BMA Market Insights: Ringing in 2019 with Greater Volatility, Higher Rates and Geopolitical Risks

While most market practitioners would gladly wave goodbye to the market volatility endured during the last few weeks of 2018, the Bridge Mason Advisors team believes market volatility will remain elevated in 2019. Uncertainty surrounding geopolitical risks, late economic cycle concerns and tighter financial conditions on the back of higher interest rates all set the stage as we kick off the new year. Further, higher interest rates coupled with concerns surrounding trade, particularly between U.S. and China, will likely support sluggish economic growth globally. We believe, however, economic activity globally will pick-up the second half of the year as some uncertainty will have passed.

While trade concerns and higher interest rates were also top of mind this time last year, the weighted benefits of a U.S. fiscal stimulus that was also on the horizon in January 2018 are no longer. Market gurus have particularly been jittery given the late stage in the current economic cycle. Nevertheless, while growth outside of U.S. borders has slowed, U.S. fundamentals continue to remain strong, paving the path for the Federal Reserve to raise rates at least twice (if not more times) this year. The Bridge Mason Advisors team sees U.S. economy humming along in 2019 and anticipates a slowdown in 2020. Here are some key themes to watch out for 2019:

U.S. Economic Fundamentals

Tight labor conditions drive our expectations that the U.S. economy will remain on stable footing this year. The competition for labor should place upward pressure on wages, driving inflation higher. Strong employment and pressure on inflation were indicative in last week’s jobs report: better-than-expected hiring in December’s payroll report (312k versus expectations of 176k) across job sectors coupled with wages surging 3.2% y-o-y, the biggest annual gain in ten years.

Further, a tight labor market will likely fuel economic output through increased buying power as more than two-thirds of GDP is comprised of consumption. Also, lower oil prices have helped grow discretionary income, serving as another driver of consumption. Risks to economic growth include uncertainty regarding the outcome of U.S. trade negotiations with many of its partners, budget concerns, Washington gridlock and that nonfinancial corporate debt levels are close to pre-crisis highs, although debt servicing costs are relatively lower.

• Unemployment level will continue to remain near the historically low level of 3.9%. A slowdown in the growth of employment will carefully be monitored as it has served as a sign for the Fed to press the pause button on rate hikes in past cycles.
• Inflation will likely remain benign. Inflation can be driven higher by increased pressure on wages given tight labor conditions, the higher cost of supplies/goods given the recent tariffs on certain imports to the U.S., rising rents and increased healthcare costs. However, countering these effects is if oil prices remain low on the back of increased supply and low demand.
• Federal Budget Concerns/Government Shutdown
  • The current suspension of the debt ceiling expires on March 1st. If Congress and the Trump Administration does not come to a resolution regarding the debt ceiling, the Treasury Department will lose its ability to borrow in the second half of the year.
  • Federal spending will exceed funds coming in by nearly $1 trillion in 2019, with the deficit increasing by 18% relative to 2018.
  • Likely to see shorter-term treasury rates higher as the government typically funds its budget largely through short-term issuance. Conversely, a continued flight-to-quality play (given concerns outside the U.S.) will likely place downward pressure on ten-year Treasury yields. The end result will be a continued flattening of the yield curve.
  • As the Democrats take control of the House of Representatives, bipartisan compromise will be warranted for any legislation to be passed over the next two years – be prepared for more Washington gridlock.
  • Budget deficit concerns will serve as a drag on the USD.
• The Federal Reserve, by its own account, expects two rates hikes in 2019. If inflation is tempered, there is less impetus to raise rates as the Fed would not want to stymie growth.
  • Outside of the rate hikes, the Fed continues to shrink its balance sheet, which further tightens available liquidity.
  • The Federal Reserve intends to provide greater transparency in 2019, holding a press conference now after every meeting.

BMA Call: The Fed will raise three times in 2019, depending on evolving data, with a strong probability that the third hike will occur late in the year. Our more hawkish stance is because employment continues to be resilient with unemployment near historically low levels and the belief that inflation will hover over the Fed’s target of 2%. Despite the volatile swings in the equity markets of late, there are few signs of concerning asset bubbles. Further, spending legislation passed by the Federal government in late 2017 and early 2018 should continue to stimulate the economy in the first half of the year. There should also be some tailwinds to the economy from the 2018 tax cuts.

