At Invesco Fixed Income, we often talk about the risks that are likely to upset global markets. In this blog, we highlight the five things we think could go right and support markets in 2019. First, the US Federal Reserve (Fed) has told markets it is willing to be “patient,” and there is the possibility this patience could last a while. Second, US-China trade tensions have calmed somewhat, as the two countries appear motivated to reach agreement on key issues. Third, China is stimulating its economy, which we believe will support growth. Fourth, Brexit is softening, with the tail risk of a hard or no-deal Brexit diminishing in recent weeks. Finally, we see no signs of an impending US recession, despite fears that disrupted markets at the end of 2018. Each of these five possibilities would likely be supportive of risk assets, in our view.
1. Fed on hold
Recent moves by the Fed have caused markets to contemplate a potential policy regime change, with a new framework that would allow target longer-term averages of inflation around 2%. For example, the Fed might allow core personal consumption expenditure (PCE) inflation to increase to around 2.5% to compensate for inflation that has remained below-target for a decade.
In some ways, the Fed has been building toward this type of policy for some time, and recent speeches by top Fed officials have emphasized such thinking. In trying to achieve a more symmetrical inflation target, the Fed would likely keep the federal funds rate stable for longer (or perhaps cut it if global growth slowed). This policy should promote stronger growth, higher inflation and easier financial conditions. If viewed as credible and durable, it would likely be very positive for risk assets, in our view. While long-dated real yields would likely remained contained, we would expect the nominal yield curve to steepen as inflation risks rose. The US dollar would likely depreciate versus emerging markets currencies, although the effect versus developed markets would probably vary, depending on relative economic performance.
If the Fed does not change regimes, and financial conditions improve and wage pressures build, it might revert to a forward-looking inflation framework. In this case, asset markets would likely resume the fluctuating risk-on/risk-off paradigm that has prevailed since 2014. Whether or not there is a durable policy shift underway, we believe a period of stability in interest rates would likely benefit markets over the medium-term.
2. Trade tensions on the mend
Trade friction has become a source of international tension, a risk to global growth, a source of potential currency volatility and a threat to financial conditions. Three major areas of friction represent truly global threats, in our view — relations between the US and China, the US and the European Union (EU) and the UK and the EU, via Brexit. We believe the downside risks are significant, but also see potential upsides in each of these areas.
First, the rhetorical “bark” of US President Donald Trump’s administration has often been more aggressive than its actual policies, given the risk of disrupting the US or global economies. The most important single trade deal so far — the revision of the North American Free Trade Agreement into the United States-Mexico-Canada Agreement — occurred with far more rumble than actual revisions warranted in the view of most trade experts. In our view, the changes were both symbolic and substantive: The Trump administration proved willing to avoid immediate and potentially severe disruption to key US states, and the symbolism was important politically — that is, the new name puts America first.
Second, Brexit is a major known unknown and would likely have asymmetric implications, but our view is that the worst case of a hard Brexit will be avoided (more on our view below). Even then, there would be hope for free trade, given the desire of many hardline Brexiteers to be free of EU rules to liberalize trade with the rest of the world.
The most important source of tension, in our view, are US-China trade negotiations and other elements of the bilateral relationship. Here we expect no quick or easy resolution, but nor do we expect the worst case. Foreign policy and national security concerns are clearly a major factor in US policy, but we believe shared interests argue against “decoupling,” as per the full-blown, Cold War geopolitical analogy. The timeline extensions to negotiations reveal that the Trump administration would like to avoid full-scale escalation, just as China’s continued negotiation suggests it is prepared to meet the US halfway. To us, the better historical analogy is not the 20th century Cold War, but rather the late 19th century, when the world was becoming economically and politically multipolar, thanks to the spread of industry. That was also a time of continued globalization, innovation and economic advancement, despite political tensions.
3. Chinese growth stabilizing
Chinese economic deceleration has caused concern about the potential indirect effects to global growth, but we are more optimistic than other market participants about China’s macroeconomic outlook and asset performance. We believe macro policy adjustments made since mid-2018 and improved market sentiment will enable Chinese growth to stabilize as soon as the second quarter.
In addition to policies already implemented (such as several rounds of required reserve ratio cuts), we expect China’s policy makers to announce further easing measures in the coming months. The People’s Bank of China (PBoC) has alluded to possible reforms that would effectively reduce private sector funding costs and measures to recapitalize banks and relax restrictions around their wealth management products, which could boost credit growth. Fiscal policy should also support growth, including tax cuts, fee reductions and infrastructure investment funded by local government special project bonds and a higher fiscal deficit.
