Waiting on the Policy Makers
Review of
2018
US
Global growth has maintained its steady
S&P500
state with growth in 2018 very similar to 2017. Unfortunately, the uncertainty of trade wars and loss of momentum in some emerging and developed countries led to downgrades to global growth forecasts in the latter part of the year. After years of loose monetary policy, the tightening seen from higher US interest rates and reduction of QE is weighing on the global economy.
Interest rates. The Federal Reserve stuck
to its guns and increased interest rates four times over the course of the year. Some of the emerging countries were forced to follow if only to protect their currencies. The eurozone and Japan were mostly unmoved although the ECB at this stage is keeping to its plan of reining in its quantitative easing. Most of the interest rate excitement was in the emerging markets. Turkish interest rates for example rose from 7.25% to 22.5% after a currency collapse and a large increase in inflation.
Geopolitics Populism is all the rage and
manifesting itself in many ways. President Trump’s tax giveaway wasn’t good economics, but it was very popular. Trade wars initiated by President Trump were another way he wanted to appear popular without carefully thinking through the consequences. Brexit was popular but maybe less so now. However, the result of the vote is to place the UK economy at risk of a significant downdraft in 2019. Populism in mainland Europe manifested itself in green jackets, the demise of Angela
1
Review of 2018
-6.2%
Brazil
Global Developed
Bovespa
MSCI
15.0%
-10.4%
Emerging markets
-16.6%
Merkel’s governing coalition and the prospect of a substantial lurch to populist/extreme parties at the upcoming European elections. Populist leaders in Turkey, Mexico Brazil, Venezuela to name just a few are leaving their mark.
Equities Equities started on a positive note but as the year closed many were halfway towards a bear market (a drop of 20% from a peak). The best individual returns in markets were in the emerging markets. Russia and Brazil were the stars
Equity market capital returns
Russia
UK
FTSE-100
-12.5%
RTX
18.1%
Eurozone Eurostoxx 50
-14.3% Switzerland SMI
-10.2%
China
Dubai
Shanghai Index
DFM
-24.9%
Saudi Arabia Tadawul
8.80%
India
-24.6%
Sensex
7.2%
Japan Nikkei 225
-12.1%
Abu Dhabi
11.7%
Singapore Straits times
-9.8%
Source: Bloomberg
up close to 20%. Russia’s performance was all the more remarkable given ongoing sanctions and the drop in the oil price. Most of the winners have been emerging markets. Emphasising the point that the emerging markets are not a homogeneous group of countries, China at the other end of the spectrum of returns was down 20%.
markets suffered more. European markets cracked earlier, weighed down by individual country political challenges. Japan muddled through the year at around the average with bursts of excitement that things may be getting better giving way to concerns about the still lack of ability of policymakers to create inflation.
The US with the benefit of President Trump’s fiscal boost to the economy saw its equity market lead the pack in the early part of the year. However, just as commentators were heralding a new bull market trade wars and higher interest rates have broken the back of the market’s advance. Other
The most significant change to the equity asset class through the year was the pick-up in volatility. Equities were at one point taking on the risk characteristics of some bonds (9%). As the year closed, equities were back to their traditional risk characteristic with a volatility of 25%.
Review of 2018
2
Chart 1 Performance of major asset classes through 2018 110
Dec 31 2017=100
Global Equities
105
100 Global Bonds 95 Gold 90
85 Dec-17
Feb-18
Apr-18
Jun-18
Aug-18
Oct-18
Source: Bloomberg
Bonds Bond yields have been on the rise almost ever since the year started. The US 10-year began at 2.40% rising to a peak of 3.23% in November. However, as we closed the year, the yields fell, though still higher than where they started the year. The most significant change has been in spreads, risky bonds have sold off more than government bonds. Emerging market debt has moved from a spread of 300bps to 435bps with quite a pronounced sell off in the past couple of months. A stronger dollar and higher US interest rates put the asset class under pressure for much of the year. 0.9% Global aggregate High yield bonds maintained good performance for much of the year very much in keeping with the performance of US equities. However, when the sell-off came, it was violent. Global High Yield 1.7% The high yield bond spread (over US government bonds) has jumped from around 300bps to 527bps in a virtual straight line since September.
Bonds
-2.7%
-1.7% Source: Bloomberg (total returns)
3
Review of 2018
Global Investment Grade
Global Emerging market $ debt
Real estate
While there are some hot spots – Hong Kong residential, in general real estate markets are feeling the heat from higher interest rates and government measures that were initially brought in to cool the market but in fact, are now contracting the market. In the UK Brexit uncertainty
has been another factor to batter the sector. The UK’s Royal Institute of Chartered Surveyors (RICS) recently noted that the UK has the weakest property market in some six years. The price balance in their October survey at -11 was the lowest reading since September 2012. Buyers and sellers are sitting on the sidelines with record low numbers of residential properties for sale. US real estate is likely to end the year with some modest positive returns. Rental growth is annualising 2-5%, with industrial property seeing the most robust growth and office the weakest. In Hong Kong, a real stand out for price appreciation in recent years, there is evidence a weakening of the market. Home prices have fallen by 1.4% in the past month. The share prices of leading real estate companies are down close to 20% suggesting the underlying market could be set for some weakness through 2019.
-1.80%
Gold
Oil (WTI)
5.60%
Commodities
Gold has broadly flat-lined for much of the
year. The strength of the dollar and rising US$ interest rates mostly held the metal back from showing absolute gains. However, at the yearend, the violent sell-off of asset classes has led investors to start to return to the market. Investors may remember that it took a little while for gold to perform in 2007/08 despite the obvious backdrop of trouble in the global economy.
Iron Ore
-11.0%
Copper -5.10% Source: Bloomberg
The dollar has remained almost omnipotent through the year. The dollar
struggled in the early weeks of the year until confirmation of President Trump’s giveaway budget. The resulting acceleration of US growth and higher interest rate expectations pushed the dollar higher. Over the course of the year, the currency gained over 5% on a trade-weighted basis. Sterling started the year well only to fall away as the problems of Brexit became more real. Emerging market currencies faced the most significant challenges, the 6% fall in the value of the Indian rupee was symptomatic of the problems faced amongst the EM bloc.
Review of 2018
4
Global economy in 2019 Rolling over or re-accelerating? Judging by the way that 2018 ended, 2019 is going to prove a challenging year for the global economy. Many of the previous drivers of global growth appear to be on the wane. Over the past decade, the global economy and financial markets have benefitted from near zero interest rates, quantitative easing (free money), and sharp increases in government spending. Initially these actions saved the world from a depression and eventually boosted global growth. The hope of a re-acceleration in growth appears to depend on some outside factor helping the global economy. The recent sharp fall in oil prices will for example help to bring down inflation and should make consumers feel they have more spending power. However, there are probably just too many factors working against growth in the coming year.
