The market has been weak during the final quarter of 2018 as volatility has picked up. We see this as being a symptom of a quarter in which monetary policy was not just tightened but tightened at an accelerating pace. This took place simultaneously around the major economies of the world. That has drawn liquidity away from global equity markets causing stocks to fluctuate further from their fundamental valuations than had been the case when monetary policy was loose during 2017 (for example). The pace of tightening in the US will be slower while outside the US most policy will be on hold (or looser). In our view interest rates and bond yields still represent poor compensation for risk relative to equities. Meanwhile falls in energy costs will act as a tax cut to consumers and businesses around the world, as it did during the last bout of volatility in 2016. As then, lower cost inflation should set the stage for a recovery in economic activity and further profit growth.
The growth environment moving into 2019 is mixed with the US remaining strong but growth outside the US more difficult. Particularly weak are China and Europe reflecting Europe’s increasing reliance on external demand to reach trend growth. Elsewhere in the UK and Japan conditions are stable if uninspiring and in particular Brexit obviously poses a threat to UK growth.
Expectations for policy are equally mixed but what we anticipated, although to not enough of an extent, for 2018 was a year of two halves in which policy would pose more of a headwind in the second half of the year. It certainly has certainly done so. The fact that the UK seemed to kick things off by raising interest rates in August was largely symbolic. It was the economic behemoths of the US and Europe that accelerated the monetary tightening.
The Federal Reserve raised rates four times in a year for the first time since 2006 in what will almost certainly be the fastest pace of tightening seen in the current cycle. Simultaneously they accelerated their effective sale of assets through the reversal of quantitative easing. That pace of sales reached its fastest in the fourth quarter which was precisely the point at which the European Central Bank began slowing its purchases and have now halted altogether.
Tightening monetary policy can make other asset classes look more attractive if, say, bonds offer more attractive returns for lower risk than equities. That is not the case now though as recent declines in bond yields mean that they still fail to compensate investors for inflation in any major economy outside the US. With interest rates and bond yields still so low they still make equities look attractive by comparison. However, the flood of bonds in the market does draw liquidity away from the equity market which means prices can fluctuate further around the true valuations of shares. That is why we believe monetary policy changes cause bouts of volatility.
The US will continue selling securities during 2019 but it won’t accelerate them as it did in 2018. It now anticipates raising interest rates only twice in 2019, the market expects it to do so even less. But it won’t raise rates more or faster than it did in 2018. We expect European policy to remain on hold throughout 2019. In Asia, China began 2018 tightening but will be loosening in 2019. Last Friday a meeting of top policy makers announced that significant cuts to taxes will be enacted in 2019 and the monetary stance will be easier still.
Japan reduced its own asset purchases materially during 2017 and 2018 since introducing a policy called yield curve control in 2016 in what was a “stealth” tightening but these now seem to have stabilised.
On the fiscal side we are now seeing more expansionary budgets from the UK, Italy and France. There are hopes that the US may provide a further boost to its economy through investment in the currently ailing infrastructure. The former Republican Congress would only approve tax cuts, rather than new spending. President Trump is happy to countenance both.
The most significant boosts however have come from the decline in energy prices caused by a combination of more supply (through the easing of sanctions on Iran and greater US shale production) and some concern over demand for the forthcoming year. High energy prices mean a transfer of income from the world at large to a small handful of producers, largely concentrated in the Middle East, Russia and the US. Gasoline prices at the pump in the US for example were close to $3 per gallon, now that is down to $2.35. That will put extra money in the pockets of consumers.
The fact that oil prices are falling means that the demand shock which preceded all the US recessions going back to the early 1980s is not currently present and that means that the cycle is now likely to be longer than previously believed. The prices of stocks have fallen quite sharply against relatively modest downgrades to economic activity.