2019 – A Year of Synchronized Global Slowing

It was widely expected at the start of 2019 that the year would be the mirror image of 2018, with policy easing seen as likely to bring an end to the global slowdown and pave the way for markets and economies to get back to the business of 2017’s synchronized global acceleration. With the calendar year now closed, we can see that this did not come to pass, at least with respect to arresting the slowdown of economic growth. If 2017 was the year of synchronized global growth, 2019 was the year of synchronized global slowing.

Where the year did look a little more like 2017 was in financial markets, at least some of them. When Federal Reserve (Fed) chair Jerome Powell announced an end to monetary-policy tightening on January 3, 2019, he set the touch paper to an equity market rally that went on to deliver the best year of the decade for global equities, with the MSCI All Countries World Index returning 26.6% in US-dollar terms.1 Underpinning the rally was a sustained easing of global liquidity conditions, which encouraged credit spreads to tighten and equity valuations to expand. Earnings growth, however, was near non-existent in aggregate, reflecting the continued deceleration of economic growth.

Given that deceleration, not all markets echoed 2017. Global bond yields continued to decline, while industrial commodity prices moved steadily lower over the course of the year. Despite the cumulative easing efforts of the Fed, the US dollar remained firm (at least until late in the final quarter). This was perhaps the most conspicuous signal that, while the Fed engineered an easing of global liquidity conditions over the course of 2019, it did not bring about a return to the state of excess liquidity that had characterized 2017. Emerging-market equities and currencies, the most sensitive to shifts in global liquidity, continued to underperform developed markets for much of the year.

Keep on Pumpin’

As noted in the previous quarter, in the face of the continued economic slowdown, central banks around the world had eased monetary policy at a faster rate than at any point since 2009. The fourth quarter of the year continued in this vein, with the Fed center stage. In the wake of September’s bust-up in the ‘repo’ market (in which banks lend cash to other institutions in exchange for collateral such as US government debt), which saw overnight borrowing rates spike sharply higher, the Fed launched various liquidity facilities intended to bring an end to the stress in the dollar funding markets that had been steadily rising all year. The central bank began purchasing Treasury bills to the tune of $60bn a month, and launched a repo facility which proceeded to grow in size over the quarter.2

The Fed was at pains to stress that this did not constitute a return to quantitative easing.3 However, its balance sheet did once again begin expanding over the fourth quarter – rapidly so. The Fed was successful in quelling the stress in the dollar funding markets. Unlike in previous years, there were no signs of funding stress over the year-end. The Fed went large, and it seems to have worked. Over the final quarter of the year, the dollar began to decline – a tentative indication that aggressive easing may have engineered a meaningful improvement in global liquidity conditions.

A Possible Inflection Point?

It was not just a weakening US dollar that engendered the change in liquidity. Price action from other areas of the financial markets was helpful to global liquidity conditions, particularly in the offshore dollar system (the locus of 2018’s deflationary forces). Bond yields rose towards the end of the year, and, having inverted in the third quarter, albeit fleetingly, the US yield curve steepened.4 Industrial metal prices stabilized and, perhaps most importantly, emerging-market equities began to outperform their developed-market counterparts. Credit spreads also tightened conspicuously.

In isolation, none of these developments are indicative of a change in the macro financial regime, but, taken together, they indicate a possible improvement in economic growth momentum.

With respect to economic data, it is far from conclusive that the global deceleration has come to an end. Of the major economies, only China’s appears to be in the process of reaching a trough. The US, Europe, Japan and the UK continued to slow into the year-end. It is premature to conclude that we have seen an inflection point in the short-term growth and liquidity cycle. That said, market prices lead hard data, and there has been enough in the price action and data over the final quarter of 2019 to take seriously the possibility of an inflection point and the likelihood that 2020 might see an acceleration of global growth.

The Year Ahead

With liquidity having eased so considerably over the course of 2019, one of the major risks to markets is much diminished. Following 2019’s central bank efforts, the US arguably has its easiest monetary conditions ever relative to economic circumstances, albeit that the same is not true elsewhere. In the era of modern central banking, expansions tend to come to an end owing to monetary tightening (often seen as a ‘policy error’), or because of problems in credit markets. As we move into 2020, neither looks to be a likely event in the near term. Central banks are on hold (with a bias towards further easing), while credit spreads moved decisively lower over the fourth quarter. There are idiosyncratic credit stresses, such as in high-yield US energy and in China, but it is erroneous to suggest that credit stresses are systemic in nature.