5
Global economy in 2019 - Rolling over or re-accelerating?
To quote the IMF Global growth for 2018–19 is projected to remain steady at its 2017 level, but its pace is less vigorous than projected in April (2018) and it has become less balanced. Downside risks to global growth have risen in the past six months and the potential for upside surprises has receded. (World Economic Outlook 2018).
Table 1: IMF GDP forecasts 2015
2016
2017
2018E
2019E
2023E
Advanced Economies
2.3
1.7
2.3
2.4
2.1
1.5
US
2.9
1.6
2.2
2.9
2.5
1.4
Euro Area
2.1
1.9
2.4
2.0
1.9
1.4
Japan
1.4
1.0
1.7
1.1
0.9
0.5
UK
2.3
1.8
1.7
1.4
1.5
1.6
Emerging and developing economies
4.3
4.4
4.7
4.7
4.7
4.8
China
6.9
6.2
6.9
6.6
6.2
5.6
India
8.2
7.1
6.7
7.3
7.4
7.7
Source: IMF
The positive factors going into reverse Interest rates – were very low, now rising Around the world we are seeing central banks raise interest rates and/or market interest rates have risen. The key driver has been the rise in the US Fed funds rate that has risen 200bps from its low. In effect whatever the Fed does, many other central banks have had to mirror. The good news is that maybe the Fed is not going to press on with further interest rate increases in 2019. But it is also bad news that the Fed may not increase interest rates in 2019 because that would reflect weaker US growth.
Global economy in 2019 - Rolling over or re-accelerating?
6
Central banks full on Quantitative Easing goes into reverse The flows of liquidity are however starting to dry up. As well as near zero interest rates, the global economy has had the benefit of substantial flows of liquidity flowing driving asset prices higher. But, the Federal Reserve has already started to withdraw money from the programme. Also, the ECB is in the early stages of reversing their QE. The Bank of Japan continues to increase its QE although at a slightly lower rate.
The ECB is in the early stages of reversing their Quantitative Easing
Chart 2 Central Bank Quantitative Easing no longer at full throttle 700
Rebased to Jan 2004=100 600
500
400
300
200
100
0
04
05
06
07
08 US Fed
09
10
11
12
Bank of Japan
13
14
15
16
17
18
ECB
Source: Bloomberg
7
Global economy in 2019 - Rolling over or re-accelerating?
Governments were spending now they are tightening their purse strings A further source of stimulus to the global economy has been government spending. Significant fiscal deficits have not just been a feature of the world financial crisis. In the past twelve months, President Trump pushed on with a significant package of tax cuts and spending increases. The package served to boost US growth and ignite a positive mood in much of the global economy. However, in recent months the market is seeing the package for what it’s worth – a one-off even that the US government cannot afford to repeat. Indeed, in much of the developed world there is little appetite for significant increases in government spending.
Chart 3 Government deficits as % of GDP 2.0 0.0 -2.0 -4.0 -6.0 -8.0 -10.0 -12.0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 EU
Germany
Japan
UK
USA
China
Source: IMF/OECD
Trade wars have become a new source of angst for the global economy and markets are unlikely to go away. The US administration is fighting a rear-guard action to defend against the inevitable competition that comes from the ongoing rapid growth of BRIC countries.
Global economy in 2019 - Rolling over or re-accelerating?
8
United States
The reality is that trend real GDP growth in the United States is somewhere around 2%
Simply unsustainable
To misquote a great US icon - Buggs Bunny - “That’s (probably) all folks”. The great US economy has had a great year. 2018 growth with the benefit of a massive fiscal boost and the tailwind of low interest rates is likely to be around 4.0%. However, in 2019 it is back to reality. The reality is that trend real GDP growth in the United States is somewhere around 2%. The markets have got a sniff of the slowdown and don’t like it.
The absence of a fiscal stimulus It is easy to forget that until President Trump came along with his massive budget package of tax cuts and spending increases economists were worried. Economic data was in a slump in June 2007. The US economic surprise index was down at -72 in a range of -100 to +100. By the time of the implementation of the President’s budget that same indicator was at +80 (Chart 1). The Trump Administration tax cut package is estimated to have added 0.6-0.8% to GDP growth in 2018; we expect that will fade to a net stimulus of around 0.3% in 2019 (Peterson Institute for International Economy source).
Chart 1 US Federal Debt to GDP expected to rise sharply on assumption of no change in policy 160 Forecast
140
120
100
80
Previous WW2 peak
60
40
20
0
1968
1978
1988
Source: Bloomberg
9
United States- Simply unsustainable
1998
2008
2018
2028
2038
2048
Chart 2 President Trump’s fiscal giveaway has also left a legacy of debt that can only impede growth in the future. The Congressional Budget Office believes that the deficit in annual deficit in 2019 could reach $1 trillion up from $779 billion in 2017. Not only are the sums of money extraordinary but it is unprecedented that the deficit is increasing at such a favourable point in the economic cycle. Often the government would be generating a surplus at this stage to allow room for borrowing when things get tough. Aggregate government debt is now at $21.9 trillion We are a long way from 2000 when the government generated a surplus of $236 billion, and the national debt was less than $6 trillion.
US Economic Surprise index peaks with the budget delivery 100 Budget delivery 80 60 40 20 0 -20 -40 -60 -80 -100 Jun-17
Aug-17
Oct-17
Dec-17
Feb-18
Apr-18
Jun-18
Aug-18
Oct-18
Dec-18
Source: Bloomberg
United States- Simply unsustainable
10
An economy operating at full capacity The US economy is a decade into its recovery from the world financial crisis. As the recovery has taken shape, it has slowly absorbed much of the spare capacity, particularly in the labour market. Economy’s don’t grow forever they eventually run out of steam as they use up all the spare resources. The unemployment rate is now below 4%, the lowest since 1969. Further growth could have come from companies investing and improving productivity, but unfortunately, companies have
preferred to spend their money on buying back their shares in effect reducing their capital deployed in their businesses rather than invest in the future. Economies simply don’t grow as fast in the absence of available workers or acceleration of investment. One point made by the Financial Times recently highlighted the problem of tax breaks feeding only marginally into investment. The five big US companies — Apple, Alphabet, Cisco, Microsoft and Oracle — increased capital investment 42% year on year to $42.6 billion. Yet they also spent a massive $115 billion buying back their own stock.
