2018 was a tough year for markets, with the US going it alone to a large extent. A number of other markets, both developed and emerging, entered bear territory during the year while the US initially continued to trend higher. But even the US had a difficult end to the year, with the MSCI US Index in USD ultimately falling 10.1% over the course of 2018.
This has left the US in a somewhat painful catch-up mode. What has changed, in our view, is the surprise that things are not surprising anymore; by the end of last year the Citi Economic Surprise Index for the US was actually in negative territory. If one looks at the Shiller cyclically adjusted P/E ratio (CAPE) of average earnings over 10 years, a level over 25 has only been surpassed four times historically: 1929, 1999, 2007 and right now. Major market drops followed those other peaks. If US CAPE were trading at or near its long-term average, it suggests the S&P 500 should be some 1000 to 1500 points lower.
A message we have been conveying is “mind the gap”. House prices in the US are growing at 6.5% year-on-year versus income growth of 4.6%. We believe an extended gap is not sustainable and house prices will have to fall. Falling house prices tend to have the effect of slowing consumer spending. With the Federal Reserve (Fed) tightening and mortgage rates rising this house price rollover can be expected to continue, in our view. Unless the two converge quickly, we believe 2020 could be a recession year.
Bond markets are also telling us something. When long-dated bond yields are lower than short-dated yields it is time to be a little worried, in our view. Overly restrictive monetary policy can destabilise growth; the risks of a recession may not be immediate, but the direction of bond markets points to a slowdown and includes the potential for an inversion of the yield curve.
There are a number of recession indicators to watch for the US economy, as highlighted in chart 1 below. Based on how these indicators behaved in previous downturns, to our mind it does not look like we are currently in or close to recession territory.
Chart 1 – US economy recession indicators to watch
Ultimately for a recession to occur in the US we believe there would need to be a sharp contraction in either residential investment (housing) or business investment. Neither are currently occurring. Recessions are, in our view, generally caused by a) high real interest rates b) fiscal tightening c) rising energy prices d) severe inflation e) trade wars or f) property collapses. While some of these occurred to a degree in 2018, such as rising real rates in the US, an oil price rise in H1 and trade wars between the US and China, many of these events appear more likely to reverse from here. First quarter economic data will therefore be crucial to maintain a risk on mode in financial markets – any sharp slowdown in consumer confidence and jump in unemployment claims are some of the ones to focus on, in our view.
In addition the US has a close to record USD 1 trillion budget deficit – 18% higher than in 2018. Military spending and mandatory spending (such as social security and medicare) are vastly outpacing revenues, even more so with the Trump tax cuts. Over the next decade the deficit is expected to grow to USD 2 trillion.
So where are we now? The world’s big three economies – US, China and Europe – are slowing. While two central banks in the Fed and the People’s Bank of China (PBoC) have tentatively responded to these worsening indicators, the European Central Bank (ECB) is running out of options having forward telegraphed itself into a corner. Any growth impulse will therefore have to come from somewhere else; we see the three most likely candidates as a favourable Brexit outcome, a de-escalation of US-China trade tensions or a re-acceleration in Chinese growth.
We think there are a number of possible outcomes as we look ahead into 2019.
1) The Fed continues to drain liquidity from the system, China refuses to jump start the world economy and the ECB ends quantitative easing. The overpriced assets of early 2018, such as technology stocks, continue to come under pressure as growth momentum slows, but this could be when value starts to meaningfully outperform.
2) Global growth continues to falter. The Fed intercedes and becomes more dovish, putting rate rises on hold, which results in dollar falls. Asia, meanwhile, achieves the holy trifecta of an easier Fed, falling oil and a weaker dollar; as a result emerging markets and Asia could start to meaningfully outperform the US market.
3) The Fed does a complete U-turn and re-injects liquidity into the system. This seems unlikely until we see some systemic blow-up such as a banking system collapse, a real Chinese hard landing or a US corporate bond market collapse.
4) China rides to the rescue as it did in 2016. This appears most unlikely as its focus is on domestic protection rather than saving the rest of the world. The massive stimulus required would cause more currency weakness and exacerbate any export slowdown.
On balance we do not envisage a recession, either US or global, in 2019 but more of a continued slowdown from the peak global growth we witnessed in 2017. Market price adjustments in the very short term, in our opinion, have gone too far and been too quick. Central bank action is likely to become more supportive in the medium term, which should help lift sentiment. Resolutions to the current trade wars would also likely provide an immediate relief rally.