A Goldilocks scenario for 2019 would require economic growth that boosts risky assets but is not so strong that it pushes up interest rates.
Economic growth is slipping in most of the world. If there’s one forecast about 2019 that we can make with confidence, it is that the configuration of growth and asset market performance of 2018 is not likely to be repeated. 2018 was a tough year for risky assets because they are leveraged to growth. The rise in real interest rates, anxiety about Fed policy in 2019, uncertainties generated by the trade war, and the Trump administration’s policies have weighed on growth and sentiment. The longstanding economic challenges facing China and the eurozone are other factors.
China, eurozone face slowdown
China and the United States, two of the world’s largest economies, wrapped up three days of trade talks in Beijing in January 2019. So far, both parties have given few details about the outcome. U.S. Trade Representative Robert Lighthizer is in charge of these negotiations, and he has a folder with a long list of “broken promises” by the Chinese on trade issues. Lighthizer will present demands that the Chinese simply will not accept. The question really is whether his view will prevail or whether Trump and Xi will privately reach a deal that will calm tensions.
In the eurozone, economic indicators continued to disappoint. The weakness among eurozone economies, especially in the second half of last year, was one of the largest surprises in the global economy in 2018. Growth is slowing, inflation is below market expectations, and domestic consumption remains sluggish. With the overall economic outlook not changing very much, it is looking more and more likely that 2019 will pass without an interest-rate hike by the European Central Bank [ECB]. The ECB ended its quantitative easing program in December. Italy, the eurozone’s third-biggest economy, continues to contend with high debt levels and a shrinking economy. In December, the European Union reached a deal with Italy on its 2019 budget, which allows the country to avoid disciplinary action.
The forecasting dance
The link between growth, interest rates, and risky assets are central to this year’s outlook. Every day we observe this dance that involves the real economy and its prospects, the financial markets, and policy makers. There are missteps and shocks. All three variables interact, react, and influence each other. Recent market movements are an adjustment to a weaker growth profile and an acknowledgement that there are downside risks. Much will depend on the Federal Reserve’s monetary policies.
U.S. economy cooling
The U.S. economy is moderating amid rising interest rates, a shifting fiscal policy, and uncertainties generated by the Trump administration’s trade policies. Our central scenario is for growth to slow to its pre-2018 range. Still, recession risks remain low. Economic indicators have started to moderate. The Institute for Supply Management’s (ISM) closely watched manufacturing index showed that U.S. factory activity in December slowed more than expected. Investors follow the ISM index even though it is an inferior indicator. Corporate investment has underperformed, and forecasts for investment spending are slipping. And the cost of capital in the U.S. corporate sector is rising. Corporate bond and high-yield bond spreads — the difference between the yields of two bonds with similar maturities — have widened. This means there is a material shift in the cost of debt, and it will affect the economic outlook. The U.S. Treasury yield curve is exceptionally flat and is indeed inverted on some measures, a sign that bond investors expect the economy to slow.
Some bright spots
The December jobs report showed that U.S. payrolls surged by 312,000 jobs and wage growth accelerated. Jobs were created in education and health, two sectors that were lagging. But detailed analysis of the jobs report indicates that not much has changed. Wage increases are still being driven by a few sectors. Consumer confidence and the quit rates (the number of people who leave their jobs) appear to have rolled over. But consumer demand is holding up well and could help buoy the economy as we roll into 2019. Manufacturing accounts for about 12% of gross domestic product (GDP). While the sector is cyclical, it would take a much larger decline in the manufacturing ISM to make us worried about a decline in GDP.
For the outlook, the risks remain asymmetric. The possibility that we are at the early stages of a capex/ productivity growth phase seems even more remote now. A trade peace deal could be signed soon, but we are not sure this would provide much positive shock. We are left with the very real risk the Fed will be too aggressive, placing too much weight on the labor market — which is at best a contemporaneous indicator — and not enough on the erosion of the economy’s prospects.