In the final quarter of 2019, investors were able to cheer the favorable resolution of two key geopolitical risks that had troubled them over recent years. First, with respect to the US-China trade tiff, a further increase in tariffs was avoided on December 15, with a ‘phase one’ deal agreed that involves a partial roll-back of US tariffs on imports from China.5 While things remain far from rosy between the two nations, this amounts to a de-escalation. Secondly, there was a breakthrough in Brexit talks, followed by a general election which resulted in a decisive victory for the governing Conservative Party, reducing the probability of a disruptive ‘no-deal’ Brexit.6

Investors’ attentions were no doubt set to turn to the US presidential election later in the year, and it would have been tempting to suggest at the turn of the year that the current US administration was unlikely to do something to upset the apple cart in an election year. The recent killing of Iranian general Qassem Soleimani clearly escalates tensions between the US and Iran. While this may as yet have consequences for the oil price, an all-out war between the two countries appears unlikely, and it is likely to be of little consequence in terms of how the US or global economies pan out over the year ahead.

‘Show Me’

The unofficial motto for the State of Missouri is ‘show me’. Following the stellar returns of 2019, that piece of Midwestern skepticism feels particularly relevant as we enter the new year. 2019 saw one of the largest expansions of valuation multiples for global equities in the last 30 years. The forward price-to-earnings multiple for the MSCI All Countries World Index expanded by 28% over the course of the year. In the last 30 years, only 2009, a year coming out of the teeth of the worst financial crisis in more than 80 years, saw a greater expansion.7 Multiple expansion ahead of better economic data is normal, but multiple expansion on this scale requires a ‘show me’ moment for earnings. With the bar raised, 2020 is about one thing: delivering.

History shows that multiple expansion has usually been followed by better earnings-per-share growth. It also shows that good returns can follow multiple expansion, but not always. Unsurprisingly, the best returns have come when earnings growth has really delivered, while the worst returns have come when earnings growth has disappointed.

Should global growth stabilize and potentially accelerate in 2020, as 2019’s multiple expansion suggests it will, earnings growth would be likely to follow too. However, while an inflection point in the short-term growth cycle may be on the cards, the relatively subdued nature of the likely acceleration means that 2020 earnings growth is also likely to be muted. Given the high bar set by the magnitude of 2019’s multiple expansion, there is a risk that earnings disappoint, which history suggests could provide a challenging environment for broad equity-market returns. The theme of ‘show me’ is likely to apply over the full course of the year ahead. It is those companies that are able to deliver earnings growth that are likely to fare best.

Build It, and They Will Come

Perhaps fiscal policy will help earnings live up to expectations in 2020. Discretionary fiscal policy was given a brief outing following the financial crisis over a decade ago, but at the June 2010 G20 meeting, the assembled leaders, perhaps thinking the global economy was on its way to recovery, advocated a shift towards consolidation given concerns about fiscal sustainability. This left central banks as the only game in town when it came to economic policy. However, more than ten years of monetary policy experimentation has seen central banks largely fail to deliver on their respective primary objectives, let alone engineer a return to the pre-crisis ‘trend’ rates of growth that fade further into the rear-view mirror with each passing year.

Even unconventional monetary policy looks exhausted. Short-term central-bank interest rates are close to zero in the eurozone and Japan, and stand at a mere 0.75% in the UK. In the US, the Fed was unable to get rates above 2.5% in the recent upswing, and its headline rate is now back down to 1.75%. Ten-year bond yields are also below zero in France, Germany and Japan, below 1% in Spain and the UK, and below 2% in Italy and the US.8 Room for action in response to a significant downturn is limited. Historically, the Fed has cut rates by as much as 5% in response to a recession. That would take US rates to -3.25% from the current level.

Meanwhile, there is mounting skepticism about negative interest-rate policy in just about every corner of the globe. Sweden’s Riksbank, the world’s oldest central bank, officially ended its experiment with negative interest rates in December, an act that was widely interpreted as a message about the damage that can come from keeping yields suppressed for too long. The relative economic performance of those economies that have been subjected to negative interest rates versus those that have not does not argue in favor of negative interest rates. While former Fed Chair Ben Bernanke made the case for negative interest rates in his address to the American Economic Association’s January 2020 meeting,9 the tide looks to have turned against negative interest-rate policy.

