Wednesday 30 January, 2019
2018 was an up and down year for global shares as investors swung between optimism and pessimism. In the end, they settled on the gloomy side as worries about the effects of a US-China trade war, rising interest rates, and a possible recession down the track trumped reasonable momentum in economies and company earnings.
Meanwhile, interest rates ended the year significantly down from the beginning of the year, as investors foresaw both lower economic growth and lower inflation on the horizon.
But will this dark mood persist in 2019, bringing with it an end to the impressive decade-long upward trend for global shares?
In this article, we outline what we see as the most probable outcomes, while highlighting the major risks to the outlook.
The global economy grew at a solid pace in 2018 as accommodative central banks and US tax cuts primed the pumps, employment rose, and incomes gradually lifted. Towards the end of the year signs of growth fatigue started to emerge, particularly in regions outside the US.
This year, the tailwinds for the global economy will likely lessen further. The effects of the US tax cuts will start to fade, which to a degree will take wind out of the sails of the world’s largest economy. US Federal Reserve (Fed) interest rate hikes will also be a dampener on growth to an extent this year.
Despite a slowdown in the US, we consider that a global recession is unlikely this year. We see the US economy ticking along, with solid job and income growth helping to keep consumers in reasonable heart.
There is little sign of significant inflation in the pipeline, which means the Fed is likely to maintain a flexible approach to monetary policy – easing back on its plans to raise interest rates if needed to keep the economy going.
Similarly, outside the US, central banks aren’t about to pull the rug out from under their economies too early as inflation remains modest. Governments in those regions are also loosening their purse strings, which will further assist activity.
The trade impasse between the US and China was a dark cloud hanging over business confidence in 2018. However, we consider that recent market turmoil and slowing in China’s economy gives greater impetus for a deal to be struck soon. If this eventuates, we expect business and investor sentiment will be boosted.
In summary, our central scenario is for a slowing global economy next year, but still growing at a modest pace. Although Inflation is likely to remain contained.
Global interest rates
With the pace of global economic growth moderating and no signs of inflation breaking out, we see large central banks slowing the pace of monetary policy tightening this year. Accordingly, we predict only gradual rises in interest rates in 2019. We see the benchmark US 10-year government bond interest rate reaching in the region of 3% for the end of the year.
There may be a considerable ups and downs in the path of global interest rates, however, due to risks and uncertainties we outline at the end of this report.
New Zealand interest rates
New Zealand government bonds were star performers of global markets in 2018 as local interest rates fell by more than those overseas. This year, we continue to see New Zealand interest rates being well anchored by several factors.
Inflation is likely to rise above the mid-point of the Reserve Bank’s 1-3% target range this year, as rising wages and recent falls in the New Zealand dollar feed through to higher prices. However, the domestic economy is likely to cool this year due to slowing construction, subdued property prices, and reduced immigration. Therefore, we expect the Reserve Bank to maintain the Official Cash Rate (OCR) at its current level of 1.75% this year and for most of 2020 to partially pre-empt the slowdown.
The possible introduction of higher capital requirements for local banks will put upward pressure on lending rates unless wholesale funding costs are lowered. This is another reason the Reserve Bank is likely to hold fire on OCR changes, despite slightly higher inflation.
Last year was notable for US dollar strength as strong economic growth and a strident Federal Reserve boosted the currency of the world’s largest economy. The US dollar now looks overvalued relative to many other major currencies on several measures. We expect the US dollar to soften somewhat in 2019 due to cooling in US growth as the boost from tax cuts fades and the Federal Reserve scales back its plans to hike interest rates.
Easing in the US dollar has in the past been generally supportive for commodities and commodity-based currencies, like the New Zealand dollar. In addition, China’s authorities have recently lifted credit restrictions and eased monetary policy, which may help to stimulate the Chinese economy over this year. Commodity-based currencies will probably be beneficiaries of this.
Counteracting these factors to an extent will be the prospect of New Zealand short-term interest rates rising even more sedately than those overseas due to a cooling local economy and anchored OCR. Therefore, we see the Kiwi dollar being relatively flat, or only moderately higher, against the US dollar over the coming 12 months. The New Zealand dollar may soften against other major currencies, such as the yen and euro, as these generally strengthen against the US dollar.
Share price falls in the last quarter of 2018 were in anticipation of a significant slowdown in the global economy and company earnings this year. In our view, the market reaction was overdone. The boost from tax cuts meant that company earnings growth in the US was extraordinarily rapid last year, and unsustainable. Earnings will inevitably slow this year, but it doesn’t mean they are falling off a cliff.
This year, global annual economic growth in the region of 3.5% will be enough to sustain positive revenue growth in the US and most major markets around the world. However, there will be headwinds to earnings. Tighter labour markets will put upward pressure on wages and this combined with marginally higher interest rates and the extra costs from US and China tariff policies will likely squeeze margins to a degree. We still expect reasonable 2019 earnings growth across most major markets in the 5-10% range.
After the severe sell-off in global share markets in the last quarter of 2018 valuations have reduced considerably. For instance, the price-to-earnings ratio for the US S&P 500 fell from around 21 at the end of August to around 17 at the end of December. This is below the long-term average of 20 since early 1990. Other global market valuations have had similar sharp falls, many starting from much lower ratios than in the US.
Therefore, there is scope in our view for a degree of rerating in global shares, which along with modest earnings growth, should see moderate positive returns from this asset class in 2019.
However, as we discuss below, returns are unlikely to come in a straight line. Significant prices swings could continue to be the order of the day as investors face several uncertainties and nervously anticipate a possible recession in 2020 or 2021.
Given our base case is for unspectacular economic growth and therefore limited increases in interest rates, we expect a modest but positive return for bonds and for them to retain their traditional safe-haven status in 2019. We expect credit spreads (the extra interest rate you require to own a company bond over a government bond) to remain relatively stable at current levels having widened in December to take into account future economic uncertainty.
Most of the risks that we anticipated at the beginning of 2018, such as inflation surprises, trade tensions, economic slowdown in China, and political troubles in the Eurozone came to the fore over the year. These risks will likely continue to zoom in and out of focus for investors this year, possibly causing moments of angst along the way. Some of the key risks we see for this year are detailed further below.
Further economic slowdown in China
The Chinese economy has slowed significantly this year. In response, the Chinese authorities have loosened credit restrictions and monetary policies, which we expect will help support the economy this year. Despite this, most economists are expecting further slowing in 2019. There is a risk the measures do not stimulate China’s economy as much as hoped and the slowdown could be sharper than currently expected. This would be a dampener on world growth and company earnings.
Overly tight central banks
Many investors see current moderate inflation and initial signs of possible economic slowdown as a reason for the US Federal Reserve and other large central banks, such as the European Central Bank, to ease back on plans to make policies less accommodative this year. If central banks don’t indicate sufficient willingness to alter their plans based on new information about the economy and inflation, then many investors will become warier of riskier investments such as shares.
US-China trade war
US President Donald Trump’s trade crusade against China have also been a dark cloud hanging over share markets recently. Based on recent noises from officials, there are hopes that détente between the two superpowers may be on the way. Nevertheless, there are deep-seated issues separating the countries and a trade deal is not guaranteed. A continuation or escalation of trade hostilities will add to costs and pare down global growth.
This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.