Increased capital investment to
The five big US companies
$42.6 billion... ...but spent
$115
billion on share buybacks
11
United States- Simply unsustainable
The Fed turns less accommodating The days of free money from quantitative easing and near-zero interest rates are now behind us. The Fed has stated its intention to take away the easy monetary conditions. Although we don’t sense that they will adopt a contractionary monetary stance, at least for the moment, equally the markets will miss the easy money conditions that were a significant contributor to previous good growth in the economy.
Slowdowns are never that smooth Developments in 2018 have in our view sowed the seeds of a significant slowdown in US growth this coming year. We know from bitter experience that these significant shifts in momentum are never smooth and this cycle looks to be no different. The good news is that with consumer price inflation remaining constrained, the Federal Reserve is unlikely to be tightening aggressively.
Bottom line is that the US economy can no longer be relied up on to be a major engine of global growth in 2019. For a variety of reasons, we may have seen the best from the US economy in this cycle. That said with so many challenges in Europe and Japan it may still be the case that the US provides relatively better growth than many other parts of the world – such a view will ensure that the US dollars strength does not unravel too quickly from current levels.
United States- Simply unsustainable
12
Populism Needs Enlightenment President Donald Trump, Brexit, The Philippines President Duterte, Indian Prime Minister Narendra Modi, Brazilian President-elect Jair Bolsonaro, yellow jackets in France – all are examples of what people might characterise as Populist geopolitical events that shook the world in recent years. There is no sign that the Populist movement is easing off. Populism is manifestly affecting asset markets. As investors we need to make judgements about its pace and how it will morph. Quite frankly, populism is to us as important as trying to fathom out what the Federal Reserve will do next with interest rates. Every day the market is trying to interpret the next tweet from Populist President Trump. And in
recent months, Populist Brexit has undermined UK equities and the currency. It is easy to be dismissive of populism as a socalled fad in the hope that it will pass. However, we believe there is something deeper that needs watching. We would prefer to see populism as a driver for change, something more akin to a new age of enlightenment rather than the negative connotation of populism. Unfortunately, populism is often coined as if popular thinking is in some way wrong and only for the masses. However, in our view, populism is about people picking on micro issues because they can’t articulate or are maybe unaware of the more fundamental problems. A case in point is in the anti-immigration movement. Antiimmigration protests have occurred over centuries if not millennia. The issue is often not immigration but something else. In the current situation, the problem is more likely to be a lack of wage growth or very poor distribution of wealth. The underlying issues are not the fault of the migrant but more a problem with the tax system, social welfare funding or a drop in trade union power.
Table 1 Short term populist thinking often leads to poor outcomes Demand Nationalism
Near term consequences Trade Wars Arms race
Long term consequences
Market consequences
Slower global growth
Risk markets hurt
Redistribution of wealth
Wealth taxes
Uncertain
Hard assets such as property lose value, stronger consumption helps stock market
Anti-immigration
Labour shortages, lead to higher wages and higher interest rates
Weaker long terms growth due to declines in growth of workforce
Restricts returns on risk assets
Fight crime
Populist leaders
Poorly executed economic policies
Economic crisis, hyper inflation and falling asset prices
Source: Purple Asset Management
13
Populism Needs Enlightenment
At the core, populism is a call for fresh thinking, a break with the past, a new age of enlightenment The world faces severe challenges from climate change, ageing populations, the integration of technology, and huge government debt. However political leadership and global institutions have largely failed to deliver sustainable solutions. One would have hoped that the world financial crisis would have brought about remarkable change to send the world in a more positive direction. But part of the reason for the growth of populism is that the world financial crisis never brought significant change. There was something obscenely wrong with the way that the very people and institutions that were at fault for the crisis
are still broadly in business. There was a great opportunity to break with the past and create something that was inclusive and new, but the opportunity was missed. Instead, that central bank policy of quantitative easing kept the global economy on a path of giving ever greater rewards to capital over labour. In essence nothing changed. Our hope that out of the all the challenges put up by populism that a more positive momentum evolves around solving some of the immediate challenges for the world. Whilst we would concede that changes needed to manage climate change and ageing populations carry with them a near term burden on economies and financial markets, the longer-term positives are potentially much more rewarding.
Table 2 Facing up to the true structural challenges would lead to better outcomes Positive change
Near term consequences
Fight climate change
Carbon industries hurt hard by increased tax, green technologies receive massive support
Long term consequences Less catastrophic outcomes, less forced migration Reduction of government debt
Market consequences
Near term, pain long term gain
Reduction of long-term interest rates, better long-term growth
Redistribute wealth
Progressive tax systems
De-escalate global conflicts
Better for global growth and trade
Stronger global growth and more rapid development of emerging countries
Positive outcome for emerging market assets
Engage with ageing populations
Positive engagement with older people to keep them in the workforce
Stronger growth as there is mitigation of decline in global workforce
Lower inflation, potentially lower healthcare cost.
Control technology
Largest companies become more heavily regulated
Humans feel less intimidated by technology
Better technology that is harnessed, and not controlling of lives. No risk of global domination by any one country or corporate
Refinance welfare system
Source: Purple Asset Management
Populism Needs Enlightenment
14
UK Brexit – Just how good or bad?
will miss out on between two and ten percentage points of GDP over the medium term. Which end of the spectrum the UK will find itself will depend on the nature of the future agreement with the EU and under what circumstances it leaves the EU. The worst outcome for the economy will be a disorderly exit that has nothing in place to replace EU membership. The Bank of England made a worst-case estimate that unemployment would rise to between 5.75% and 7.5%, with inflation at between 4.25% and 6.5%. In their opinion, this would bring about a policy response from the MPC where interest rates might have to climb to as high as 4%. We stress this is a worst-case scenario, but you always must be prepared for adverse outcomes.
As we write Theresa May has just won a confidence vote and will spend the next week trying to win some concession from her EU colleagues. Only then might she be able to get her plans through Parliament before her deadline of January 21st, 2019. However, how bad do the experts believe Brexit will be for the UK economy and what might its impact be on the financial markets? Economists universally believe that Brexit will be bad news for the economy. Academic research and major institutions such as the IMF and OCED believe that the UK economy
Chart 1 Impact of Brexit on the level of GDP over the medium term (%) Dhingra and others 2017 CEP (2018, inc. productivity adj.) HMG (2018) OECD Long run HM Government (2018) IMF NIESR (2018) Vandenbussche et al (2017 trade) Oxford Economics (2016) PwC (2016) CEP (2018) Felbermayr et al (2018) Dhingra and others (2017) Open Europe (2015) -12
-10
-8
-6
-4
-2
Source: IMF
15
UK Brexit – Just how good or bad?