Some economic data have already started to stabilize and improve. Corporate funding costs, especially onshore bond yields, have posted significant declines, and credit growth picked up strongly in January. Considering the time lag from policy implementation to economic response, we expect China’s series of easing measures to stabilize growth sometime in the second quarter or early in the third quarter of 2019.
4. Brexit getting softer
We think a “no deal” Brexit, defined as the UK leaving the EU on March 29 without an agreed transition period (and reverting to World Trade Organization trading terms) is unlikely. We think the UK government, a majority of members of parliament (MPs) and the EU appreciate the potential economic damage from such an outcome and will seek to avoid it. We also think the EU will be willing to extend the March 29 deadline under almost all circumstances.
In our view, the most likely Brexit scenarios are:
- UK Prime Minister Theresa May extracts minor concessions from the EU regarding the “Irish Backstop” (the allowance of an open land border on the island of Ireland, regardless of future UK-EU relations) and her tweaked deal passes the UK Parliament.
- Failing the first option, May is forced to pivot toward accepting a softer form of Brexit, probably including a permanent customs union, which could win the support of Labour MPs, offsetting the likely dissent from the Eurosceptic wing of her own Conservative Party.
The lack of certainty as we approach the March 29 deadline is likely to cause financial market volatility, but the passing of a tweaked version of May’s deal or a softer Brexit could result in the appreciation of sterling, underperformance of UK gilts and outperformance of UK credit, especially financials.
Another scenario not discussed above is another referendum, resulting in the UK remaining in the EU. Although this is probably more likely than “no deal,” the chances of another referendum are relatively slim, in our view. Beyond the practical issues, such as a lack of agreement on the format, there does not appear to be a parliamentary majority for a new public vote. Since all but a tiny fraction of Conservative MPs oppose a referendum, its chances would rely heavily on Labour Party support. Recent votes, however, suggest substantial Labour opposition to overturning Brexit and the prioritization of a soft Brexit before a referendum. We think a new referendum, which does not guarantee that the UK would remain in the EU, would only be likely if all other options have been exhausted, probably including another general election.
5. Recession not on the horizon
In late 2018, many prognosticators called for a recession by the end of 2019, roiling markets. Increased market volatility only exacerbated growth worries, but first-quarter economic data have not shown signs of recession. In addition, the Fed has begun to wind down its tightening cycle, helping to calm markets. These developments give us confidence that the US will avoid recession in 2019 and likely beyond.
Employment data have been especially strong. The moving average of monthly job growth, one of our favorite indicators of current growth, is near cycle highs at around 240,000 jobs.1 The Job Opening and Labor Turnover Survey has also rebounded to new highs, suggesting that labor demand is strong.2 While manufacturing surveys point to some softening in the economy compared to the very rapid pace of growth in mid-2018, they still indicate a strong level of current activity.
Increased market volatility experienced at the end of 2018 may likely have some slowing effect on growth this year. But the pause in the Fed’s interest rate hiking cycle and its shift to a more dovish stance should ease financial conditions and support interest rate-sensitive areas of the economy, like housing, potentially reducing the drag caused by previous market volatility.
All five areas we discussed have been the source of uncertainty and risk over the last year or so. We think a number of these areas could turn from headwind to tailwind for financial markets, and that would be broadly supportive of risky assets in the near future.
With contributions from James Ong, Senior Macro Strategist; Arnab Das, Global Market Strategist, EMEA; Yi Hu, Senior Analyst; and Michael Siviter, Senior Portfolio Manager
1 Source: Bureau of Labor Statistics, Nov. 1, 2018 to Jan. 31, 2019.
2 Source: Bureau of Labor Statistics, Feb. 12, 2019.
Blog header image: AshDesign/shutterstock.com
UK gilts are bonds issued by the British government.
A risk asset is any asset that carries a degree of risk, such as credit bonds and equities.
The core Personal Consumption Expenditure (PCE) Index measures the price level of an economy’s consumer goods and services, excluding food and energy categories.
Real yields are adjusted to remove the effects of inflation. Nominal yields include the effects of inflation. The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
The required reserve ratio is the portion of reservable liabilities that commercial banks must hold onto, rather than lend out or invest.