Annus Horribilis

With another calendar year in the bag, it is useful to reflect on what happened over the course of the last 12 months before attempting to anticipate what 2019 has in store for investors. When comparing 2018 market performance to the forecasts that constituted the bullish consensus at the start of the year, it is fair to say that the year did not turn out as expected.

2017, lest we forget, saw the first period of synchronized global growth since the global financial crisis a decade earlier.1 To many, it marked the point at which the global economy had finally left behind the period of rolling crises that began with the financial crisis. Economies had finally returned to the equilibrium of macroeconomic textbooks. As such, economic growth was thought likely by many to remain on trend. With the volatility of the post-crisis period behind us, a serene economic expansion was seen as likely to deliver healthy returns for risk assets. Compared to the sunny outlook that prevailed at the start of the year, 2018’s market performance could not look starker.2

If we could first know where we are, and whither we are tending, we could then better judge what to do, and how to do it.

Abraham Lincoln

2018 was remarkable for the breadth of market losses; it was a year in which there really was nowhere to hide. According to data compiled by Deutsche Bank, 2018 was the calendar year with the largest proportion of 72 different assets classes posting a negative total return in dollar terms over the period since 1901.3 2018’s mostly weak market returns are made all the more striking when compared to those of 2017, which was a blockbuster year for returns. The Deutsche Bank data set shows that 2017 was the year with the lowest share of asset classes posting a negative total return in dollar terms since 1901. If 2017 was the year to be out of cash and into anything, 2018 was the year to be out of everything and into cash.

By the end of 2018, concerns about the economic outlook had increased, but for the majority of 2018 the consensus view was that the economy remained resilient (indeed, many appear to believe this is still the case). As such, lackluster market performance was a conundrum. With the economy so robust, market declines must have been attributable to a series of market-driven shocks, wholly unforecastable ahead of time.

Or, perhaps the received wisdom which informed the bullish consensus – namely that market prices reflect economic fundamentals– is wide of the mark.

Money Makes The World Go Round

Financial assets are nominal instruments; they are priced in units of money. The fortunes of financial-asset prices are far more closely tethered to the evolution of the global monetary structure than they are to the ‘real’ economy, particularly over the short term. While this has been true throughout history, it has been even more so in the post financial-crisis world of hyperactive monetary policy. In responding to apparent crises, Adam Smith’s ‘invisible hand’ of the market has been replaced by the not-so-invisible hand of the central banker, and by modern-day mandarins in Beijing. The last ten years have seen both intervene aggressively in financial markets and the economies over which they preside.

As we have outlined previously, we find the ‘crisis-response- improvement-complacency’ framework developed by Robert Feldman useful in seeking to navigate the post-crisis world of state intervention. The last significant ‘response’ began in late- 2015 in reaction to the ‘crisis’ of mounting financial-market stress and economic slowdown. Global central banks embarked on the largest combined intervention effort in history to the tune of over $5 trillion between 2016 and 2017, giving us a grand total of over $15 trillion in central-bank balance sheet expansion courtesy of the Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of Japan.4 In tandem, Beijing implemented a massive debt- fueled stimulus package. It was this collective effort that underpinned the ‘improvement’ in the global economy and delivered the stellar returns from financial markets in 2017. This was an indiscriminate inflation, built on money created by agents of the state.

By understanding this causal link between the balance sheets of state agents and the performance of financial-asset prices, 2018’s market performance did not come as a surprise. The synchronized global growth of 2017 led to ‘complacency’ among policymakers, which in turn led to policy tightening both from central banks and from authorities in Beijing. As a result, 2018 was the year that global money growth stalled. 2018 saw a sharp slowdown in credit creation from both central banks and the private sector. The reversal of the 2016/17 credit surge has led to renewed asset-price declines and waning economic momentum.

Here we go again?

So, with respect to the outlook for 2019, does 2018 constitute another crisis to which we will see another response? Are the state interveners getting ready to play their heavy hand again? While cards are still being held close to chests, there are tentative signs of a response.

Over the course of 2018, in response to flagging economic momentum and ailing markets, a slew of measures were announced to stimulate the Chinese economy, particularly in the second half of the year. However, these measures were not enough to prevent China’s equity market ending the year with the largest decline among the major markets.5 It was notable that in 2018 the authorities were consistently at pains to stress that any easing would be measured and consistent with realizing longer- term strategic objectives. It appeared that policymakers were still prioritizing financial stability rather than economic stability, as has been the case since the second half of 2017. However, with China’s economy continuing to slow into the year-end, and with data suggesting its manufacturing sector had contracted for the first time since 2016, have policymakers begun once again to prioritize economic stability?

The People’s Bank of China began the year by announcing that the reserve requirement ratio (RRR) would be cut by 1%, reducing the share of deposits that commercial banks must hold in reserve at the central banks, thereby injecting $117 billion into the banking system.6 This is the latest, but perhaps most concerted, effort to boost lending by the central bank which largely resisted calls for aggressive monetary easing in 2018. It appears that the fiscal pumps are also being primed.