0
Unemployment
Inflation
Could the pound have fallen too far? Sterling is already close to all-time lows on a trade-weighted basis — the fall from grace since the Brexit vote took the Sterling broad trade-weighted index down from 87 on the day of the vote to 75 today. The weakness of sterling will worry the central banks as could usher in much higher inflation in the future. Indeed, if you look at the level of future inflation priced into the bond market is currently 3.6% up 60 basis points since the middle of last year. We have to agree that a good measure of trouble is already priced into sterling. However, we sense it would be a shock still if the UK left the EU in a disorderly way. Hence talk of a drop to say $1.15 is possible, but we would assume that the pound would rebound off such a level. Should the situation ever resolve with the UK staying in the EU, sterling could easily rebound 10-15%.
would rise to between 5.75% and 7.5%
between 4.25% and 6.5%
Source: Bank of England
Chart 2 Looking at UK asset markets there is already a fair amount of bad news seemingly priced into the market.
UK Broad Trade Weighted Sterling back to lows 110 105 100 95 90 85 80 75 70 65 60
93
95
97
99
01
03
05
07
09
11
13
15
17
Source: Bloomberg
UK Brexit – Just how good or bad?
16
The UK equity market has continued its steady relative decline against the global market index. As Chart 3 shows, we are at the lowest relative level in over 25 years. So, despite the benefit to UK based companies of having a generally weaker sterling, UK companies have not been able to take advantage of. Again, we would expect a knee-jerk negative reaction if the UK left the EU in a disorderly manner. However, we should remember that the UK market generates the majority of its earnings from overseas markets.
Chart 3 Relative Performance of the UK equity market against global equities in local currency 250
200
150
100
50
0
69 72 74 77 79 82 84 86 89 91 94 96 98 01 03 06 08 11 13 15 18
Source: MSCI and Bloomberg
Taking a view on UK bonds is more hazardous given the range of outcomes. We are very mindful of the Bank of England’s belief that a disorderly exit from the EU would lead to a burst of inflation and chance of a sharp increase in interest rates. The UK gilt market already prices a 5-year inflation rate of 3.6%. For the moment the Bank of England is not addressing the inflation risk as they are fearful of how they would handle the loss of growth from the current uncertainty due to Brexit negotiations. In other circumstances, short-term interest rates would have probably continued to rise.
17
UK Brexit – Just how good or bad?
The UK gilt market already prices a 5-year inflation rate of 3.6%
Chart 4 Chart 4 shows that UK shortterm interest rates remain very low and the gilt yield curve very flat. Should Brexit prove more damaging to growth it is entirely possible that short-term interest rates rise to head off inflation, but longterm interest rates drop as the market fears the deflationary impact of higher interest rates on longer-term growth. Hence long-dated gilts might still offer some protection against Brexit, but we have to stress that its very hazardous investment environment and our conviction level with any view is low.
Higher UK short rates may drive lower long rates 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00
3.00 2 -10 yield spread (rhs)
2.50 2.00 1.50 1.00 0.50 0.00 -0.50
short term interest rates (lhs) 92 94 96 98 00 02 04 06 08 10 12 14 16 18
-1.00 -1.50
Source: Bloomberg Note: Chart shows three month ÂŁ Libor and the yield spread of two year and 10 year gilts.
UK Brexit – Just how good or bad?
18
Opportunities in 2019 UK assets: Even before the crisis in risk markets at the end of the year, UK assets had already fallen a fair way. For international investors, the fall in UK assets was compounded by a fall in the value of sterling. With UK equities at a long-term low relative to global markets and sterling at what many believe to be a very cheap level we think there is merit in looking to bottom fish in the UK.
Chinese equities: China is big, and China will
Infrastructure The ASCE estimates the US needs to spend some $4.5 trillion by 2025 to fix the country’s roads, bridges, dams, and other infrastructure
grow. Like any emerging market, there are times when investors overly worry about some of the structural challenges that face the country. Before the sell-off of markets, China was one of the significant underperformHealth care ers of the year. However, the underlying economic growth rate of 5-6% helps Healthcare spending growth China to grow out of its problems. At a in Asia Pacific is running at 20% compared to 10% in US and near 10-year valuation low we expect Europe (Singapore Business) Chinese equities to come back onto the radar of buyers in 2019.
Where there is true growth Technology With the Nasdaq already in a bear market, we suspect that investors will be sniffing around the technology sector for opportunities in early 2019. As a general principle, we prefer small and medium-size companies to giants such as the FAANGs that have led the sector’s previous good performance. We are concerned that big tech will face increasing scrutiny from regulators and governments around the world.
Technology by 2025, wireless voice and data networks will be available to every human on earth. 3 billion more people will be connected to the internet
Health care Technology is collaborating with traditional healthcare to bring significant advances that show massive potential in the future. Old healthcare, particularly drug companies
19
Opportunities in 2019
dependent on old product portfolios may find themselves under ever-increasing pressure from governments trying to rein in healthcare spending.
Infrastructure Climate change meets governments looking to have an excuse to spend. High government debt will mean that governments are under pressure to only spend on essential projects. Ageing infrastructure in western countries provides an excellent reason for governments to support their economies. Also, climate change puts much of that Gold infrastructure under pressure with flooding and extreme temperatures only accelerating the demise of ageing Gold rose 180% between August bridges, and roads. 2007 and September 2011
Safe equity income will be king
Government debt US government 10-year bond yields dropped 225bps in 2008
Given the recent wild gyrations in capital values of assets ageing populations will be keen to seek out safe yields from equities. Consumer staple companies, REITS, very selective financial and energy companies come to mind as potential sources of solid dividend yields and income growth that may appeal.
Risk diversifiers Gold – as we argue in another sec-
Interesting to know...
tion of our report, we believe gold is poised to provide some good returns in 2019. That being said, we think you don’t have to just see the metal as a source of return but as a way of providing risk mitigation against fears of a significant sell-off in markets. Note that back in the financial crisis of 2007-09 gold did not make its outsize gains until late in the crisis.
Government debt – investors will need
the safety of what is coined a risk-free asset. US Treasuries are often the asset of choice during a crisis. Back in 2007-09 it was one of the very few assets that displayed its negative correlation with the equity sell off.
