A neutral interest rate policy is associated with a normal yield-curve slope. Last year, the Federal Reserve (Fed) went well past neutral, almost inverting the yield curve and raising fears of recession. We believe a 2019 pause in Fed policy will allow the global economy to heal after the excessive tightening of 2018.
THOUGHT OF THE WEEK
The strong U.S. consumer continues to drive robust retail sales—splurging to the tune of around $1,100 per person this holiday season. Amid shifting preferences toward e-commerce and omnichannel retailers, the consumer remains a key driver of corporate earnings for 2019, supported by a healthy jobs market and higher wage gains.
GLOBAL MARKET VIEW
European stocks underperformed the rest of the world last year, but given the economic, political and policy headwinds still facing the region, we retain a tactical underweight in developed Europe against an otherwise pro-risk stance in global equities.
We are maintaining our overall absolute equity allocation across all risk profiles. However, we are lowering our non- U.S. developed equity allocation and adding to U.S. large-cap equities. We maintain our risk exposure in emerging market equities.
Weakening leading indicators of global growth combined with softer-than-expected incoming data from Europe and China and aggressive Fed tightening have created an explosive mix that culminated at the turn of the year with a surge in risk aversion and financial-market turmoil. Indeed, a hawkish Fed policy and rhetoric increasingly out of sync with the economic outlook predictably spurred a frantic market rush to translate shattered expectations of prudent Fed policy into growing expectations of recession by the end of 2019.
We have long perceived excessive Fed tightening as the main risk to the outlook. As such, we believe that, although unsettling, the late-2018 market riot gave the Fed enough lead time to reconsider its policy and ultimately seek to prevent an unnecessary recession. Assuming the Fed pauses for a while to allow the economy to digest the cumulative effects of its tightening to date, and assuming that the dollar has peaked—due to the Fed pause itself and to downside pressures coming from four years of rising trade deficits—our base-case scenario for 2019 remains for a continuation of a "Goldilocks" U.S. growth and inflation environment. However, Fed policy remains key.
Supporting our view, a more-accommodative tone in recent speeches by Fed officials and an internal debate regarding the wisdom of unabated monetary-policy tightening apparent in minutes from the December 2018 Federal Open Market Committee meeting have already greatly improved market sentiment. Extreme risk aversion has given way to a meaningful retracement of the late-2018 equity-market declines, a stabilization in long-term Treasury yields, and a rollover in credit spreads, volatility and the trade weighted dollar index.
A slowdown in the first half of 2019 appears inevitable, however. First, housing affordability, homebuilding and home sales have likely weakened enough to keep consumer spending from becoming exuberant in 2019 despite strong real income growth and still-elevated confidence levels. Second, the full effect of Fed hikes to date on small businesses' sales, earnings, worker compensation and hiring plans has yet to be fully felt. Third, negative effects from softening manufacturing and trade activity overseas, with particularly broad-based weakness in European industrial production, should also restrain U.S. growth and the manufacturing Institute for Supply Management (ISM) index, as should heightened uncertainty around trade disputes.
As discussed last year, a moderation in the manufacturing ISM index following a longer-than-expected stretch of exceptional strength was imminent given its mean-reverting characteristics (Exhibit 1). After greatly defying expectations on the upside last year, the index appears to have finally cracked, with a plunge in December led by deep-diving new orders, themselves an important leading indicator of the business cycle. The index is a proxy for the most cyclical part of the economy and thus is closely watched for clues about corporate revenues and earnings growth.
While downtrends in the ISM index tend to be accompanied by deteriorating annual returns on equities and commodities, the current downturn should benefit from a number of supports that may make it shallower and less protracted than the previous two minicycles of the current expansion (2011–2012 and 2014–2016). In turn, this would soften the negative effects on revenues and earnings growth that typically accompany downturns in this index. Specifically, we expect pro-growth U.S. policies, still-strong business sentiment, very favorable real consumer-income underpinnings, and a likely further dollar depreciation to help the ISM index bottom at a higher level (possibly around 51 versus 48) and quicker (likely by midyear) than in the previous two episodes.
Exhibit 1: ISM Index Likely to Continue to Surprise to the Upside with a Shallower First-half Slowdown and a Sharper Rebound.
Sources: Institute for Supply Management/Haver Analytics, Chief Investment Office. Data as of January 16, 2019.
If past correlations are any indication, this pattern would suggest that year-over-year equity returns should remain under pressure before starting to improve in the second half of 2019. If correct, this would be consistent with the S&P 500 index inching closer to its September 2018 peak as the year progresses. As they lead the cycle and are more sensitive to changes in the dollar, commodity prices could also benefit, likely bottoming soon and possibly gaining up to 10% by fall.
