Flash­ing new warn­ing signs: Is global re­ces­sion loom­ing?

The Star Malaysia - StarBiz - - Viewpoint - What are we to do? LIN SEE-YAN [email protected]­tar.com.my

HOL­I­DAYS are a good time to think about what’s go­ing to hap­pen in 2019.

In­vestors went through the tough­est De­cem­ber in his­tory.

So, they en­tered the new year feel­ing rather more un­set­tled about the 2019 out­look. Look­ing back, world stock mar­kets were hard hit by a global econ­omy that has be­gun to slow down, had got­ten less sup­port from cen­tral banks, and be­gun to face se­ri­ous trade con­cerns. Since its re­cent high in late Sep­tem­ber 2018, MSCI World In­dex had de­clined by some 15% in highly-volatile trad­ing, in­clud­ing De­cem­ber’s last week of wild swings.

Con­trast this against 2017 when vir­tu­ally all as­set classes clocked in gains, fol­low­ing un­usu­ally low volatil­ity. In­deed, the key fac­tors which in­vestors have to bal­ance – ex­pected re­turns, price volatil­ity (or vari­ance) and un­der­ly­ing cor­re­la­tions (i.e. co­vari­ance) all moved in tan­dem to de­liver a re­ally “dream” year.

How­ever, 2019 presents a rather dif­fer­ent pic­ture in an en­vi­ron­ment where mon­e­tary au­thor­i­ties are ex­pected to re­verse quan­ti­ta­tive eas­ing (QE) and the Fed rais­ing in­ter­est rates, in ad­di­tion to valid con­cerns over growth in Europe and China. What’s wor­ri­some is that in­vestors’ frame of mind has since con­verged down­wards, where oc­ca­sional ral­lies bring out sell­ers in­stead of look­ing to buy on dips in the face of the with­drawal of easy money.

While hop­ing for the re­turn of calmer times (not re­flected in the wob­bly first week of 2019), the likely out­come in the year ahead will be framed within a tri­fecta of grow­ing un­cer­tain eco­nomic prospects, con­tin­u­ing un­set­tled mar­kets, and added in­sta­bil­ity aris­ing from cen­tral banks be­ing less able to counter geopo­lit­i­cal de­vel­op­ments.

Key take­aways

Given that in­vestors and mar­kets have been shielded for so long by cen­tral banks’ mon­e­tary largesse, it is pru­dent for in­vestors to pro­tect them­selves by: (i) un­wind­ing some of the ex­cesses that had de­vel­oped in the past year (in­clud­ing in­vest­ment prod­ucts that over prom­ise), and be more aware of con­tin­u­ing bouts of un­set­tling volatil­ity that at times, can be quite un­re­lated to eco­nomic fun­da­men­tals; (ii) build­ing ad­e­quate de­fences into port­fo­lios in the face of en­hanced dif­fi­cul­ties in find­ing good hedg­ing in­vest­ments in in­creas­ingly dis­torted mar­kets.

Bear in mind, bonds are less than stel­lar right now. The shift in Fed pol­icy from QE to QT (quan­ti­ta­tive tight­en­ing) will tend to drive down bond prices, while the im­pact of a global trade war will hurt growth and lift in­fla­tion; and (iii) re­assess­ing the long­stand­ing mantra of hold­ing more cash at this time – in or­der to be able to gain pro­tec­tion and earn a de­cent in­come; also, of­fers the op­por­tu­nity to take ad­van­tage of in­dis­crim­i­nate sell-offs and volatile trad­ing mar­kets that in­evitably will oc­cur.

Four co­nun­drums

After a rot­ten Oc­to­ber and a limp Novem­ber, US S&P 500 fell 15% in value be­tween Nov 30 and Dec 24. De­spite an as­ton­ish­ing 5% rise after Christ­mas, the in­dex fin­ished the year 6% be­low where it started. As I see it, the un­set­tling and volatile mar­kets have set up some key co­nun­drums to be reck­oned with in the course of 2019.