Opportunities in 2019
20
Bonds- The Going Gets Tougher After nearly five decades of strong performance, bond markets now face a much stiffer test. For the 40 years from 1969 through to 2008, the S&P500 index returned 9% and so did 20-year Treasury bonds. And yet the equity market had 50% more volatility than bonds. Bonds truly had an exceptional period. Decades of falling inflation and short-term interest rates have provided a very robust but unrepeatable backdrop for bond markets. Looking forward, bond markets seem unlikely to have such solid support. Each bond sub-asset class will be assessed by investors on their individual merits with the tailwinds of global disinflation no longer available. Since the world financial crisis, investors have been lulled into a false sense of security with bonds. Two things are wrong with recent history; firstly compound returns have been exceptional and secondly risky bonds have appeared almost riskless. The latter stages of 2018 have been a wake-up call, and there could be more trouble ahead.
Chart 1 Recent year total returns from bonds are unrepeatable 240 220
140 Global Aggregate total return index (rhs) 130
200 180
120
160 110 140
Global high yield total return index (lhs) 100
120 100
90 80 60 2007
2009
2011
Source: Bloomberg
21
Bonds for all seasons
2013
2015
2017
80
A weakening global economy and the scaling back of quantitative easing by the Federal Reserve and the European Central Bank will be a significant headwind to the performance of riskier bond markets. Sizeable purchases of bonds by central banks have provided an almost guarantee of solid performance from even the riskiest corporate bonds in recent years. While we have our reservations about riskier bonds, long-term government bonds have good natural support from insurance and pension funds looking to buy long-term assets to match their long-term liabilities. Ageing populations in the west also
provide good support as many people approaching retirement tend to de-risk their portfolios and buy high-quality bonds. Also, if we are indeed facing a recession in the coming year, government bonds are probably your friend. Going back over seven recessions, in the first half of that recession, bonds provided much better (and positive returns) to at least in part compensate for the poor performance of equities. The only time this didn’t happen was in 1973/74. The oil crisis led to a sharp climb in inflation naturally dragging down the performance even of bonds (Table1).
Bonds for all seasons
22
Table 1 US Government bond returns outpace equities in early recession
Start date
End date
In-sample correlation
Dec-69
June-70
0.47
Nov-73
Jul-74
0.02
Jan-80
Apr-80
0.17
Jul-81
Mar-82
0.41
Jul-90
Nov-90
0.66
Mar-01
Jul-01
-0.16
Dec-07
Sep-08
-0.61
Chart 2 The US 10-year government bond yield has dropped sharply into the turn of the year reflecting concerns over the outlook for global growth and the still limited sight of significant inflation pressures. We suspect that yields will be biased lower and hence see longer-dated US government bonds as a good risk diversifier in the coming year‌ as history shows
US 10-year government bond yield with a downside bias 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Bloomberg
23
Bonds for all seasons
Lower quality bonds are likely to have a tougher time if economic activity markedly weakens
Total return Equity
Total return Bond
-19.5%
5.3%
-15.2%
-3.5%
-5.6%
5.3%
-11.2%
12.9%
-8.3%
3.6%
4.8%
0.7%
-19.3%
4.5%
Source: PIMCO, equities based on S&P500, bond returns based on US 10-year government bond total return index
High yield bonds, in particular, tend to have some of the characteristics of equity and hence can display high volatility during periods of economic stress. Also, there are concerns that high yield bonds have weakened their covenants, in essence, reducing the quality of the collateral that backs a bond in the case of default. However, even with all these challenges for the asset class, high yield debt should not be written off. After all, your starting yield of around 7.4% in dollar terms offers a good return to absorb some of the possible losses. An actively managed portfolio of high yield credits in an environment of a muddlingthrough global economy, with monetary conditions that are not too tight, could still eke out a positive return in 2019.
UK gilts have a mixed outlook The lack of clarity on Brexit is having a significant dampening impact on the economy leading to calls for interest rates cuts. However, the likely cost of Brexit to the government must increase the likely supply of bonds in the coming years. Throw into the mix the attitude of the Bank of England who is keen to raise interest rates in the absence of a marked setback in the economy from Brexit and the outlook for gilts is particularly complicated. UK gilts will, however, continue to be in good demand from institutions particularly insurance companies. New legislation will require UK insurance companies to allocate more of their reserves to gilts in the future probably at the cost of demand for equities.
Bonds for all seasons
24
Equity Markets In Search of Conviction Equity markets have turned the year in poor shape. Fears over the outlook for global growth and some poor corporate news have put markets into a tailspin. Fear is finally taking over from greed. How far investor fear will take markets in the coming months is difficult to discern. Market sell-offs tend to exacerbate the weak points of the global economy and financial system. We would, however, see the sell-off in markets as an opportunity to build positions in countries, industries and investment strategies that are well placed for the future.
investment flows over the longer term. If anything, the current challenges in the financial markets are putting into focus the difficult outlook for developed countries of slowing GDP growth and structural imbalances. China for sure has its problems, and a one-child policy has for sure brought down its growth rate in recent years however the country still has significant potential for growth. Changing political leadership in parts of Latin America will increase the hope that at least some countries can realise the potential of significant natural resources and growing labour forces. In India, the prospect of a Prime Minister Modi pressing on with his economic reforms post a likely win in upcoming elections should keep investors engaged.
IMF GDP Forecasts see emerging and developing outpacing the growth of developed economies
Countries- Emerging markets We expect the premium growth available in the emerging markets to continue to attract strong
2015
2016
2017
2018E
2019E
2023E
Advanced economies
2.3%
1.7%
2.3%
2.4%
2.1%
w1.5%
Emerging and developing economies
4.3%
4.4%
4.7%
4.7%
4.7%
4.8% Source: IMF
Sectors – keep with growth Infrastructure In the developed world, although governments are probably loathing to increase still further their debt burden, the need to upgrade infrastructure is too urgent to ignore. Much of the developed world’s
25
Equity Markets
infrastructure is in urgent need of major repair or upgrading. Japan for example after the lining of one tunnel collapsed with a loss of lives; they set about replacing the lining of many of the country’s 9760 tunnels (with a total length of over 4000km). The United States received a D+ from the Association of Structural engineers for its infrastructure in 2017 however to date little has been done. President
Trump has been more focussed on building his ‘Mexican Wall’ than making funds available for critical infrastructure. That will have to change. Worldwide infrastructure spending is expected to double between now and 2025.
Technology This is not the year 2000 bubble. Technology companies of today have real businesses with revenues and very transparent strong growth prospects. Our preference is to stay away from the FANNGs that may be challenged by greater regulation (Facebook, Alphabet) and natural product decline (Apple) in the future. For example, Deloitte in its annual UK Technology Fast 50 identified some of the winners of the future. Those fifty companies had achieved an average four-year growth rate of 2,176%.
