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Year-end turbulences heralding difficult 2019?

4 January 2019

Happy New Year and here’s to a more joyful 2019 for investors!

As our 2018 table of asset class returns below shows, 2018 brought even less joy for investors worldwide than we had expected. The only consolation is that it came after two very pleasing years of investment return and did not reflect a similar downward development across the global economy. Indeed, the state of capital market sentiment could not be more contrary to one year ago, while the rate of economic growth has merely fallen back to the previous state of ‘˜slow but steady growth’ which gave us one of the longest economic cycles in history.

Admittedly, looking ahead into 2019 appears more precarious from the UK perspective, given most expected to know by now what shape Brexit would take. With the only consensus seemingly being decisive opposition to a no-deal crash Brexit it is not surprising that the economists’ outlook for the UK is very hesitant, with the majority forecasting a procrastination of the exit proceedings leading to more or less a repeat of the 2018 environment of subdued, below-potential growth in the UK. We have this week dedicated an article to the consensus 2019 outlook of UK economists, as they were spot on with their 2018 forecasts, and capital markets have written down prospects of UK investment assets much more than we believe is justified.

Outside the UK, where the 2019 outlook was not overshadowed by such fundamental paradigm shift potential, unusual year-end market volatility provided unnerving signalling potential for investors. Instead of a pleasing year-end Santa rally, stock markets – particularly in the US – experienced a rollercoaster of flash crashes and flash recoveries as we have not seen in living memory. However, regular readers will know that we anticipated as much on the back of the tight market liquidity in the run-up to Christmas, which had persuaded us to refrain from increasing our equity allocations (after almost a year of being underweight) and in light of the now very attractive valuation levels compared to a year ago. In another dedicated article we therefore discuss the likely drivers of the market action between Christmas and New Year and what it does and does not tell us about 2019.

Turning to more soothing developments, we were pleased to observe that our prediction of a resolution before year-end of the Italian budget dispute with the EU came true and thus removed one of the major European scare stories.
Further East, China’s leadership reemphasised in its New Year messages its determination to follow its long term course of structural reforms towards more ‘self-reliance’ and less dependence on credit growth and export surpluses. Meanwhile, policy action by the Chinese central bank and the bank regulator(to ease credit funding access for hitherto locked-out smaller private enterprises) informs us that the leadership appears to be prepared to do what it takes to counter the inevitable economic reform pain, but without a repeat of the 2015 credit binge of large and state owned enterprises. Early signs of a re-acceleration of the services sector bode well in this respect.Flash market surges provide glimpse of market upside potential

Further East, China’s leadership reemphasised in its New Year messages its determination to follow its long term course of structural reforms towards more ‘self-reliance’ and less dependence on credit growth and export surpluses. Meanwhile, policy action by the Chinese central bank and the bank regulator(to ease credit funding access for hitherto locked-out smaller private enterprises) informs us that the leadership appears to be prepared to do what it takes to counter the inevitable economic reform pain, but without a repeat of the 2015 credit binge of large and state owned enterprises. Early signs of a re-acceleration of the services sector bode well in this respect.

Over in the US the year started with a reminder for the Trump administration that US wealth may be more dependent on trade with China than it would like to admit. Declining Apple iPhone sales in China led to a 10% fall in Apple’s share price, costing investors more than $70 billion in notional valuation losses. It may therefore not be surprising that President Trump is making increasingly optimistic (Twitter) statements about the prospects of a US -Sino trade settlement.

US central bank chair Jerome Powell calmed the other major pre-Christmas stock market concern (of a monetary policy error through overtightening) by stating that the US central bank would take a ‘patient’ approach to raising interest rates and to unwinding its post GFC stimulus. This was very welcomed by markets as it coincided with a surprisingly strong US jobs and wage growth data release for December which would otherwise have further fuelled market concerns over further interest rate hikes. In tune with the previous week’s market volatility, stock markets rallied by up to 4% on the day, leading to a strong start to 2019 for equity investors.

A strong first week does not make a strong year, but the series of recent upward surge days informs us that we are not alone in judging market valuations as having undershot economic reality as much on the downside towards the end of 2018 as they overshot it at the turn of 2017 to 2018. There are many changes and adjustments in train which will continue to cause heightened market volatility, not least because numerous of them depend on political decision-making which has become less predictable in the short term.

Overall though, the developments since Christmas have provided us with more reassurance that Q4 market action has once again been excessively emotional in light of the likely future path of global economic growth: not back to the ‘˜old normal’ as quickly as perhaps anticipated by many a year ago, but nevertheless steady and expansionary – rather than falling off a cliff towards global recession.