Bond mar­ket pes­simism: At last year’s close, the US$14 tril­lion US gov­ern­ment bond mar­ket (whose 10-year bond bench­mark is the most widely watched) ral­lied, bring­ing down yields (as prices rise) as in­vestors an­tic­i­pate US growth to slacken from its stim­u­lus-in­duced high. Ten-year yields fell to a low of 2.63% over the past month.

Still, an­a­lysts ex­pect the yield to av­er­age at 3.44% by end 2019, ac­cord­ing to a re­cent Bloomberg sur­vey. For most, the press­ing ques­tion re­mains whether the flat­ten­ing US yield curve will re­ally in­vert – a his­tor­i­cally re­li­able har­bin­ger of re­ces­sion to come, when­ever short bond yields rise above longer-dated bonds. The spread on 3-month and 10-year Trea­suries has fallen to a mere 0.15%age point, down from 0.86 per­cent­age point at end-Sep­tem­ber.

This is near lev­els seen in De­cem­ber 1994 and June 1998 – but then, the spreads didn’t turn neg­a­tive. The late Jan­uary 2019 Fed meet­ing should pro­vide fur­ther guid­ance.

QE ends in Europe: Prospects for Europe will be shaped by Euro­pean Cen­tral Bank’s (ECB) de­ci­sion to end its mul­ti­tril­lion euro bond buy­ing pro­gramme that it be­gan in 2015. ECB’s pur­chases cer­tainly de­pressed yields and its ab­sence will cer­tainly ex­ert some up­ward pres­sure, even though its port­fo­lio will be main­tained at €2.6 tril­lion. Out­come in the mar­ket will de­pend on re­sump­tion of euro­zone growth, res­o­lu­tion of global trade ten­sions, a messy Brexit or in­tran­si­gence of Italy’s pop­ulist gov­ern­ment, as well as the di­rec­tion of Ger­man bond yields.

These fac­tors tend to feed on each other, lead­ing to a po­ten­tially dif­fer­ent than ex­pected dy­nam­ics – one likely to be chal­lenged by forth­com­ing ma­jor Euro­pean elec­tions fea­tur­ing pop­ulist ex­pan­sion­ary fis­cal poli­cies.

Quo vadis US stocks: Has US stocks peaked? Strate­gists see two op­tions: (i) there will be a “last hur­rah” fol­lowed by con­tin­u­ing sell-off as re­ces­sion hits; or (ii) peak has passed & prices will drift down­wards as was past ex­pe­ri­ence a year be­fore re­ces­sion sets in. Macro-risks abound and are well known. Mis-steps by the Trump ad­min­is­tra­tion have added to the sense of un­ease. In the end, what re­ally mat­ters is cor­po­rate earn­ings growth – ex­pected by an­a­lysts to rise 8.2% in 2019, against up 20.5% in 2018.

The S&P 500 is to­day trad­ing at 14.15 times earn­ings over the next 12 months, im­ply­ing stocks are as cheap as in 2013, the last time this in­dex traded at that level, ac­cord­ing to Fac­tSet. Fur­ther­more, JP Mor­gan has al­ready priced in a 60% chance of re­ces­sion within a year in its S&P 500 fore­cast.

So, the in­dex will con­tinue to test in­vestors’ nerves. One thing is sure: the com­ing year is likely to be bumpier than in­vestors have be­come ac­cus­tomed to.

Yuan to slide?

China’s yuan re­mains a wild card in the face of the Chi­nese stock mar­ket be­ing the worst per­form­ing ma­jor mar­ket in 2018. Res­o­lu­tion of the trade dis­pute be­tween the United States and China and per­for­mance of the Chi­nese econ­omy will be cen­tral to the yuan’s fate. Con­sen­sus among banks and forex strate­gists is that US dol­lar will fal­ter in 2019 (it ap­pre­ci­ated 4.3% in 2018) in favour of the euro.