Healthcare
have been ballooning in many parts of the world, but government budgets are increasingly under pressure. For investors, judicious investment in those companies that have good revenue growth coupled with an ability to maintain margins will be paramount. Companies that have novel drugs that serve a large market and those that bring technology that can save costs will be the investments of choice in a growth sector.
Investment Strategies- Investing for income. Many of the world’s equity markets now have dividend yields above their respective long-term government bond yields (Table 1). While equities have higher volatility than government bond yields, for long-term investors who can whether the possible short-term capital losses, holding equities with reasonable yields and the prospect of good dividend growth can prove a rewarding strategy.
Ageing populations give significant support to the growth of the healthcare sector in the coming years. The one important caveat to the sector’s growth will be affordability. Healthcare budgets
Table 1 Selective countries and their dividend yields and government bond yields Country
Equity market dividend yield
10-year government bond yield
United States
2.21%
=2.56%
Euro area
4.02%
0.15%
UK
2.23%
-0.05%
Japan
4.94%
1.19%
China
2.75%
3.10%
Australia
4.76%
2.19% Source: Bloomberg
Equity Markets
26
Look Through Trade Disputes, and there’s Growth in Asia Sino-US trade relations will dominate Asian markets in 2019 with much of the political friction hopefully behind us. Regional GDP growth rates continue to be robust, albeit slightly softer than at the height of the equity boom. Inflation rates are at the low end of central bank tolerance ranges. Absent an aggressive rise in US rates, and the US dollar, Asian central banks shouldn’t need to raise interest rates. Having fallen a long way Asian equity markets are now cheap, on a relative basis, compared with G7 markets. Asian fixed income offers better risk-adjusted returns than US fixed income, particularly high yield. Moreover, Asian FX has already endured some downside as the US has raised rates. On a relative basis, Asian equities and fixed income look in much better shape in 2019 than they did for most of 2018.
27
Asia Outlook
China with corporate debt at almost 300% of GDP, can’t open the credit floodgates as it did in 2009.
Chart 1 MSCI Asia ex-Japan relative to MSCI World 120
110
100
90
80
70
60 2007
2009
2011
2013
2015
2017
Source: Bloomberg (Jan 2007 = 100)
US trade-war: President Trump looking for ‘The Deal’ The most important marker for 2019 will be the on-going stand-off between US President Donald Trump and China. At the G20 summit in late 2018, the US gave China extra time to start to open its markets before the US hiked its tariffs from 10% to 25%. The US has set 1 March as the new deadline. It is unlikely that the US establishment wants tariffs at 25%. Trade makes us wealthy, and trade reacts badly to rising tariffs. The Chinese certainly don’t want US higher tariffs. That can be seen by China’s hurried rush to redraft President Xi Jinping’s China 2025 plan to rapidly increase the market share of Chinese companies in home markets. However, the warning to investors is that a delay in implementing higher tariffs usually only happens once. It thus seems likely that China will eventually make the necessary gestures to avoid substantial tariff hikes. With corporate debt at almost 300% of GDP China can’t open the credit floodgates as it did in 2009. The US President, having
Asia Outlook
28
emerged from the mid-term elections with some bruising, is looking for an early deal and the chance to claim victory. The ball is in Beijing’s court. Our view is that this spat will remain a drag on markets in the first quarter, but then a still robust outlook for world trade and GDP growth should dominate financial markets.
Politics: an opportunity, providing China offers concessions, and North Korea stays quiet Three other critical political events occur outside of China with those in India and Indonesia giving additional encouragement to market reformers. India holds a general election in April and May with Prime Minister Narendra Modi’s National Democratic Alliance having suffered some setbacks in state elections towards the end of 2018. But the microeconomic reforms instigated by PM Modi have yet to fully bear fruit. PM Modi has spent five years formalising markets and streamlining the tax system to reduce fiscal waste. Even with a more slender majority, these reforms will continue to reward growth-focused investors. Indonesia’s President Joko Widodo is seeking re-election in April and faces Prabowo Subianto, the same challenger as in 2014. For markets, the incumbent president represents a more orthodox policy menu, and there appears little reason to vote Subianto second time around. With inflation low and Bank Indonesia (BI)
29
Asia Outlook
Chart 2 China’s domestic market share targets (%) 0
10
20
30
40
50
New energy vehicles Hi-tech ship components New & renewable energy equipment High performance medical devices Industrial robots Large tractors & harvesters Mobile phone chips Wide body aircraft 2020
Source: Stratfor
2025
60
70
80
in no need to raise interest rates a second term for PM Widodo would be positive for local markets. Lastly, Japan’s House of Representatives (Upper House) holds elections in July for 121 out of 242 its seats. These are less important than elsewhere unless the governing Liberal Democratic Party suffers a significant drop in seats that robs it of the two-thirds majority in both houses that provide for constitutional reforms. Voting polls show this as unlikely, and Prime Minister Shinzo Abe looks set to remain in full control of his Abenomics policy agenda.
Don’t forget forex, US dollar gains hurt in 2018
often mean local currency fixed income isn’t hedged either. Ignoring FX risk cost investors dearly in 2018. From around the middle of the year both the Chinese Renimbi and Indonesian Rupiah came under particular pressure (Chart 3) In 2019 the risk of foreign exchange either adding to losses or reducing returns will diminish. Notwithstanding a rapid drop in the value of EURUSD, which the consensus does not expect, the value of USDCNY and the CNY basket should remain stable through 2019. There was less sign of intervention in the second half of 2018 as capital outflows dropped off and the trade balance began to shrink.
Chart 3
Fund managers don’t tend to hedge their equity exposure to Asian markets. High-interest rates
Asian FX has fallen already 115 Currencies against the dollar (Dec 2017=100) Indonesian Rupiah
110 Chinese Renminbi
105 Taiwan Dollar
100
95
90 Dec-17
Feb-18
Apr-18
Jun-18
Aug-18
Oct-18
Source: Bloomberg
Also, we don’t expect the US Federal Reserve to raise interest rates more than twice in 2019 although the market is discounting less than a 50-50 risk of a further rate rise. Without rising interest rates and faster US growth to boost the US dollar we expect Asian currencies to trade flat or mildly higher in 2019, favouring exposure to Asian markets.
Asia Outlook
30
Gold your Friendly Asset Class in 2019
Central banks are buying gold at the fastest rate in some six years.
It’s time for gold in your wealth planning.
The Egyptian Central Bank is buying gold for the first time since 1978.
Gold is one of the oldest asset classes used in the wealth planning. As a recognised store of value, it was the asset class of choice for many centuries. In our financially sophisticated world of stock and bond markets and exotic derivatives, it is often overlooked by investors. In our view, gold always has a role to play particularly when the global economy faces some challenging times.
