What Will Shape the Markets in 2019? A Game of 20 Questions, Part I
My wife and I were immersed in a game of 20 questions over the holidays on a flight to North Carolina (yes, after 23 years together, that’s the kind of conversation that constitutes something fresh and exciting). For the unfamiliar, the premise of 20 questions is simple: one player gets to ask a series of 20 yes or no questions to try to figure out what person/place/thing the other player has conjured up. Answering the questions is usually pretty easy, but in this case, especially with no internet access readily available, I was not certain how to answer “is the person dead or alive?” Instead I gave my best guess—that I was 70% confident he/she was alive. Sure enough, upon landing, Wikipedia was quick to confirm that Olivia de Havilland is still alive and kicking at 102—and that she had quite the frosty relationship with Joan Fontaine, the only siblings to win a lead acting Oscar.
In case you are wondering, the relevance of all this to financial markets is that, to the extent one can ask the right questions, the best available answer is often something other than a concrete "yes" or "no." Rather, one has to use ones best judgment based on an assessment of the probabilities. It is in that vein that my posts this month are modeled after 20 Questions, with my best sense of the relevant probabilities provided for the 20 issues I believe are likely to prove the most germane over the course of 2019.
1) Will the US economy enter recession in 2019? 30% probability.
Recessions almost always precede or accompany bear markets. In that sense, December’s market rout, the recent deceleration in global economic growth, the lingering uncertainty associated with US/China trade tensions and the unprecedented transition from quantitative easing to quantitative tightening have placed many on full recession watch. Despite those fears—and a litany of others, including those related to a highly unorthodox US presidency—our view is that 2019 will ultimately mark the longest period of sustained economic growth in US history. Most economic indicators related to employment trends, industrial sales, consumer spending, consumer confidence, consumer debt, and money supply remain far from levels associated with a looming recession. Still, we fully acknowledge that 30% is an uncomfortably high probability. The flattening of the yield curve and the recent downshift in auto sales are among the key indicators that bear watching. We also fear that a continued market sell-off could itself trigger a brief recession, much as what happened after the tech bubble burst in 2000. Finally, to the extent recent surveys indicate that nearly half of major US CFO’s expect a recession in 2019 (with over 80% expecting one by the end of 2020), we could see a self-fulfilling prophecy if corporate capital expenditure decelerates markedly.
2) Will the Federal Reserve raise interest rates the 2-3 times that it expects in 2019? 5% probability.
The key market mantra of the post financial crisis era has been “don’t fight the Fed”—or more specifically, don’t fight the greatest monetary stimulus in recorded history, both in the US and globally. Hawkish rhetoric from Federal Reserve Chairman Powell unnerved investors in October, sparking that month’s steep sell-off. After taking a more dovish tone toward the so-called neutral level of rates in November, the Fed Chairman clearly was not as dovish as the bulls wanted in mid-December when investors were seemingly startled by the Fed’s “dot plots” and the Chairman Powell’s apparent reluctance to reduce the rate of decline in the Fed’s balance sheet. As per question number one, we are by no means fatalistic on the US economy for 2019. However, we do expect growth to revert toward the 2%—or “goldilocks” level—that prevailed during most of the Obama years. Simply put, in order to retain the Fed’s cherished sense of independence following President Trump’s persistent criticism, we believe the Fed had to take a somewhat hawkish tone in December. We expect that tone—and the resulting actions—to become far more dovish over the balance of the year. The economy simply isn’t strong enough anymore to absorb several more rate hikes, along with the effective tightening created by $50 billion a month in Fed balance sheet reduction. We expect the Fed to come to that conclusion sooner rather than later.
3) Will inflation accelerate meaningfully past the Fed’s 2% target in 2019? 15% probability.
Another reason that we believe the Fed moves toward the sidelines in 2019 is that we continue to see little inflationary pressure in the economy. The inflationistas (a nod to David Zervos at Jefferies for the catchy name) continue to point toward higher wage pressure due to low unemployment and the impact of a prolonged trade war as their primary fears. We believe most secular forces are aligned in the other direction due to global competition, technology (including the so-called Amazon effect), and demographics (US labor force growth is anemic with new entrants essentially flat versus 10%+ growth during the inflationary surge of the late 1970’s). Moreover, we also believe that a prolonged tariff-driven trade war would tilt deflationary, not inflationary, due to demand destruction. In any event, the recent decline in most commodity prices should help quell any significant inflation fears, at least in the near-term.
4) Will the US and China enter a prolonged trade war? 30% probability.
There’s a Springsteen song for just about everything but the relatively obscure Two Faces from 1987’s Tunnel of Love comes to mind here. President Trump has harbored a consistent view for the better part of 40 years that the Chinese (in particular) have taken advantage of the US on the trade front. Alternatively, the President takes immense pride in his Art of the Deal negotiating methods. It is not quite the mutually assured destruction that helped to avoid a nuclear confrontation during the Cold War, but our view is that there is an element of mutually assured economic destruction in play here if both sides continue to up the tariff ante. Rationality is most likely to prevail at some point during the year. As discussed just below, the Chinese are no longer acting from a position of economic strength—and nothing likely matters more to President Xi and the Chinese leadership than economic and social stability. Similarly, as much as he wants to please his base, President Trump surely realizes that his re-election chances will plummet if the US economy and equity markets continue to suffer from trade-related uncertainty. The ultimate deal may not go very far toward a true leveling of the playing field, especially as it pertains to the critical issue of intellectual property. But some moderate concessions along the lines of the recent reformulated NAFTA agreement should kick the proverbial can far enough down the road for the two sides to reach an accord—although quite possibly not within the currently prescribed 1Q19 timetable.
5) Will the Chinese economy reach the government’s 6%-6.5% GDP goal? 35% probability.
Based on the official Chinese data, the probability is probably north of 70%. In actuality, we're thinking more like 35% (investors have long questioned the reliability of some of the key Chinese economic results). Be that as it may, we cannot help but recall the 2007 words of then-premier Wen Jiabao that "the biggest problem with the Chinese economy is that the growth is unstable, unbalanced, uncoordinated, and unsustainable." A dozen years later, the Chinese economy remains highly unstable, in our view. While the economy has become far less export dependent, it has essentially replaced a large current account surplus with excessive investment, a likely property bubble and debt to GDP that has skyrocketed from 170% of GDP in 2008 to about 300% today. The Chinese have relied upon aggressive fiscal stimulus efforts in the past to sustain growth and President Xi may well authorize additional stimulus in 2019 to help forestall a so-called hard landing. We suspect that the country will eventually face longer term challenges reminiscent of those faced by Japan nearly 30 years ago when it turned out that the "Japanese economic miracle" was not sustainable. It will be no easy task to better balance the debt-laden Chinese economy with stronger consumer demand, more efficient state-owned enterprises, less corruption, and less reliance on costly and often wasteful capital expenditure. However, in the near-term, our best guess is that China muddles through in 2019 with respectable real growth of 4%-5%. Such growth could help stabilize investor sentiment toward emerging markets and provide support for many recently thrashed commodities. Despite our lukewarm expectations for the Chinese economy in 2019, the combination of significant passive inflows and P/E valuations at multi-year lows of about 11x may provide solid upside over the course of the year if trade tensions with the US dissipate.