in like a lion, out like a (small) bear
11 December 2018
In many ways, this dismal performance was surprising. Corporate profits have grown strongly in many regions, notably the US, where corporates beat expectations again and again. Inflation has remained in ‘Goldilocks’ territory: not too hot that it went above target, not so cold that it raised fears of deflation. There are, however, many explanations for poor market performance – trade frictions, fears of a slowdown in the US, actual slowdowns in Europe and China – but to our minds, the chief culprit is rising US interest rates.
The Federal Open Market Committee (FOMC), which sets official US interest rates, has been hiking for almost three years. But for much of this period, indices of financial conditions, broad measures which incorporate equity prices and corporate bond spreads, have actually eased. Moreover, the FOMC raised rates more slowly than it had indicated for 2016 and into 2017. That all changed towards the end of 2017, and this year, when the FOMC tightened in line with its plans. Over the summer, the FOMC’s rhetoric became more hawkish and the equity market finally succumbed. Any doubts over the importance of interest rates were dispelled on the 28 November, when marginally dovish remarks by Federal Reserve Chair Jerome Powell sparked a significant equity rally.
The worry over rising US interest rates has recently given way to concerns about the inverted US yield curve, perhaps the best leading indicator of a recession. The most widely used measure of the yield curve is 2s10s (10 year yield minus 2 year) and it has inverted ahead of every one of the last nine US recessions. However, it has taken around a year and a half, on average, between the inversion and the recession. The shortest length of time has been 9 months. With 5-year yields below 3 and 2-year yields, we have now pressed the button on a less-commonly-followed timer clock. 3s5s and 2s5s have also inverted before each of the last 9 recessions but have taken between 18 months and 2 years to lead to the median recession. Many prefer 3 months vs 10 years as a predictor. The good news is that this curve spread is still at +48 basis points.
Beyond the US, performance in terms of both economic and corporate earnings growth has been less impressive. Growth in China and Europe slowed and they each have additional problems. For China, it became clear as the year progressed that the row with the US went far beyond trade to include diplomatic and strategic considerations. With industrial profits falling, Chinese equities (down 28% from its peak in January this year, as per MSCI China) have been amongst the worst performers in the world year-to-date. The rally following the much-anticipated Trump-Xi dinner proved short-lived.
In the case of Europe, Italy has become a major issue. The new coalition government has proposed a budget that scraps some of its predecessor’s reforms and introduces new and generous provisions for a “citizens’ income” and a “flat” tax rate of 15% and 20% respectively. The European Commission has made strong objections and is likely to recommend that the Excessive Deficit Procedure is invoked. Negotiations are ongoing but the issues have already led to a sharp rise in the yields on Italian government bonds and signs of weakness in Italian business confidence. Critical in all this are the reactions of the credit rating agencies. So far, the coalition has been cautious and is talking about some restraint in its fiscal plans but concerns remain. Italy needs growth and the current government risks weakening the economy by proposing a fiscal expansion designed to do precisely the opposite.
Meanwhile, the UK negotiations over Brexit are reaching a crescendo. Talk at the start of 2018 was of ‘hard’ versus ‘soft’ Brexit. By the summer it had shifted to ‘deal’ versus ‘no deal’. As we write, many scenarios are possible, including a cliff-edge departure, an amended version of Mrs May’s deal, a second referendum, a general election, a crisis-induced National Government or even the unilateral revoking of Article 50. It is hardly surprising that UK equities and sterling have performed so poorly thus far this year.
While the travails of the UK are extraordinary, the volatility of financial markets beyond these shores is not out of the ordinary. The spike in volatility in February and the subprime auto loans problem in the US in the summer were significant events but they were brief with few knock-on effects and caused no systemic problems. The system is now much more resilient than it was a decade ago but volatility has certainly not been eradicated. A year ago, we suggested that the only thing we had to fear was the absence of fear – the market was too complacent. Fear is widespread today. As for the UK, 2019 looks set to be another year of political drama and economic uncertainty.