Russia, has accelerated its purchases of gold
Chart 1 Gold price sideways since 2013‌ but positives building 2000 1800 1600
1400 1200 1000 800 600
400 200 0 2001
2003
2005
2007
2009
2011
Source: Bloomberg
31
Gold your Friendly Asset Class in 2019
2013
2015
2017
There are many supports for the gold price.
Central bank buying Central banks are buying gold at the fastest rate in some six years. Central bank buying doesn’t per se have a significant impact on the price of gold, given that they often buy directly from their country’s mines. However, the fact that more and more emerging market countries are adding to their gold holdings can only add to gold’s credibility as a valid currency for retail investors. The Egyptian Central Bank is buying gold for the first time since 1978. India, Indonesia, Thailand and the Philippines re-entered the market after a multi-year absence.
Gold is one of the
oldest asset classes used in the wealth planning.
The geopolitical challenges that many countries have had with the United States is prompting many Central banks to diversify their reserve holdings away from the US dollar. Russia, for example, has cut by four-fifths its holdings of US government bonds, while accelerating its purchases of gold.
Chart 2 Central bank Net Cumulative Purchases (tonnes) 400 350 300 250 200 150
100 50 0
Jan
Feb 2013
Mar
Apr 2014
May
Jun
2015
Jul
Aug
2016
Sep
Oct
2017
Nov
Dec
2018
Source: Macquarie
Gold your Friendly Asset Class in 2019
32
Doubts over the financial sector
However, to quote the IMF in its September 2018 Financial Stability report:
The recent marked underperformance of the bank sector in global equity markets (Chart 3) has investors somewhat concerned about a 2008 type crisis breaking-out. Note the pronounced strength of the gold price coincident with the significant underperformance of the global banks sector against the global equity market from 2007-2012. Banks have never recovered their loss of relative performance. The sector has recently again started to underperform. To date that underperformance is not on a par with what we saw in the dark days of the global financial crisis. However, the sector still appears vulnerable.
Medium-term risks to global financial stability and growth remain elevated. A number of vulnerabilities that have built up over the years could be exposed by a sudden, sharp tightening of financial conditions. In advanced economies, key financial vulnerabilities include high and rising leverage levels in the nonfinancial sector, continued deterioration in underwriting standards, and stretched asset valuations in some major markets. Total nonfinancial sector debt in jurisdictions with systemically important financial sectors has grown from $113 trillion (more than 200 percent of their combined GDP) in 2008 to $167 trillion (close to 250% of their combined GDP). Banks have increased their capital and liquidity buffers since the crisis, but they remain exposed to highly indebted companies, households, and sovereigns; to their holdings of opaque and illiquid assets; or to their use of foreign currency funding.
Central banks have been at pains to show that their stress tests show that banks are well prepared for any challenges ahead.
Chart 3 Global banks equity sector shows marked underperformance against the market 2100
(Jan '07 = 100)
1900
110 100 90
1700
80
1500
70
1300
60
1100
50
900
40
700
30
500 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
20
Gold prices (lhs)
Banks relative (rhs)
Source: Bloomberg
33
Gold your Friendly Asset Class in 2019
On a more tactical basis, some of the headwinds to gold’s absolute performance are in abeyance. It appears that the Federal Reserve is not minded to raising interest rates significantly from here. High US interest rates tend to put investors off from holding gold that is a non-yielding asset. Secondly, with the dollar rising against many other currencies, the assumption is that dollar strength is bad news for gold. That is not always the case; from late 2007 to March 2008 both the gold price and the dollar rose. The gold price rose 50% at a time of extreme risk aversion, with both the dollar and gold performing together as defensive assets. Although the gold price subsequently fell back in 2009, the metal eventually went on to post a high of $1900 in 2011. Crucial for momentum to gather in any gold price rise, will be evidence of buying by retail investors. Back in October 2018, ETFs backed by gold saw a pickup in interest from retail investors. These ETFs had retail buying equivalent to 23 tonnes of gold in October and further buying through November.
In 2007/08 the gold price rose 50% at a time of extreme risk aversion, with both the dollar and gold perform together as defensive assets.
Chart 4
Retail buying of gold shows signs of recent modest strength Gold backed ETF’s holdings of gold 90 Million of Troy oz
80 70
60 50 40 30 20 10 0 2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: Bloomberg
Gold your Friendly Asset Class in 2019
34
The Complexity of Oil Market Likely to Keep Oil Prices at their Recent Lows The oil market always could deliver surprises, but its complexity has stepped up with the wane of OPEC’s power, and the increasing scale of US production. Also, the situation has become more complicated because of the gap between the cost of producing oil in any given country is often less relevant than the price a country needs to break-even on its government budget. Saudi Arabia is a case in point; the country’s marginal cost of production is probably below $10, but its government needs a price over $80 to cover its prolific spending. There has also been a more fundamental shift in OPEC behaviour in 2018. While in the past many OPEC countries would talk about the aim of targeting a certain price of oil. Now the conversation is much more
Chart 1
OPEC estimates 31.4m b/d of crude will be needed from the bloc to balance markets, more than 1.5m b/d less than what the bloc produced in November.
Oil prices are down sharply from their 2018 highs
CRUDE OIL
Source: Bloomberg
35
The complexity of oil
about maintaining a stable oil price. As 2018 closed, they appeared to have achieved neither. Oil market commentators have highlighted that President Trump’s comments that OPEC was operating as an illegal oligopoly manipulating oil prices higher have not fallen on deaf ears. Indeed, the US President’s remarks have been followed up by moves to call out OPEC as price manipulators which could kick off sanctions and other legal steps in the United States. OPEC, wishing to avoid such a scenario, appears to have changed strategy and acted to stabilise the market. There was a recent agreement between OPEC and Russia to 1.2 million barrels per day of output cuts starting from January 2019. Russia and other non-OPEC countries made their contribution of 0.4 mb/d cuts to add to OPEC’s reduction of 0.8mb/d. However, this is seen more like an attempt to stabilise prices rather than push prices higher. The agreed cuts in production, in any case, were undermined to some extent by reductions to the forecasts for oil demand from both OPEC and the EIA for 2019. The reports point to a tougher year ahead for OPEC countries as both cut their projections for the demand for OPEC production in 2019. OPEC estimates 31.4m b/d of crude will be needed from the bloc to balance markets, more than 1.5m b/d less than what the bloc produced in November.
level of oil prices. OPEC may have hoped that the fall in production from Venezuela and sanctions on Iran would have supported oil prices; however, the latter has been diluted down by the US acquiescing to individual cases for countries such as India to continue to import Iranian oil. Also, as we turn the year US onshore supply will benefit from new pipelines coming on-line, particularly in the Permian basin, US output can only continue to climb to new records. The oil price finished the year at the low end of its 12-month range, and we see little reason to believe that will change much in 2019. The days when OPEC action could meaningfully sustain an oil price at elevated levels now look well gone absent a significant geopolitical fallout. The scale of both US and Russian production is keeping OPEC in check, and hence the oil price in 2019 is likely to reference generally weak demand growth and pockets of global oil production. Oil prices are likely to stay near their 2018 lows.