This is so as US growth weak­ens, prompt­ing the Fed to stop rais­ing rates – at a time when pol­icy nor­mal­i­sa­tion gets un­der way in Europe and Ja­pan. In this re­gard, I also ex­pect the yuan to con­tinue to re­main weak.

Dis­con­nect for Fed

The fu­ture be­longs to the United States as the Fed be­gins to en­gi­neer a soft land­ing. The Fed knows soft land­ings are rare and often, not pain­less! The chal­lenge: to man­age mod­er­at­ing growth while keep­ing in­fla­tion as low as pos­si­ble, but avoids a re­ces­sion.

To be fair, the econ­omy has sel­dom looked stronger. But stock prices and bond yields ap­pear to sig­nal the on­set of re­ces­sion as growth in over­seas economies, es­pe­cially Europe and China, has slack­ened. This dis­con­nect presents the Fed with a dilemma as in­vestors get skit­tish.

The choice for the Fed: keep nudg­ing in­ter­est rates higher to con­tain in­fla­tion and pro­tect the do­mes­tic econ­omy; or be sen­si­tive to stresses abroad and in the mar­kets by hold­ing rates steady – even nudg­ing them lower. This is not new for the Fed: it averted re­ces­sion while rais­ing rates in 1994 and 2015; but stum­bling into down­turns in 2001 and again in 2008.

At an­other point of uncer­tainty in 1998, the Fed cut rates and sus­tained global growth. To­day’s sit­u­a­tion is com­pli­cated by forces out­side the Fed’s con­trol: trade dis­pute be­tween the two gi­ants, and gov­ern­ment shut-down. As of now, the Fed chose flex­i­bil­ity – lis­ten­ing pa­tiently to the mar­kets and stay­ing cool!

I am re­minded of the ref­er­ence to 1998 as be­ing anal­o­gous to to­day, when fi­nan­cial cri­sis in Asia and Rus­sia and the near fail­ure of a gi­ant hedge fund prompted the Fed to cut rates. The fol­low­ing year, US econ­omy took off and the Nas­daq bub­ble burst. As in 1998, in­vestors were stunned by the US ex­po­sure to events abroad. So be­ware!

Try­ing to pre­dict mar­kets is per­ilous at best. At this stage of an age­ing busi­ness cy­cle, in­vestors have good rea­son for con­cern.

Two de­vel­op­ments heighten this un­ease: (i) earn­ings mul­ti­ple for the S&P 500 has fallen 16% from its peak in late 2017; and (ii) US Trea­sury yield curve has started the process to in­vert – 12-month yield is to­day higher than those of all Trea­sury ma­tu­ri­ties of up to seven years. Has the Fed tight­ened too much as a re­ces­sion loi­ters be­yond the hori­zon?

Still, the con­sen­sus is that re­ces­sion risk re­mains low, with the risk be­ing higher in 2020 than in 2019. We’ll just have to wait and see.

As the stock bull mar­ket ap­proaches its 10th year, the re­cent roller-coaster ride in the mar­ket has prompted an­a­lysts to re­think their 2019 fore­casts. With volatil­ity show­ing no signs of abat­ing, the com­mon view is to lower fore­casts on S&P 500, most by 5%-10% for end-2019.

No doubt, the mar­ket is des­per­ately seek­ing clar­ity. In­deed, fi­nan­cial mar­kets have since been be­hav­ing as if the next re­ces­sion is around the cor­ner. No­bel lau­re­ate Sa­muel­son once quipped that the stock mar­ket has pre­dicted nine of the last five re­ces­sions – so let’s not over-re­act.

In the end, I ex­pect calm heads to pre­vail since the un­der­ly­ing fun­da­men­tals aren’t dis­in­te­grat­ing as much as in­vestors are pric­ing them. Cur­rent data con­tin­ues to point to some bright spots across the US econ­omy.