The National Development and Reform Commission, China’s top planning agency, has approved urban rail projects in eight cities and regions worth a total of $125bn. China is set to add 6,800km of rail lines this year, a 40% increase from the amount of track laid in 2017. This surge in project approvals stands in sharp contrast to the beginning of 2018, when Beijing abruptly cancelled the construction of subway lines in several cities to slow the growth of local government debt.7

It has not taken long for the authorities to fall back on that time-honored vehicle for extravagant malinvestment- debt-fueled transport infrastructure. It is clear that recent months have seen a gradual shift in focus away from deleveraging towards fiscal and monetary stimulus.

Patient Powell

Despite the previously untroubled US equity and credit markets joining the global sell-off in the last quarter of 2018, the Fed administered another 0.25% rate hike in December and confirmed it would continue to follow the predetermined plan to reduce the size of the central bank’s balance sheet.8 This was despite growing calls from market participants and commentators, including President Trump, for the Fed to stop tightening monetary policy. Following the rate-setting meeting, the market sell-off accelerated over the final two weeks of the year, rolling over into the opening week of 2019. Perhaps unsurprisingly, Chairman Powell appears to have had his hand forced by the markets.

When joining a panel discussion at a meeting of the American Economic Association meeting in Atlanta (on January 4, 2019), Powell was not expected to discuss monetary policy, given the occasion came only two weeks after the last Fed press conference. He immediately pulled out some prepared comments, perhaps crafted over the previous 24 hours of rapidly deteriorating global market conditions.

Powell hit all the right notes for those in markets baying for a dovish Fed: “As always, there is no pre-set path for policy and, particularly with muted inflation readings that we’ve seen coming in, we will be patient as we watch to see how the economy evolves”.9 Powell stoked expectations of a pause in further rate hikes by referring to the 12-month hiatus that followed the December 2015 rate hike as an example of the Fed’s willingness to be flexible in response to changes in financial conditions. While Powell stated that the Fed does not believe the reduction of its balance sheet was in any way a cause of the market turbulence in the fourth quarter, he went on to say that “if we came to the view that the balance sheet normalization plan — or any other aspect of normalization — was part of the problem, we wouldn’t hesitate to make a change”.10 In homage to those with whom he shared a stage (former Fed Chairs Bernanke and Yellen), he noted that crisis-era tools worked, and that the Fed is prepared to use them again.

Back to the races?

The market reaction to Powell’s comments was telling. The S&P500 rallied by over 3.4% on the day, suggesting that the bull market lives on.11 While the strike price of the Powell Put may have been lower than that of the Yellen or Bernanke Put, rest assured it remains in place. But is it enough?

Certainly, Powell showed more sympathy to the plight of financial markets than he had been willing to do on previous occasions. It is also clear that monetary and fiscal policy in China is set to provide more support in 2019 than it did in 2018. But the Fed is not the only central bank in town, and a pause in US rate hikes is not guaranteed to arrest the ongoing tightening of global liquidity. On the other side of the ledger, the ECB ended its own €2.5 trillion asset-purchase program in December, and for now the Fed continues to reduce its balance sheet by $50bn per month.12 Meanwhile, the stimulus announced by China falls well short of that seen during 2016/17.

As it stands today, we believe that this is not a repeat of the combined global stimulus that reflated the global economy and markets in 2016 and 2017. Perhaps the cavalry will come, but it remains distant at the start of 2019. It is possible that policymakers could potentially repeat the trick of 2016/17, but as yet we cannot be certain that global money growth is about to pick up.

The Ugly Truth

The sharp bounce in asset prices in response to a few sentences from a central banker on the last day of the first week of 2019 was not a vote of confidence in the economic outlook. It was more a replay of the vote of confidence in the ability of central banks to do ‘whatever it takes’ to ensure the continued inflation of financial markets. But while it is possible that we are on the cusp of policymakers responding to the ‘crisis’ of 2018, the true crisis is the system that has been created by decades of inflationary policies.

As the ECB brings its asset-purchase program to a close, it is worth reflecting on the continuing political upheaval across Europe. It serves as an important lesson to those who champion inflationary policies. Proponents of quantitative easing (QE) no doubt expected the printing of€2.5 trillion of new ‘money’ to have, at least for a period, worked to pacify the masses over which the ECB presides, by boosting demand. Detractors of unsound money and credit are anything but surprised by heightened political instability throughout the eurozone.

Bubbles are instruments of redistribution. The bubbles inflated by QE have, we contend, only served to exacerbate inequality; those with assets have seen their wealth inflated, while those without have seen them become unaffordable. Politicians have been complicit, with inflationary policies perpetually alleviating them of the need to address structural issues requiring difficult choices and reform.

However, such short-termism has only exacerbated structural challenges. By preventing the purging of misallocated capital, and sustaining excesses, central banks have ensured the factors of production are structured in a fashion that does not produce the output necessary for governments to deliver on their respective social contracts. The French ‘gilets jaunes’ are the latest manifestation of this societal sclerosis.

This is the crisis that stems from inflationary policies, but you won’t hear that from a panel of inflation- targeting central bankers.


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