Chart 2 Forward pricing of Brent oil shows little change by end of 2019
Oil supply looks biased to the upside. Oil market supply now appears to be more dominated by suppliers who are price takers rather than price manipulators. OPEC, more than ever, has to share the world stage in the oil market with the United States and Russia who are both able to compete with Saudi Arabia regarding the scale of output. Unlike Saudi Arabia, neither Russia or the United States are so sensitive to the Source: Bloomberg
The complexity of oil
36
Real Estate Beware of Wealth Taxes and Climate Change Real estate has been an asset class of choice for investors the world over. Partly it has been due to some of the exceptional returns that we have seen over the past three decades and partly because people in many parts of the world have preferred to own their own property rather than rent. Our concerns over real estate are manifold. Firstly, we can’t see how the past strong growth of real estate prices can be repeated in the future. Real
estate returns have been a huge beneficiary of the (unrepeatable) marked drop in interest rates over the past three decades. Secondly, bricks and mortar are a strong candidate for a tax attack by populist governments looking to raise revenues. Wealth taxes are part of an increasing agenda of governments seeking to redistribute wealth and/or increase revenues to pay down debt. Around the world, wealth taxes are few and far between, however, there is decidedly more discussion about them. Indeed, ironically it was Donald Trump in 1999 who suggested a 14.25% tax on people worth $10m or more to help pay off the national debt of $5.7 billion. Those wealth taxes would now need to raise $22trillion!
Very Limited wealth taxes around the world Argentina
1-1.5% of wealth for resident and nonresident
Bangladesh
a surcharge based on wealth, charged on income tax
France
payable by residents and non-residents on real estate
Germany*
abolished in 1996
Greece
Individuals are subject to wealth taxes
Netherlands
local taxes on real estate
Norway
Tax on capital exceeding NOK1.5m at 0.85%
Poland
rates determined by municipalities
Russia
Cadastre value of residential property (0.5%) and residential (2%)
Spain
Payable by non-residents on value above Euro700k. Taxes progressive from 0.2% to 3.03%
Switzerland
Levy determined by the Canton based on net wealth of the individual
Source: UHY Real Estate Guide 2017
37
Real Estate Review
Climate change is a further
factor to consider when investing in real estate...
Selling points such as sea view and ‘on a river front’ are no longer seen as necessarily positive factors when assessing the value of a property. Research early in 2018 showed that properties exposed to rising sea levels sell at a 7% discount to comparable properties not subject to climate-related risk. In Australia, they have developed a website to see what the risk of flooding might be on any part of Australia. In the United States, natural disasters in Florida and North Carolina are leaving many properties uninsurable. With more than 3.8 million households altogether, North Carolina has only about 134,000 flood insurance policies (source: In the UK current estimates are that in the next 50 years British winters could be up to 23% wetter and summers 24% drier. The summer of 2018 was the joint hottest in England on record. Owners
have been encouraged to include green roofs, sun shielding, water resistant doors, raised electrical sockets, rainwater harvesting and cement floors in their properties design. For those who invest in commercial property, climate change and general environmental issues are becoming much more important in the valuation of the real estate asset. Some developers see business merit in showing clients not only what the carbon impact is of their real estate Properties investment but also exposed to rising sea levels sell at a how climate change is affecting their portfolio.
discount
Sources 1. http://iopscience.iop.org/article/10.1088/1748-9326/aabb32) Jesse M Keenan, Thomas Hill and Anurag Gumber 2. http://coastalrisk.com.au/ 3. insurance journal November 2018
Real Estate Review
38
Risks for 2019 Worse but more normal 2018 has ended the year with financial markets’ risk very elevated. However, to a degree we are only seeing the normalisation of risk in the markets after many years of below normal levels. In particular, the end of major quantitative easing has taken away one of the major factors supressing the volatility of markets in recent years. Whatever the challenges in 2019 we can expect their impact on the financial markets to be maybe magnified relative to eth experience of recent years.
Chart 1 Marked rise in both bond and equity market volatility 40
6.50
35
6.00 5.50
30 US 10 year bond volatility Index (rhs)
25
5.00 4.50
20 4.00 15
3.50
10
3.00
Equity volatility Vix Index (lhs) 5
2.50
0 Dec-17
Mar-18
Jun-18
Sep-18
Dec-18
2.00
Source: Bloomberg
Climate change
•• •• •• ••
Extreme climatic event causes more visible and costly damage to a major economy Insurance losses, damage to near term growth. the world takes more seriously the risks from climate change.
Wage growth takes off Central Banks may push on with aggressive interest rate increases. Equity markets sell off on fears of narrowing margins. we start to see some redistribution of wealth which may mitigate some of the populism.
39
Risks for 2019
Falls in asset prices causes set back in global growth
•• •• •• ••
The machines disturb the markets by persistently selling as the riskiness of markets rise.
bad news for global growth and companies pause their investment programmes for fear of investing in a country locked out of trade.
•• •• •• ••
the fall in the outlook for economic growth leads central banks to pause helping liquidity conditions.
Hard Brexit
near term GDP growth falls and unemployment starts to rise. central banks hold off on further monetary tightening.
Trade tension escalate still further
A series of corporate debt defaults leads to a major repricing of corporate bond risk
•• ••
liquidity in corporate debt markets could dry up causing major challenges for investors and companies that need to rollover their debt.
marked falls in risk asset classes and declining liquidity. they get properly regulated in the future.
More Populism movements take to the street bad news for incumbent governments. new political movements motivated to spend money supportive of growth equities eventually do well but government bonds and central bankers don’t like it.
••
although we believe still a remote possibility there is a risk of an extremely disrupted UK economy until processes and procedures are hastily negotiated.
•• •• ••
it’s difficult to see one
Sharp setback in European and Asian we would expect central banks to step in economies sends the dollar still higher and try to stabilise what would by then be a disorderly market. Asian currencies and fixed income markets under pressure German and swiss equities benefit from competitive exchange rates
Risks for 2019
40
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