Instead, fiscal policy is increasingly getting the nod, with the global slowdown of 2019 only seeing more people and institutions add their voices to the call for fiscal policy to play a greater role in the management of economies. It is starting to look like a matter of when, not if, governments will loosen the purse strings.

We have long anticipated that extraordinary monetary policy would not deliver the type of economic recovery desired. We had anticipated that another recession would be necessary before fiscal policy would play a greater role, but it looks increasingly likely that this will not be the case.

It takes many to dance the economic ballet that delivers price stability and economic growth.

Christine Lagarde, President of the European Central Bank (ECB)

In the US, the fiscal deficit has been steadily widening since 2016, and in the UK both main parties in the December election campaign promised greater fiscal spending, with the new Conservative government scheduled to announce its new fiscal program in March.10 In the meantime, the government in Japan passed a fiscal stimulus package in December, while the European Central Bank’s new President Christine Lagarde is leading the charge in Europe. Calling on governments to introduce policies that are more conducive to growth, she remarked that it “takes many to dance the economic ballet that delivers price stability and economic growth”.11 In Germany, while Angela Merkel’s government is unlikely to change the policy of fiscal restraint for which the country has become so well known, it is worth noting the victory of a left-wing team – who favor the introduction of a large stimulus package – in a recent leadership election for Germany’s Social Democratic party, a partner in the governing coalition.

Gold Keeps Sparkling

Perhaps it is the growing calls for governments to adopt more active fiscal policy outside of recessions that has revived the price of gold over the last year and a half, and particularly over the last six months. In the wake of the global financial crisis, gold rallied on the belief that low interest rates would usher in inflation. On April 11, 2013, gold staged a sudden and dramatic crash, dropping 13.5% in two trading days. 2013 marked the year when there was a growing recognition that inflation was not going to arrive as expected, at least not in goods and services. 

On January 6, 2020, the spot price of gold in dollars recovered sufficiently to overtake its price from April 11, 2013,12 confirming its emergence from the bear market established that day. Since 2013, real yields and gold prices have tended to track each other. Lower real yields have been accompanied by a higher gold price. If gold is set to continue to advance from here, real yields are likely to need to move lower, either through higher inflation expectations or lower nominal rates. Rather conveniently for gold, more activist fiscal policy makes the prospect of declining real yields very real indeed.

A greater role for fiscal policy does not mean that monetary policy will be abandoned. Interest rates will have to be kept low in order to finance larger and sustained fiscal deficits. We should expect interest-rate control and, in due course, the central bank to be crediting the government account. Should economic policy increasingly channel money into the real economy rather than the financial markets, there will almost certainly be a sustained acceleration of inflation as measured by the goods and services that make up consumer price inflation baskets. Financial repression and accelerating inflation will usher in lower real yields – conditions that make the yellow metal sparkle.

1 Source: Bloomberg, 12.31.19
2 https://www.wsj.com/articles/fed-will-purchase-treasury-bills-at-least-into-second-quarter-of-2020-11570806265
3 https://www.forbes.com/sites/greatspeculations/2019/12/11/is-the-fed-gearing-up-for-a-new-round-of-quantitative-easing/
4 https://www.ft.com/content/2d7c0a62-2b1e-11ea-bc77-65e4aa615551
5 https://www.theguardian.com/business/2019/dec/13/china-confirms-phase-one-trade-deal-us-tariffs
6 https://www.bbc.co.uk/news/election-2019-50765773
7 All data sourced from Bloomberg, 12.31.19
8 Source: Bloomberg, 12.31.19
9 https://www.cnbc.com/2020/01/06/ben-bernanke-the-fed-shouldnt-rule-out-using-negative-interest-rates.html
10 https://www.theguardian.com/uk-news/2020/jan/07/budget-2020-sajid-javid-brexit-tax
11 https://www.ecb.europa.eu/press/pressconf/2019/html/ecb.is191212~c9e1a6ab3e.en.html
12 Source: Bloomberg, 01.06.20

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