While growth may be stabilizing globally, the U.S. has been ahead of many of its counterparts regarding its economic output. Bigger concerns abroad, namely Brexit, fiscal stability in Europe, lower economic growth in China, and the impact of higher rates on emerging markets will fuel demand for U.S. assets in the near term. A trade deal between China and the U.S is supportive of global growth. We believe a trade agreement will eventually come to fruition.

Risks to our projection surround growth moderating or slowing in the latter half of the year or sooner. Tight labor conditions are indicative of a tightening of resources, which may pose a challenge to growth going forward. Also, by the third quarter, the benefits of the 2018 fiscal stimulus and government spending will have subsided. Outside of consumption, government spending (17% of GDP) and business investment (17%) are the largest components of domestic growth. Business investment domestically has precipitously slowed throughout 2018, in part due to lower oil prices and concerns surrounding global growth.

Finally, more acute attention will be paid to any potential negative wealth effects given a weakening housing market coupled with falling asset prices (i.e. stock markets and thereby retirement/investment portfolios). Economic data, both growth and inflation, while obvious, will be key in driving the Fed’s rate trajectory.

Central Bank Activity

When the great financial crisis occurred the Federal Reserve was the first major central bank to ease monetary policy followed by the Bank of England and European Central Bank. So, it may be no surprise that the Fed was the first to hike rates followed by the BoE and the ECB has only recently announced ending its QE program. While both the BoE and the ECB have concerns unique to their local economies to manage, we would expect divergence in monetary policy from both aforementioned central banks compared to the Federal Reserve towards the end of the year.

• European Central Bank: The uncertainty theme extends to the European region given questions surrounding trade with the U.S., a smooth Brexit, fiscal soundness and changes in leadership – all of which may easily impact economic growth and confidence in the area and drive the ECB’s rate decision.
  • The ECB ended its EUR 2.6 trillion bond-buying programs in December, but the bank will continue to reinvest money it receives from maturing securities to soften the bank’s end to quantitative easing. At its December meeting, the ECB held its lending facility at 0.00% and deposit facility at -0.40% with the expectation that it would not raise rates sooner than the fall of 2019.
  • While the market largely predicts the ECB to hike rates in 2020, ECB official Sabine Lautenschlaeger recently noted that if data in the first half of the year reflects inflationary pressure upwards it may warrant a 2019 rate hike.
  • The outcome of ongoing discussions between the EU and the U.S. could also easily affect economic output. For example, U.S. tariffs on German cars could lower German GDP by 0.2% in 2020. Further, the trade tensions between the U.S. and China could have adverse effects on the Eurozone.
  • The region’s fiscal responsibility is currently challenged by Italy’s budget concerns and French President Macron’s recent promise to not raise taxes (to appease the recent demonstrations by the Yellow Vests).
  • Outside of concerns surrounding Italy and France a threat of a no-Brexit deal is also driving confidence down and contributing to a slowdown in economic output for the region.
  • Adding to uncertainty in the region is ECB President Draghi’s term ending on October 31, 2019. Jean-Claude Juncker’s term as the head of the EU Commission also ends this year.

BMA Call: The ECB will raise once in the latter half of 2019. The Euro will face more downward pressure in the first half of the year given the uncertainty surrounding trade talks and fiscal concerns, but as the U.S. eventually breaks on its rate hikes, the Euro will likely strengthen versus the USD on the back of diverging monetary policies.

• Bank of England: The BoE has its hands tied until there is an outcome regarding Brexit, which is scheduled for March 29th. A smooth Brexit could easily pave the path for a rate hike by the bank mid-year. Conversely, a disorderly departure may force the bank to lower rates despite the fact that a bad breakup may cause the pound to weaken and incite inflation. Nevertheless, either a smooth Brexit or another referendum seems more plausible given the disastrous impact of a disorderly exit.
  • The BoE raised its key rate to 0.75% in 2018.
  • BoE Governor Mark Carney is also expected to leave at the end of the year with his successor to be announced by the summer of 2019. Carney extended his term by a year in 2018 to help with Britain’s departure from the EU.

BMA Call: A smooth Brexit will likely call for the BoE to hike at least two to three times in 2019. Moving beyond Brexit, consumer confidence will likely gain traction again, tighter labor markets and upward pressure on wages will ensue. Again, given the slight divergence in monetary policy (a more hawkish BoE vs. a less hawkish Fed), we see a greater probability of the GBP appreciating versus the dollar by year-end.

