Some thoughts on the 2019 outlook

It is with some trepidation that we look ahead to 2019. There are indications that economic activity is slowing and markets are selling off as they adjust to changed circumstances, which is reason enough to be concerned. But the overriding concern is politics with Donald Trump applying his policy of unfiltered Tweeting rather than rational engagement, on issues ranging from China and North Korea to veiled threats about the position of Fed Chair Powell. Brexit continues to demonstrate why political decisions are too important to be left to politicians and the European elections in May will give voters another chance to demonstrate their support for populists who continue to undermine the rules-based system on which we depend.

Starting first with the economics, it is unlikely that we will see recessions in any of the world’s major economies this year (hard-Brexit considerations in the UK notwithstanding). Both the US and euro zone are projected to lose some momentum this year, with growth rates around 2.5% and 1.4% respectively roughly around 0.5 percentage points lower than in 2018. That is far from a bad outcome if realised, although some of the data around the turn of the year suggest that the slowdown may be a bit more abrupt than we thought a few weeks ago.

But the US cycle in particular looks long in the tooth: So long as the US does not fall into recession before July, it will surpass the 120 month upswing between March 1991 and March 2001 as the longest on record. But the strength of each successive upswing is weaker than the previous one and policy makers continue to fret about the weakness of productivity growth, which is the key driver of living standards, compared to previous cycles. Another puzzle for policymakers is the absence of inflation, and I doubt that inflationary concerns will justify monetary tightening in 2019. But I maintain my view that interest rates that were set in order to deal with economic conditions a decade ago are not appropriate for today’s environment. The Fed was right to raise rates since late-2015 which at least gives it some monetary ammunition to deploy in the event that the economy turns down – room for manoeuvre that neither the ECB nor BoE have.

Against this backdrop, why are markets so jittery? I have long maintained that a large part of the correction reflects a repricing after investors pushed asset valuations too far on the back of loose monetary policy and recovering growth prospects. In the course of the first nine months of last year, investors continued to force US equities higher despite the fact that the Fed was clearly engaged in monetary tightening, buoyed by the fact that cuts in corporate tax cuts were giving earnings a one-off boost. Reality finally began to take hold during the autumn but what surprised me was that many market commentators were surprised.

Regular readers may know that I track Robert Shiller’s 10-year trailing P/E for the S&P500 as a measure of the extent to which markets are out of line. Last month it dipped below 30 for the first time since summer 2017 (the post-1950 average is 19.4). On the basis of current data, the S&P500 would have to fall by another 10% just to return the P/E index to 25. This would put the S&P500 around 2270, representing a 23% decline from the September 2018 peak and only around 3% below the pre-Christmas flash crash low. Making stock market predictions tends to make fools of us all, but I would not be surprised to see US equities making a 10% downward correction during the course of this year. Whether we go lower depends very much on the outlook for 2020. I am not hopeful.

Politics remains the big concern for markets. Dealing with the easy one first, I do not believe that the UK will be allowed to crash out of the EU without a safety net in place so my prediction Is that there will be no no-deal Brexit (probability 80%). Note that the probability is not 100% – such has been the lack of economic rationality during the whole Brexit process that there are major tail risks and the events of December 2018 give little confidence that the UK knows precisely what it wants and, more worryingly, how to achieve it.

A more difficult question is what will happen in the US-China trade dispute. As a (usually) rational individual, I find it difficult to understand why the US would want to ratchet up the pressure. Admittedly, the trade dispute is hurting China but this week’s announcement by Apple that slowing Chinese revenues will hurt profits is an indication that the process is also beginning to impact on the US. My guess is that some of the tension will ease in 2019 once Trump is satisfied that China has taken some pain. But as one who has habitually underestimated Trump’s unwillingness to play by normal rules, I may be accused of being too sanguine. However, one prediction I will make is that impeachment proceedings will not be initiated against Trump as Democrats realise that the process will be politically counterproductive.

Europe will likely to continue grinding along in low gear. The economy has lost momentum and EMU members increasingly have to deal with domestic political issues. I would not like to offer odds on Angela Merkel remaining as German Chancellor, given that she has already announced her departure. But September will mark the halfway point of her final term in office and it might be deemed a good time to hand over the reins.

One change we know is happening for sure is that Mario Draghi will end his eight-year term as ECB President. The smart money suggests that he will be succeeded by former Bank of Finland governor, Erkki Liikanen. I have no strong opinions on the matter but I suspect whoever it is, it won’t be Bundesbank President Jens Weidmann whose stock with southern European nations is not high. Also this year, we can look forward to the announcement of who will succeed Mark Carney as BoE Governor, as he is scheduled to depart in January 2020. Whenever anyone asks me, I say the BoE need look no further than FCA Chief Executive Andrew Bailey. But given that Carney has already twice extended his tenure, who knows whether he might do so again?

We all know that there are no certainties in life. But I hope I am right about my Brexit call above all others. Because if I am wrong, my blog posts around early April might become less frequent as I am forced to forage for the food that we used to import.