The combination of a "soft-landing" in the ISM index with a gentle dollar depreciation this year and a stronger nominal gross domestic product (GDP) growth environment than in the previous two midcycle slowdowns suggests that most of the deceleration in corporate revenue growth is probably behind us. Indeed, highly sensitive to changes in the dollar, revenue growth decelerated sharply from +11% year-over-year in the second quarter of 2018 to +4.7% six months later, largely as a result of the 2018 dollar appreciation. As shown in Exhibit 2, we expect 2019 average revenue growth of around 6% (compared to +9% in 2018), with similar likely gains for earnings per share.
Exhibit 2: S&P 500 Revenue Growth Likely in Mid-to-high Single-digit Range This Year.
Sources: Standard and Poor's/Haver Analytics, Chief Investment Office. Data as of January 16, 2019.
Consistent with our view for continued expansion and healthy revenue growth for the foreseeable future, credit spreads, which tend to increase substantially before a recession and which spiked along with other measures of risk aversion in December, have given back about half of their December flare-up and remain much below average. Fittingly, so do other financialstress indicators, such as the TED spread. The stabilization of the yield-curve spread in positive territory following its December plunge also fits our outlook.
As shown in Exhibit 3, the spread (here shown as the difference between the 10-year and 2-year Treasury note yields) dropped close to territory typically associated with one-year-ahead recession signals, but renewed curve steepening while the Fed pauses is possible, consistent with a prolonged expansion into late 2020. That's because the widening gap over the past year between our yield-curve spread estimate based on the fundamental justifications for Fed tightening and the actual spread has long indicated increased market perceptions of an unnecessarily restrictive Fed policy. Its recent collapse reflected more than a slowdown as outlined above. It reflected a rising fear of a Fed-induced recession by the end of 2019. As discussed above, a rate-hike pause would allow the economy to absorb the tightening to date, prolonging the expansion into at least late 2020, given otherwise strong U.S. economic fundamentals. Viewed this way, the late 2018 Fed mistake and strong market reaction may turn out to be beneficial to the longevity of this expansion and bull market in equities. The ball remains in the Fed's court, however.
Exhibit 3: Yield Curve Flattened More Than Justified By Inflation Pressures As Fed Got Carried Away.
Sources: Federal Reserve Board/Haver Analytics, Chief Investment Office. Data as of January 16, 2019.
The start of 2019 marks 20 years since the launch of the euro, which on January 1, 1999, became the centerpiece of a half century of deepening European economic integration. But two decades on, European leaders have relatively little to celebrate. The European Union's (EU) second largest economy, the U.K., risks a chaotic exit from the bloc. Its fourth largest economy, Italy, has only recently agreed to EU fiscal rules after challenging them for months. Economic growth is cyclically weak. And for eurozone members, the absence of a fiscal union and stalled progress on the banking union prevent a coordinated policy response to crises of the type witnessed in 2011–2012. European stocks underperformed the rest of the world last year, but given the economic, political and policy headwinds still facing the region, we retain a tactical underweight in developed Europe against an otherwise prorisk stance in global equities.
Across 50 private forecasters surveyed by Bloomberg, the current consensus is for eurozone economic growth to fall to just 1.5% in 2019 — the slowest pace in five years. And the rate of growth in expected earnings for European equities has also fallen, with the 12-month change in year-ahead earnings per share for the region weakest among the major developed markets (Exhibit 4).
Exhibit 4: Growth in Expected Earnings Weakest in Europe Among Major Developed Markets.
U.S. is S&P 500, Europe is Euro Stoxx 600, Japan is Topix. Source: Bloomberg. Data as of December 2018.
Even after last month's agreement between the European Commission and the new Italian government, there remains a risk of new budget clashes in 2019. The EU's third and fifth largest economies, France and Spain, each recorded fiscal deficits of 2.7% of GDP in the latest reading for 2018— close to the 3% limit imposed by the union's Stability and Growth Pact (SGP) (Exhibit 5).
Exhibit 5: EU Budget Deal Reached with Italy, but France and Spain Close to EU Deficit Limit.
Source: Bloomberg. Data as of Q2 2018.
Five countries— Germany, France, Italy, Spain and the U.K.— account for roughly 70% of both EU GDP and developed Europe market capitalization (Exhibit 6). They therefore warrant the most attention from investors focused on European markets in aggregate. But near-term economic and political challenges for each of the five are likely to constrain equity returns, while additional risks from upcoming elections in the European Parliament and shifting European Central Bank (ECB) monetary policy may further weigh on investor sentiment toward the regional market.
Exhibit 6: Western Europe GDP and Market Capitalization Dominated by Five Countries.
Developed Europe market capitalization based on MSCI Europe index. Sources: International Monetary Fund, MSCI. Data as of 2018.
Germany likely suffered a contraction in economic activity in the second half of 2018 after recording its first negative growth print for over three years in the third quarter. The weakness has been driven in part by temporary domestic factors—slower vehicle production due to tighter emissions regulations and droughtrelated delays to imported parts and raw materials. But as a major exporter of capital goods, external headwinds from slower industrial activity in China may be more persistent. This comes alongside a weakened chancellor, a probable successor who represents the status quo and deeper structural problems in other large EU trading partners.
