With the bull market scaling new heights and global growth re-accelerating, I explained last month why this situation is likely to continue (see Why The Bulls Are Back In Charge). But I noted at the end of that paper that, as investor sentiment becomes increasingly bullish, it will become appropriate to focus more analytical attention on the risks that could disrupt these positive trends, while still retaining a risk-on asset allocation that reflect by far the most likely scenario, which is simply that the positive trends of the past decade will continue for at least another year or two.
This is what I did in November 2017 (see Goldilocks And The Ten Grizzly Bears). Without pretending to have any kind of crystal ball to predict the future, I listed 10 macroeconomic, political and valuation issues that were already becoming apparent by that autumn, and which carried the risk of becoming much more serious in the year or two ahead. These provided a useful framework for thinking about the market turmoil and economic surprises of 2018.
Here, then, is my attempt to repeat that exercise by looking at 10 worries that are currently bothering investors, which may or may not intensify into serious problems in the second half of 2019 and 2020. Today, I will merely summarise each in a few paragraphs to create a risk framework which clients will hopefully find useful and which I will update in the coming months. In each case, I attach my subjective guess of the probability that the risk will materialize in the next 12-18 months and become a serious obstacle to the continuing bullmarket.
Significantly weaker growth in US or China (<10%)
A US recession and/or Chinese financial crisis appeared to be the main cause of the market panic last December and many investors still believe that a US economic expansion now entering an unprecedented 11th year must be living on borrowed time.
There is, however, no empirical evidence or theoretical basis for the idea that economic expansions die of old age. Post-war US expansions have varied in length from 12 months to 120 months – and 212 months excluding the effects of the 1990-91 Kuwait war. And the present expansion in Australia, which is one of the world’s most inherently cyclically economies because of its exposure to commodity prices and property speculation, is now in its 29th year and still going strong.
Recessions are usually caused by monetary or fiscal tightening or financial crashes. But major US policy tightening is almost inconceivable until after the 2020 election, and the Chinese economy is only just starting to respond to the policy easing of late last year.
Of course, in the pre-Keynesian world, where business cycles were driven by capital investment, rather than monetary and fiscal demand management, recessions usually occurred because entrepreneurs ran out of profitable investment opportunities. But this kind of classical – or Wicksellian – recession has rarely occurred in the post-war period. And despite last year’s panic about a recession caused by deteriorating business “animal spirits”, data from the US and China showed very little sign of major weakness in the second half of last year. My conclusion, therefore, is that a recession or major slowdown in the US or China is very unlikely, even in the event of a further escalation in the trade war (a risk I return to below).
Recession in Europe (25-50%)
The data from Europe unfortunately tells a very different story. In the second half of last year, while investors were needlessly fretting about the US, China and emerging markets, it was Europe that was actually sinking into stagnation, or outright recession. This could be seen in the revisions to the International Monetary Fund’s 2019 growth projections to take account of data releases in the past six months. While projections for China and the US were essentially unaltered, growth in the European Union was downgraded by 0.6pp to 1.3%, in Italy by 0.9pp to only 0.1% and in Germany by a whopping 1.1pp to 0.8%.
To make matters worse – and the threat of a European recession much greater – the EU has, as usual, responded to weak data with exactly the wrong policies. While the Chinese and US authorities can usually betrusted to respond to weaker data by boosting demand, the instinct in Europe is to do the opposite. Instead of counter-cyclical monetary, fiscal or credit easing, the eurozone policy response is almost invariably pro-cyclical. The European Commission tries to force Italy to cut public spending and raise taxes; the German government cites narrowing budget surpluses as an excuse to cut investment; the European Central Bank stops bond purchases, and bank supervisors respond to a credit crunch by pressing banks to raise capital and increase provisioning for non-performing loans.
These policy responses largely explain why the eurozone has spent half the post-crisis decade in recession, while the US has enjoyed an unprecedented period of uninterrupted growth. And if a recession does hit Europe it could easily trigger a global financial crisis because of the weakness of the European banking system and the EU’s instinctively perverse policy responses.
In the present downturn, however, there are two glimmers of hope. Firstly, Germany is now taking over from Italy as the EU’s worst-performing economy. This is good news because Germany’s economic problems will encourage more expansionary domestic policies, as they did in the 2008–09 recession, and may even dissuade German politicians from inflicting unnecessary austerity on their trading partners, as they did during the 2010- 13 euro crisis, when Germany seemed immune. Secondly, EU institutions are facing an unprecedented existential threat from populist politics – and as a result dangerously pro-cyclical austerity policies are less likely than in previous economic downturns.
Combining these political pressures for slightly more rational macroeconomic management with the generally decent conditions in the global economy, an outright recession in Europe is unlikely. That is why my base-case scenario for asset allocation is a modest economic recovery in Europe, which in turn should trigger strong temporary rebounds in European cyclical assets badly beaten down by last year’s terrible data surprises and the still very negative expectations for the year ahead. But even if the probability of an EU recession or financial crisis is well below 50%, we should recognise that most of the risk to the world economy lies in Europe, and Europe is the region that bullish investors must watch most carefully to decide when to draw in their horns.
The Fed’s dovish U-turn becomes a hawkish S-turn (<10%)
December’s shift in US monetary policy was arguably the biggest and most abrupt U-turn performed by the Fed since August 1982, when Paul Volcker suddenly abandoned monetary targeting in response to the Mexican debt crisis. Since there was no sudden change in US data between the first week of December, when the Fed was outspokenly hawkish, and the last week, when it turned unequivocally dovish, the main explanation for last year’s U-turn must have been that month’s dramatic movements in financial markets.
Butifa-12% plunge in equity prices and a brief inversion in part of the yield curve was enough to force a dovish U-turn, isn’t it possible that a powerful bull market on Wall Street and a steepening of the yield curve could provoke an equally abrupt shift back to hawkish policy?
Such a hawkish U-turn seems unlikely in the next 18 months, partly because of political pressures ahead of the 2020 election, brutal so because of a genuine intellectual shift in the Fed in favor of a more symmetrical inflation policy that would require an extended overshoot of the 2% target. So this is a low probability risk, but investors should keep it under review because of the implausible expectations for rate cuts implied by the present positioning in US bonds and the psychological obsession with Fed policy in all asset markets worldwide.
US inflation accelerates to above 2.5% (<10%)
Another low probability risk, but one that would have a big impact, is US inflation. While several measures of prices and wages are gradually creeping upward as the US economy continues to enjoy full employment, aninflation upsurge serious enough to worry the Fed would probably require core PCE to jump above 2.5% and stay there for several months. That would be a major surprise. There has been absolutely no evidence in recent data of PCE inflation accelerating, even while wages, total compensation costs, gold prices and median consumer prices (see the chart over leaf), along with other traditional leading indicators of inflation, have been edging up.
As long as this situation persists, which it will partly because of the way core inflation is measured, the bond markets are likely remain relaxed about monetary tightening. And with no monetary tightening on the horizon, investors in equities, property and other risk assets will probably treat creeping inflation more as an opportunity for faster top-line growth, than as a threat to valuations.
Trade wars: US-China, US-EU or EU-UK (25-50%)
Trade wars were a risk that seemed to be all but eliminated a few weeks ago. Now they have returned with a vengeance with Donald Trump’s escalation of anti-China tariffs. Since we have discussed at length the various scenarios for the US-China confrontation (see The Trade WarStory Lines Harden), I have only two points to add, with regard to market impacts. The bad news is that powerful voices in the Trump administration seem not to be content with a trade war against China, and are eager to wage war with Europe as well by imposing punitive tariffs on the autosector.