in the short term. Financial conditions have tightened. We’ve seen a fall in equity markets, a flattening of the Treasury yield curve and, of course, widening corporate spreads and risks to the global economy have increased quite significantly.
And I think the Fed have moved from this ideological stance to a more pragmatic approach. They’re watching the incoming data, they express they are prepared to be patient and that’s encouraged us, I think, to rein in our expectations when it comes to the Fed hiking cycle, although we still believe that we’ll see two further hikes during the course of this year and one in 2020.
Remember this is a political impasse between President Trump and the congressional democrats about the funding of his wall, the $5.6 billion that’s required to do that and that’s resulted in nearly 800,000 federal workers not getting their pay cheques, large parts of the Federal government shutting down. So you’d expect that to have an effect, and we have heard from some economies making minor changes, minor adjustments to their growth forecast in the first quarter but it doesn’t look like it’s going to be material at this stage.
Now if you listen to the White House, they’ll tell you there’s real risks around this. They’re saying that growth could fall by half of 1% in the first three months of the year, which is a really dramatic number, but most independent economists wouldn’t suggest that is going to be the case.
In order for that to be the case, I think you’d need to see sentiment filtering through to business and consumer confidence. So far there’s very little signs of that happening. So it’s grabbing the headlines but not necessarily having a dramatic effect on the economy just yet.
Well, you’re absolutely right. The most significant economic disappointment during the course of 2018 certainly was Europe. If you go back to 2017, economists believed the continent had indeed achieved this escape velocity, helped by the global rebound that we saw in manufacturing and trade, which as we know disproportionately benefits Europe’s very open export-orientated economies. Most economists believe that the growth that we saw in 2017, 2.5%, remember that’s the strongest that we saw in a decade, would have continued that momentum into 2018. So why was it such a disappointment?
Well, there’s a range of factors I suppose. There was weaker external demand. We saw the impact of the strikes and the protests in some of the key economies, particularly of course the likes of France which was impacting the supply chains and activity.
What a tough time it’s been for the German manufacturing sector, particularly of course the automakers, they had to deal with tariffs, they had to deal with a tougher emissions standard, a slowdown in Chinese demand as well for their cars, and that certainly infringed upon their growth profile. If you look at Germany, it just managed growth of 1.5% during the course of last year.
It’s the weakest that we’ve seen in five years. Think about that budget battle that was taking place in Italy. That had a significant impact in terms of business confidence, resulting in reduced investment, less hiring, household consumption was weaker than you probably would have expected as well. And all of that of course had a significant effect in terms of growth.
The good news in terms of the outlook is the fundamentals internally still look pretty supportive. You’ve got loose financial conditions, you’ve got high levels of consumer confidence, unemployment’s at its lowest level since November 2008. So we think, actually, conditions in Europe will stabilise during the course of this year and maybe we can expect growth of somewhere close to 1.5% in 2019.
Well, we’ve been talking about the Federal Reserve and their rapid approach to try and normalise policy. It’s been a little bit slower, much slower in fact from the European Central Bank. Remember, they embarked upon this huge quantitative easing programme back in January 2015. Since then they’ve injected something like 2.6 trillion into the system.
The better data that we’ve seen in the past couple of years, the pick-up in inflation, has encouraged them to move away from that emergency policy stance. So they have begun the process. They ended their bond-buying programme at the end of last year, although still remain committed to reinvestment.
So I think it’s going to take some time for them to improve the forward guidance which would then set the stage finally for them hiking the deposit rate. So I don’t think we’ll see a hike in the deposit rate probably until September 2019 this year, when we expect a 15 basis point increase.
The real debate of course is when does the European Central Bank think about hiking interest rates. They’ve already told the market they’re committed to keep interest rates down at zero for a prolonged period of time, at least until the summer of this year. We believe it will probably take a little bit longer than that, and don’t think about the first hike from the European Central bank probably until the first quarter of 2020.
I don’t think we should be too shocked by the slowdown that’s been taking place in China, as China’s a much bigger, much more mature economy than it was just a few years ago, of course, when it was growing at that 10% plus growth rate.
We know the numbers are in for 2018 that showed a significant slowdown. Once again, three consecutive quarters of slowing down during the course of the year. Full year growth for 2018 was down to 6.6%. That’s from 6.8 in 2017. In fact, it’s the slowest growth rate that we’ve seen in 28 years.
Money and credit expansion slowed more than expected. Industrial production, fixed asset investment, these were the powerhouses of course of the Chinese economy, still growing but below 6% which is a significant milestone. The future of the economy, things like retail sales, have also been decelerating. We’ve been talking about the auto sector, that contracted last year by 6%. It’s the first time we’ve seen that in two decades. Manufacturing PMI slowed to its lowest level in 26 months.
I think in terms of the outlook, there’s a couple of things really to focus on here. Number one, of course, the trade wars. US protectionism continues to exert downward pressure. The US, remember, imposed tariffs on 250 billion dollars’ worth of Chinese exports to the United States.
China exports somewhere about 600 billion dollars’ worth. They’ve threatened to put tariffs on the remaining amount. If you were to take maybe a 20% tariff and apply it to those exports and take into account changes in terms of trade flow and domestic production, it’s certainly possible you could see Chinese growth because of those measures slow by maybe another four tenths of 1%.
Alongside that, there’s this debt deleveraging programme that’s been taking place in China. China’s capital markets are relatively underdeveloped, therefore companies are reliant on indirect financing. That’s led to a huge increase in terms of credit growth, pushed leverage up to historically high levels, led to concerns about the shadow banking system.
Authorities have been aware of that and have been trying to rein it in. So they’ve been reducing the amount of debt given to state-owned enterprises, been measures to reduce the risk of bubbles developing in the property sector. There’s also been financial market reform as well, restrictions on credit growth, increased bank supervision.
So for me there’s a real balancing act taking place amongst Chinese authorities, mitigating the risks coming through from trade wars, deleveraging the economy but still trying to maintain that strong growth profile. But they have proved themselves both ready, willing and of course able, I think, to stimulate growth as and when required. We’ve seen reduction in things like the reserve requirement ratios, we’ve seen tax cuts in certain areas and, of course, infrastructure investment.
But I think there’s always this debate when it comes to China whether we’re talking about hard landing or soft landing. For me it’s a glide down to slower but more reliable growth over the course of the next few years. We think Chinese growth will come in around 6.2% during the course of this year, probably slowing to around 6% as you look out to 2020.
It’s been a pleasure, thank you.
All opinions and estimates are given as of the date hereof and are subject to change.
Barclays Private Bank provides discretionary and advisory investment services, investments to help plan your wealth and for professionals, access to market.