In France, the ongoing street protests have forced government concessions in the form of a publicly funded increase in the minimum wage and tax relief for pensioners and lower-income earners. The demonstrations themselves are estimated to have shaved 0.1 percentage points from growth last quarter, with the industry impact concentrated in tourism, restaurants and hotels. But the future budget impact should be more significant for markets. French sovereign debt spreads have not widened as we saw in Italy last year, but the new measures are expected to cost around 0.4% of GDP, raising the risk that France's fiscal deficit breaches the SGP limit in 2019.
Italy itself has temporarily averted a political rift with the EU after the government revised down its proposed fiscal deficit at the end of last year. But Italy's low rate of trend growth (which has registered just 0.3% annualized since euro inception) has been the major driver of its rising public debt-to-GDP ratio and will only be compounded by the new budget resolution. The government revised down its growth forecast for 2019 from 1.5% to 1.0%, meaning its fiscal problems have likely only been deferred rather than resolved.
Spain is the only one of Europe's big five economies expected to grow above the EU average this year, but as in France, the 2019 government budget is likely to be the major concern for markets. The Spanish prime minister is targeting a 5% increase in public spending on regional investment projects, pensions and other benefits in order to gain enough support for his minority government. Passage of the budget would avoid the risk of new elections and the potential installation of a coalition of opposition parties that would include far-right euroskeptics. But the European Commission at the same time has cast doubts over the government's ability to fund the proposed budget while still adhering to EU fiscal rules.
Following last week's rejection of the U.K. government's EU withdrawal agreement, uncertainty over the Brexit process has also increased. There is now a high likelihood that the March 29 exit date will not be met, whichever path is chosen by lawmakers over the coming days and weeks. And the involvement of members of Parliament across parties should also reduce the chance of a no-deal outcome, given that the majority of them do not support it. The prospect of a softer exit that leaves the U.K. more closely aligned with EU trade policy could lift near-term sentiment in markets from current levels. But it should be emphasized that any type of exit would reduce economic output. Under the government's official scenario analysis, a worst-case no-deal Brexit would leave the economy up to 10.7% smaller after 15 years. But even the mildest possible form of exit would still reduce output by up to 2.4% over the same period. The effect on the remaining EU-27 would be smaller overall as U.K.-EU exports relative to U.K. GDP are roughly four times larger than EU-U.K. exports relative to EU GDP. But the impact on individual EU countries and sectors with more exposure to U.K. demand, such as German automakers and French agricultural producers, would be greater.
The policy outlook for two important European institutions also leaves us cautious over prospects for the regional equity market in 2019. All seats in the European Parliament will be contested in parliamentary elections at the end of May, a process that will allocate key EU-wide powers such as approval of the annual EU budget and veto power over new EU trade agreements. Mainstream centrists currently control the Parliament. But in line with trends at the national level, populist parties are expected to make gains in the upcoming vote, and this raises the risk of more disruption to the EU's legislative agenda.
Our final major concern is eurozone monetary policy. The ECB ended its asset purchase program last month, pledging to keep its balance sheet at the current size of 4.7 trillion euros until well after it starts to raise interest rates—a process not expected to begin until late 2019 at the earliest (and likely much later). The ECB is well behind the Federal Reserve in normalizing monetary policy, but for three main reasons the shift in policy could further unsettle local markets over the course of the year. First, core inflation in the eurozone stands at just 1.0%. Though the Bank's "below but close to 2%" mandate is based on the higher headline measure, headline inflation has historically reverted back toward core and not the other way round. Second, the ECB is likely to reinvest less back into the debt of the three large economies with the weakest fiscal positions. The Bank already holds Italian, French and Spanish bonds in greater proportion to its targeted allocations, meaning the initial pace of reduction in quantitative easing will be faster for these three markets. And third, President Mario Draghi is due to finish his term at the end of October. This means an unknown and untested successor will ultimately oversee the process of rate increases and balance sheet reduction, raising the potential for a policy mistake. We expect a gradual recovery for global equities overall this year, but economic, political and policy risks cause us to remain underweight in European markets.
Online sales increased over 20% versus a year ago, representing an acceleration from 2018 over 2017 (Exhibit 7). Mall traffic was down low single digits, but conversion rates increased substantially. Discounts were larger, and free shipping was de rigueur. Toys, apparel, prestige beauty and electronics were big winners. Total holiday retail sales increased 5.2%, which was above consensus expectations of +4.5%.
What to expect next:
The bright light going into 2019 is the housing related do-ityourself and pro contractor business.
Exhibit 7: Desktop & Mobile Digital Commerce Share of Corresponding Consumer Spending.
Source: Comscore. Data as of January 2019.
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