Global equity markets have tumbled in recent weeks on the back of concerns over higher interest rates and continued macroeconomic headwinds (e.g., tariffs). As the year draws to a close and we head into 2019, we believe the markets will focus on three issues: implementation of US trade policy, the price of oil, and the trajectory of interest rates. We believe that although market volatility is likely to continue, a lot of bad news has been discounted. Some fundamentals are still supportive, and global earnings growth appears healthy despite some downward revisions. There is reason to be optimistic on selective equities and bonds looking forward into 2019.
In 2019, US policies, both towards China on trade and Iran on oil, will be the most important factor bearing on global markets. On September 24, a 10 percent tariff on US$200 billion of Chinese imports came into force, tripling the total US dollar value of goods imports impacted by tariffs (from all trade partners) imposed since the beginning of the year to roughly US$300 billion (or 1.5 percent of US GDP). President Trump has threatened to raise these tariffs to 25 percent on Jan. 1, 2019. While most investors now agree this will happen, it is doubtful that it is fully discounted in market prices, as markets are bad at pricing such binary events. If it doesn’t happen that would be certainly be a market positive development.
Should the US make good on its threat to impose tariffs on another US$267 billion in Chinese goods following Beijing’s retaliation after the US$200 billion round of tariffs, then according to the scenario analysis, that would pretty much be the “worst case” modeled by economists, expected to dent US and Chinese GDP growth materially from 2019 onwards.
Given the lags involved, the negative impact of tariffs is more likely to show itself the first half of 2019 than in the fourth quarter of 2018, while the full adverse effects may not be seen until 2020. Based on prior comments, it seems like the Fed will likely approach trade from a medium to long-term view that sees trade conflict as being more growth dampening than inflation promoting.
That would imply, on balance, lower (rather than higher) rates over time. There is a perceived risk of potential damage to both economies, and a potential likelihood of a sharp fall in the stock markets. With that in mind, we think the US and Chinese governments will still strive to find a way to prevent tariffs increasing again from current levels: it is simply too costly from both an economic and a political perspective for either government.
Oil is another US policy-driven macro worry for equity investors in the fourth quarter of 2018. We think markets have fully adjusted to the idea of Brent at US$80 per barrel (pbl), but not to US$90 pbl or US$100 pbl. The omens are not good. In September the International Energy Agency (IEA) reported a third consecutive month of upward revisions in its estimates of global oil demand. India’s top four oil buyers, meanwhile, have requested no Iranian crude shipments for November, which suggests they intend to comply with the United States’ strict sanctions. While Indian imports will not be reduced to zero, the reduction will likely be large. Iranian crude coming off the market may total 1.5 million barrels per day (bpd) by November compared to May levels. This would leave Iranian oil exports at approximately 900,000 bpd, a severe curtailment indeed.
OPEC’s joint market monitoring committee, in a September review, decided to just “wait and watch” rather than raise its output ceiling. The best hope for global growth now is that Saudi Arabia will pull oil from storage to limit/prevent the oil price exceeding US$100 pbl. Saudi does not want to see a sustained oil price surge to US$100 pbl or higher that over time would encourage increased global exploration & production (E&P) investment and ultimately much lower oil prices.
There is also growing pessimism over global economic prospects. Here we note that there has never been a world recession, unless the US economy enters a recession first, which for the reasons stated above we do not expect. Of course, the risks to global growth have clearly increased this year. 2020 may suffer from a number of other headwinds, e.g. first steps to tighter European Central Bank (ECB) and Bank of Japan (BoJ) monetary policy; some loss of China growth momentum as the 2018–19 stimulus fades; the longer term impact of import tariffs as global supply chains relocate; growing stress in credit channels reflecting a shortage of US dollar liquidity.
Overall, we feel one should not become too negative towards the global economy at this point – it may be better to ignore the bearish media. After all, GDP growth remains on track to match last year’s pace, the strongest since 2011. The IMF’s downward revisions take some of the shine off the global outlook, including for Emerging Markets (EM) and Asian economies. Slower growth will be reflected in further earnings downgrades for 2018 and 2019. Thus, we expect positive economic growth and corporate profits to continue in 2019 despite headwinds from trade wars and rising interest rates, as such, we maintain a moderate overweight for equities within multi-asset portfolios.
We expect a divergence in equity returns across geographies with regions such as Japan, EMs and Europe undervalued relative to the US. However, we expect only mid-single digit returns from US equities in 2019, and thus on a 12-month horizon prefer to overweight Japan, Asia and EM. Within fixed income, we expect US Treasury yields to continue rising as the Fed hikes rates through 2019.
This will weigh on all government bonds so we remain underweight. We still expect a low positive total return from 10-year US Treasuries in 2019, but are much less well disposed towards other Developed Market (DM) bond markets.
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