This time last year we were enjoying a positive background for markets with synchronized global growth and a surge in profit expectations. Today the mood is very different. Growth has slowed, markets ended 2018 on a sour note and fears of recession are widespread. The data have certainly been soft. Global industrial production, a key driver of the economic cycle, has stalled. Does this imply a looming recession? We think not. Global PMIs suggest a pick up and a series of distortions such as inventories being built ahead of Trump’s tariffs (later postponed) need to be considered. On balance, we expect a return to modest growth in the Spring.
A slowdown in growth
Key PMIs remain in expansionary territory, but with the exception of Japan, the trend has been downwards over the last 12 months.
Inflation is major reason for believing worries over recession are overdone. We are still in a benign inflationary environment. The specter of deflation has receded and for many countries inflation remains under 2%, which in turn limits the extent to which central banks need to hike rates.
Source: BMO Global Asset Management, Bloomberg as of December 20, 2018. PMI – Purchasing Managers Index. YTD – Year to Date.
Global inflation is not too hot, not too cold
It is important, however, to acknowledge that risks have risen. Slowing growth, tensions around trade, populism and Brexit are all providing headwinds and uncertainty, triggering the moves we have seen in risk asset prices of late. These themes look set to persist, but with investors in a heightened state of nervousness, any surprise on the upside can have a big positive impact.
Source: Minack Advisors as of December 2018. OECD – Organization for Economic Cooperation and Development.
The U.S. in focus
The outperformance of the U.S. economy and its stock market has been a standout theme in recent years. However, with profits high and the labor market tight, many are beginning to question whether this can continue. The cost of labor is integral to assessing the prospects from here as it is a key determinant of both profits and the Federal Reserve’s decision-making process. When assessing the evidence, wages are rising (unsurprising given low unemployment levels) but the level of appreciation remains relatively gentle. Of course, the data needs to be constantly monitored and the Fed’s favored measure, the Employment Cost Index, a quarterly series released later this month, should be examined closely.
Source: Minack Advisors, BMO Global Asset Management as of December 2018.
Perspectives on the yield curve
The yield curve, the difference between long and short-dated yields on government bonds is usually positive. With the U.S. yield curve flattening, the prospect of an inversion – which in turn has been a reliable indicator of recession – has increased. A focus on some of the detail here, however, means we are not unduly concerned. The role of banks and their willingness/ability to lend is an important consideration. In a typical recessionary environment, margin compression results in banks cutting back lending. Currently, however, margins have been increasing which with banks being well capitalized, provides a significant positive going forward.
The investment environment also provides reassurance. Rather than being in a typical cycle characterized by overinvestment, squeezed margins and subsequent retrenchment in hiring and investment activity, we stand at a juncture in which investment levels remain relatively low. This supports our view that the cycle still has some way to run.
Quick views on the UK, Europe and China
- Brexit uncertainty – whatever the details of the eventual Brexit deal, the prospects for the UK are set to be uncertain for many years to come. In terms of politics, the Conservative Party is deeply divided and attention will soon begin to focus on what a Labor government could mean. The ever-important housing market reflects this backdrop, with London notably weaker in terms of activity. More generally though, the UK economy’s emphasis on the service sector bodes well as many associated activities extend well beyond Europe.
- Europe to improve? – uncertainty is a theme on the Continent too, with social unrest in France, a coalition government in Italy and the need for ongoing reform all casting doubt on the long-term transition to a European super state. Europe’s stock markets have significantly underperformed since the global financial crisis, with corporate earnings lagging behind those in the U.S. The performance of the European economy disappointed in 2018 but we do feel that there is scope for improvement in 2019.
- China Crisis? – another big disappointment has been the performance of China’s economy. A combination of factors are at play. Huge borrowing levels provide a drag and mean that turning credit on to offset any slowdown isn’t as effective – we don’t, however, think a banking crisis is on the cards. Structural issues are also making themselves felt – economic ‘miracles’ typically slow when income levels reach around $7000 and there is an ongoing transition towards an economy with a more service-orientated composition. Expect the authorities in Beijing to step up their efforts to boost the economy.
Asset class takeaways
We entered 2018 with a cautious view on fixed income, wary on the prospects for bonds given valuations and the backdrop of rising interest rates and a reversal of quantitative easing. We maintain that stance, believing that whilst equity returns may be low in 2019, they look set to outperform bonds. Geographically, we are overweight the U.S., Japan and the emerging markets (ex-China), neutral on Europe and underweight China and the UK.
The S&P 500® Index is a capitalization-weighted index of 500 large-cap U.S. stocks.
The MSCI All Country Ex-U.S. Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the U.S.) and 24 Emerging Markets (EM) countries. With 2,136 constituents, the index covers approximately 85% of the global equity opportunity set outside the U.S.
The Employment Cost Index (ECI) measures the change in the cost of labor, free from the influence of employment shifts among occupations and industries.
Investments cannot be made in an index.