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Muted replay of 2015 or end of cycle approaching 2019?

23 November 2018

It certainly helped nerves this week that the US was distracted by their Thanksgiving celebrations and politics in the UK calmed down, after the Eurosceptic Tory rebels’ spectacular failure to deliver on last week’s promise to bring about a vote of no confidence against Theresa May’s leadership. Still, stock markets took little notice and continued their decline, fanning widespread discussion over whether a 2019 global economic downturn has become all but certain, now that risk asset markets seem to be anticipating one.

As discussed last week, this feels reminiscent of late 2015 and early 2016, to the point of a déjà vu. Back in Q1 2016, ‘Mr. Stock Market’ was proven wrong by reaccelerating economic growth on the back of Chinese fiscal stimulus and a windfall from lower oil prices, as well as falling credit yields. This time around there is again stimulus from China, though it is admittedly less decisive. But added to this we also see considerable (yet waning fiscal) stimulus from the US. The oil price and bond yields have once again fallen, but nowhere nearly as much as back in 2016.

On the other hand, economic activity has not decelerated as much either and corporate profitability has continued to increase rather than contract. Unfortunately, just as back then, global liquidity supply – read cheap credit – has been reduced just as much if not more by the combination of US central bank monetary tightening, inadvertent Chinese monetary tightening (through their crack down on their shadow lending markets) and the usual retreat of short term risk capital we see once a market correction gets into full swing.

Unfortunately, the advanced stage of this economic cycle increases everyone’s suspicion that it’s about to end, which in itself can create a self-fulfilling prophecy. But there are reasons for thinking that might not be the case. If 2018’s slowdown cools the economy enough to stop major asset bubbles expanding to bursting stage or central banks raising rates too fast, it could merely prolong the cycle even more. Effectively, this correction may have created a far more solid base for 2019 than what we had at the end of 2018. Equity markets are no longer valued as uncomfortably high relative to their aggregate forecast earnings and dividend yields are back in sync with risen bond yields.

This leaves the risk that an external shock or central bank error on monetary policy could render current forecasts unachievable. This explains the even higher than usual attention on central banks’ policy statements and the focus on any potential shocks from politics. We will not hear much from central banks until the end of December, but I would suggest that they are unlikely to become unsupportive of the economy, should markets by then have been proven correct in their implied anticipation of a substantial slow down.

So, back to politics. Over the course of the coming week, US president Trump’s trade war meeting with China’s leader Xi is likely to dominate headlines worldwide. There has obviously been plentiful analysis and speculation as to what may happen, but given Donald Trump’s unpredictability I would suggest there is at least a 50/50 chance for either some form of breakthrough or another couple of months of utter confrontation. A breakthrough because the US president desperately needs a thriving rather than declining economy to stand any chance to get re elected, or confrontation because Trump likes himself most when in ‘deal making combat’. We will know more next week and discuss the outcome here.

Regarding Brexit, we will know more by Monday already, if the EU summit goes ahead as planned. Even after the relative calm in UK politics compared to last week, debate in the media would suggest that we are no nearer to knowing whether the next weeks see May’s proposed EU Withdrawal Treaty terms for Brexit passed or another referendum or even another round of elections.

What we have observed this week is that politicians seem more uncertain about voting for a future relationship with the EU which (at least in the early years) will be less advantageous for the UK economy than the membership status quo, without returning envisaged levels of independence. On the other hand, do they ask the electorate for a second opinion, which will return the country to the level of division across society that proved so painful and divisive 2 years ago and is unlikely to resolve the dispute anyway?

Business leaders on the other hand appeared far more willing to accept the proposed withdrawal terms and leave EU membership and the prospect of regaining full sovereignty behind, given the terms seem much better than they feared.

Either way, the prospect of a no-deal crash Brexit scenario appears to be fading, which was supported by a slight strengthening of the value of £-Sterling against the €-Euro and US$. In the past, this has proven a fairly reliable barometer for the state of Brexit.