• Bank of Japan: The BoJ will likely maintain its loose monetary policy as inflation remains below the bank’s target. The export economy will also be sensitive to any trade negotiations with the U.S. and the result of the China/U.S. trade conflict. The key policy rate will thereby likely remain at -0.10% through 2019.

• People’s Bank of China: The PBOC has the balancing act of preventing asset bubbles by tightening policy and yet managing an economic slowdown due to trade tensions with the U.S. While the bank continues to inject liquidity in the market through certain measures, it has refused to cut its policy lending and deposit rate. By doing so, it may incite capital outflows and place more downward pressure on the yuan, particularly as the Fed has tightened policy.
  • To spur investment the government recently announced fiscal stimulus, increased government spending regarding infrastructure and opening the market more to foreign investments.
  • The PBOC has also recently relaxed targets on reserve requirements to benefit loans to smaller firms. The bank cut reserve requirements for banks four times in 2018. The first reserve cut (i.e. 100bps on cash) for 2019 was announced on Friday, which could result in about $210 billion of additional liquidity. More cuts are more expected this year.
  • On the flip side, the bank started tightening liquidity by entering into a smaller amount of reverse repurchase agreements (about 40 billion yuan) relative to the amount maturing (about 110 billion yuan) – thereby reducing liquidity in the financial system last week. Reverse repurchase agreements allow the bank to purchase securities from financial institutions with the agreement to sell them back in the future.

BMA Call: Likely continue to see this balanced approach by the PBOC where it selectively decides how liquidity should be injected into the market. While economic data of late appeared bleak, we see the PBOC continuing to keep its tightening stance on its policy rate to avoid further downward pressure on the yuan.

Geopolitical Risks

Geopolitical risks also take center stage with a number of key elections, trade negotiations and rising tensions most notably between the U.S. and China and the Middle East.

1. Continued trade talks between the U.S. and China, the result of which could have rippling effects on the global economy.
2. Trade negotiations between the U.S. and Japan/U.K./EU.
3. A smooth Brexit remains uncertain, as U.K. PM Theresa May has yet to receive approval from the U.K. parliament on her proposal.
4. Middle East instability, particularly in Iran and Saudi Arabia.
5. Uncertainty surrounding Italy’s budget crisis and if the European Commission will launch an Excessive Deficit Procedure where Italy may face fines and sanctions. Italy is the third largest economy in the EU (excluding the U.K.).
6. Key elections in 2019: Argentina, India, South Africa, Canada, and Australia.
7. U.S. budget concerns – the debt ceiling suspension ends on March 1st.
8. Ongoing Mueller investigation and the potential impact on the Trump Administration.

Other Risks

• Oil Prices
  • Crude prices have fallen about 40% below $50/barrel after reaching a peak last October of more than $76/barrel.
  • Oversupply has pressured oil prices downward. Weaker global growth will likely temper demand, further pushing prices lower.
  • Underpinning higher oil prices is a trade deal between the U.S. and China. A resolution may stimulate the global economy and increase the demand for oil.

BMA Call: Bullish in the short-term with WTI range-bound between $45 and $55. Longer-term, we are more bearish given growing supply and relatively lower demand.

• Emerging Markets faced an exodus capital in 2018 on the back of higher U.S. rates and a stronger USD. Given the strong selloff in EM assets seen last year, we believe 2019 will likely see a reverse in course. As the Fed nears ending is tightening policy, the USD should eventually weaken – a plus for emerging economies. Further, lower oil prices will serve a boon to the sector, in particular for oil-dependent countries such as India and Turkey.
  • Geopolitical risks continue to linger – key elections are scheduled throughout the year from Argentina to India. While Argentina managed to get funding from the IMF, concerns surrounding sustained fiscal stability remain.
  • Tighter liquidity conditions and any fallout of trade negotiations between the U.S. and the rest of the world, in particular, China and Brexit could pressure EM assets. Although, most valuations are starting off from relatively low levels giving way to more upside than down.

BMA Call: We are cautiously optimistic on Emerging Markets. Our more bullish sentiments focus on certain countries including 1) Brazil given the focus on pension reforms and simplifying the tax system and 2) India, given weak oil prices and structural reforms that should help private sector investment.