Of course, no one knows for cer­tain when the next down­turn will come. If a re­ces­sion does come, the chances of it be­ing mild sit at 88%. To­day, writhing mar­kets are an ex­ag­ger­a­tion. Nev­er­the­less, I know of rep­utable an­a­lysts stand­ing by their calls.

What then are we to do?

Be that as it may, at the re­cent an­nual meet­ing of the Amer­i­can Eco­nomic As­so­ci­a­tion in At­lanta, a se­nior IMF of­fi­cial warned that “The next re­ces­sion is some­where over the hori­zon and na­tions are less pre­pared to deal with that than they should be,” in the face of a growth out­look that is be­ing un­der­mined by trade ten­sions, pol­icy flaws and weak­ness in Europe, Asia, Africa and Latin Amer­ica.

This is timely ad­vice. As I see it, it is al­most in­con­ceiv­able that the global econ­omy will re­main healthy in the face of se­ri­ous eco­nomic prob­lems in both China and the United States, even leav­ing aside their con­flicts over trade and tech­nol­ogy. Europe lacks eco­nomic en­ergy and the un­cer­tain­ties as­so­ci­ated with Brexit, French protests, Ger­man po­lit­i­cal tran­si­tion and Ital­ian pop­ulism mean the con­ti­nent is more likely to be a source of prob­lems than a so­lu­tion.

What’s re­ally wor­ri­some is that gov­ern­ments will find it in­creas­ingly dif­fi­cult to ef­fec­tively use fis­cal or mon­e­tary mea­sures to off­set the im­pact of the next re­ces­sion.

Fur­ther, I agree that the sys­tem of cross-bor­der mon­e­tary sup­port mech­a­nisms – in­clud­ing cen­tral bank swap fa­cil­i­ties, has been sys­tem­at­i­cally un­der­mined ren­der­ing it rather in­ef­fec­tive. What’s re­ally needed is for gov­ern­ments to pay par­tic­u­lar at­ten­tion to keep­ing their econ­omy well-oiled and on a level tra­jec­tory, rid­ding it of cor­rup­tion and build­ing buf­fers, while not fight­ing with each other (as in ris­ing pro­tec­tion­ism, trade wars) and do­ing things that might ac­cel­er­ate growth, forc­ing it to take a down­turn.

They need to de­velop bet­ter poli­cies to help their pop­u­la­tions adapt to cope with in­ten­si­fy­ing global com­pe­ti­tion in­stead. I should add that global trade com­pe­ti­tion is hav­ing a very un­even im­pact on the US work­force in par­tic­u­lar, stok­ing in­equal­ity. The crit­i­cal chal­lenge for mon­e­tary and fis­cal pol­icy will be to main­tain suf­fi­cient de­mand amid im­mense geopo­lit­i­cal uncer­tainty, in­creas­ing pro­tec­tion­ism, high ac­cu­mu­lated debt lev­els and struc­tural and de­mo­graphic fac­tors lead­ing to in­creased pri­vate sav­ing and re­duced pri­vate in­vest­ment.

As I see it, it is the irony of our time that pru­dence re­quires the re­jec­tion of aus­ter­ity.

For­mer banker, Har­vard ed­u­cated econ­o­mist and Bri­tish Char­tered Sci­en­tist, Tan Sri Lin See-Yan is the au­thor of The Global Econ­omy in Tur­bu­lent Times (Wi­ley, 2015) and Tur­bu­lence in Try­ing Times (Pear­son, 2017). Feed­back is most wel­come.

Shap­ing euro­zone: The euro sculp­ture in front of the head­quar­ters of the Euro­pean Cen­tral Bank (ECB) in Frank­furt. Prospects for Europe will be shaped by the ECB’s de­ci­sion to end its mul­ti­tril­lion euro bond buy­ing pro­gramme that it be­gan in 2015. — Reuters

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