Fed tightening and market jitters in Q4 2018
In the months leading up to autumn, markets were already volatile due to the uncertainty created by a trade spat between China and the US. Nevertheless, global equities had returned 4% (including dividends) between the end of December 2017 and the end of September 2018. Yet, when Fed Chair Powell warned that we’re “a long way” from neutral on US short-term interest rates on the 3 October, global equity markets (including the US) were spooked and fell sharply. Essentially, investors had become unnerved about Powell’s hawkish comments and what impact Fed tightening would have on economic growth, company profits and financial conditions.
The Fed has since taken a less hawkish stance on monetary policy. First, Mr. Powell delivered a more dovish tone in a speech at the Economic Club of New York on the 29 November compared to his 3 October comments. Second, although the Fed raised interest rates at its policy meeting in December, the Committee indicated it would take a pause on raising interest rates every quarter (the Federal Open Market Committee reduced its interest rate projections this year from three hikes to two hikes, and expects just one in 2020 to complete the cycle). And third, in the December FOMC statement, the Committee showed a modest degree of caution by stating it will “monitor global and financial developments and assess their implications for the economic outlook”, which suggests that the Fed stands ready to ease policy, if required.
Even so, following the December FOMC, the US stock market index fell by 1.5% on the day, its worst decline in response to a Fed rate increase since 1994. Markets reacted negatively, as the Fed did not rule out further rate increases. Moreover, Mr. Powell said that the Fed is satisfied with its program to reduce the size of its balance sheet through quantitative tightening (QT), and had no plans to change it. Markets are concerned, as there is plenty of uncertainty in an untested QT program on autopilot and its impact on the economy. Global equities, as measured by the MSCI All Country World Index (ACWI) benchmark, fell 12.7% in the final quarter of 2018, the biggest decline in more than seven years.
However, critically for equity markets, the US dollar trade-weighted index (TWI) appears to have peaked. It would be reasonable to see a decline in the US dollar TWI (i.e. the cost of US dollar money) as an important offset to the shortage of dollar liquidity, which has precipitated stress in banks (eg, Deutsche Bank, as a globally systemically important bank) exposed to US dollar-denominated debt in emerging markets.
Market outlook for 2019
The global economy is undergoing growing pains. The fundamental growth backdrop has weakened somewhat as the Fed tightens monetary policy. US real GDP growth is slowing from around a 3% clip in 2018 to 2.6% expected by the consensus in 2019. Elsewhere, output growth in 2019 is anticipated to grow by 6.2% in China, 1.6% in the Eurozone, 1.5% in the UK and 0.9% in Japan, with all countries and regions here showing a steady deceleration from 2018.
Analysts have now taken into account the changed macro backdrop and marked down consensus earnings expectations. Equity valuations have also become less demanding; the MSCI ACWI is currently trading on 12.9 times forward earnings, which is lower than when markets last wobbled over global growth expectations in early 2016.
There are now two scenarios for the trajectory of equity markets; (i) if the decline in the US dollar (and US 10 year Treasury yields) reflects a severe downturn in US growth, or even a recession, it would likely lead to further equity downside; or (ii) if the decline in the US dollar reflects a nearing in the end of the US rate cycle, and with US growth holding up, this would provide an opportunity for equities to recover from oversold levels. We believe scenario (ii) is the more likely outcome, but risks have increased.
Market tail risks
There are a number of dates in 2019 that could potentially be catalysts for market tail risks that lead to greater risk aversion. These include; i) 1 March: the US will decide on whether to raise tariffs to 25% from 10% on $200bn of Chinese imports; ii) 29 March: the UK is due to leave the EU. A no deal Brexit could lead to a severe dislocation in both the UK and European economy, as well as in financial markets, and also lead to a snap election in the UK that potentially delivers a left-wing Jeremy Corbyn government. iii) 23-26 May: European Parliamentary elections will be held on these dates. A populist backlash could help anti-EU parties gain ground in European parliament and influence the direction of reform in the union. iv) Mid-summer: Around this time US Congress must raise the US debt ceiling limit to avoid a default on US government debt.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.