The slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike in interest rates by the US Federal Reserve on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will still be able to raise interest rates next year. As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes has already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. I doubt Macron will recover from this debacle. I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.
Red cups at Starbucks, a festive range of bags at Marks and Spencer, special window displays on the lit-up and decorated high street – can only mean one thing – Christmas is coming. However, for me, what really signals the arrival of the holidays is the arrival of The Nutcracker. This family-friendly ballet set to Pyotr Ilyich Tchaikovsky’s famous notes “The Nutcracker” originated in Russia. It made its debut at the Marinsky Theatre in St. Petersburg in 1892, a year before Tchaikovsky’s death and is based on “Nutcracker and the Mouse King,” an 1816 story by German author E.T.A. Hoffmann which tells the story of a little girl Clara, her toy nutcracker and their adventure in a kingdom of sweets at Christmas time. The original version was panned by critics and wasn’t performed outside Russia in its entirety until 1934 when Nicholas Sergeyev staged it at the Sadler’s Wells Theatre in London. In the US, The Nutcracker didn’t become popular until 1954 when George Balanchine’s (a Russian-American ballet dancer turned choreographer) production for the New York City Ballet – complete with a Christmas tree rising out of the stage – hit the mark with the audience and an American tradition of watching the ballet at Christmas was born. This ballet has everything – fantasy, love, spectacle and the music is brilliant and familiar because it is out of copyright and therefore has featured in countless advertisements. Some reports suggest that this one ballet accounts for 40-50% of the annual revenues for professional ballet companies.
Source: Moscow Ballet (www.nutcracker.com)
Whilst The Nutcracker is a festive treat, what theatregoers don’t realise is that they are watching an important period of history. Russians living in St. Petersburg who saw the ballet for the first time were part of a generation experiencing a level of prosperity never seen before in history. The Industrial revolution had brought rich dividends to Europe and the US, and Russia was very much considered a part of Europe then. The middle class lived in secure and comfortable homes with amenities such indoor plumbing, an electric stove, radio, television, and even hair dryers! It was a time of innovation and prosperity in Europe and the US. The decade that was the 1890s brought forth so many ideas and inventions that the Commissioner of the US Patent Office at the time, Charles Duell said in 1899 -“Everything that can be invented has been invented.” We see hints of prosperity in the opening scene of the ballet – it’s Christmas Eve and Clara and her extended family are hosting a huge Christmas party with an abundance of food, drink and gifts. It symbolises a world that loved globalism and trade. In the ballet, you see foreign delicacies – Spanish hot chocolate, Chinese tea, Arabian coffee and the famed sugar plum fairies, Danish shepherdesses, and of course Russian candy cane dancers along with a beautiful array of fantasy figures. Little did the people then know what was to soon to follow in Russia and in Europe. The happiness, merriment and times of plenty would soon give way to the darker sides of humanity – revolution and war – which would adversely impact the lives of millions.
With populism, protectionism and revolution again in the ascendency, are we in for similar times ahead?
The year 2018 will go down as one of the best in the nine recent years of US economic expansion. The unemployment rate, at +3.7%, remains at a 49-year low. US GDP rose by +3% in Q3 from a year earlier, a rate of growth exceeded in only three other quarters in this expansion that began in March 2009. Inflation reached the US Federal Reserve’s (Fed) target of +2% without overshooting it and wage growth is inching up to +3% (still well below the +4% of past expansions). Meanwhile, in the rest of the world, the year began with most major economies expanding – leading some to think that Europe was going to expand at an even faster rate than the year before. Regular readers of this newsletter will know that – because of its structural problems – I take a very dim view on the Eurozone economy. By the third quarter, output in Germany – the Eurozone’s largest economy – had contracted and the Eurozone is expected to grow at sub +1% rate this year. Japan has also seen a slowdown and as China’s economy and global trade volumes slowed, many Central Banks globally took a step back from sounding hawkish on interest rates.
As the table below shows, this year, the US is a stand out performer in an otherwise miserable sea of red in the world of equities.
And to think that everything was going well for US equities – despite the sharp -11% correction in February. The S&P 500 Index (SPX) was up over +9% until early in October, before the narrative of a US-China trade war, Fed interest rate increases, a turn in the economic cycle and a strong US Dollar took a stranglehold on equities. This all resulted in a sharp -14% market sell-off since then (see chart below). Traders and speculators out-manoeuvred investors and it’s been a volatile market ever since.
Markets & Economy
The Fed will conclude its final meeting of the year this Wednesday with markets widely expecting the Fed to raise rates by +0.25%. This will take the Fed Funds Rate to the +2.25% to +2.5% range. However, the slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected this week, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will be still be able to raise interest rates next year. As per the Fed Funds futures pricing, the most-likely scenario (at a 40% probability) is no change in the Fed Fund Rate for the entire 2019. The likelihood of one rate increase sits at 33% and two hikes at 12%. At the extremes – a rate cut stands at 10.6% and the odds of a repeat of 2018 with more than two hikes is a meagre 2.4%.
In the November 2017 Market Viewpoints, I forecast that the 10 Year yield on US Treasurys would “finish the year in the range +2.85% and +3.0%” and we are at +2.86% currently. For the next year, I forecast that we are going to see, at most, two rate hikes from the Fed and the 10y yield on US Treasurys will finish the year in +3.25% to +3.4% range.
As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes have already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. The Bank of France has halved its forecast for France’s GDP growth in Q4 from +0.4% to +0.2% and the deficit is to balloon to -3.4% of GDP (well above the 3% ceiling that the Eurozone nations have to abide by).
Recall that Italy’s 2019 planned deficit, which is set to be -2.4%, has been a problem within the EU.
The next recession will tip France over and make its budget a concern for Brussels and a big headache for Germany and the European Central Bank (ECB). I doubt Macron will recover from this debacle. He has lost the trust and confidence of the French people and will have a very hard time to govern going forward.
The French middle class are sick of taxes. The chart below sums up why The Gilets Jaunes have garnered overwhelming support. Hours before the government cancelled its proposed tax rise, a poll conducted for French newspaper Le Figaro showed 78% believed the yellow vests are fighting for France’s general interest.
The Organization for Economic Cooperation and Development (OECD) released its annual Revenue Statistics report last week and France topped the charts, with a tax take equal to 46.2% of GDP in 2017. That’s more than Denmark (46%), Sweden (44%) and Germany (37.5%), and far more than the OECD average (34.2%) or the U.S. (27.1%, which includes all levels of government). Macron’s France shows that states can’t support themselves solely with progressive income taxes. More taxes are equal to less progress. France has resisted supply-side reforms for decades and engendered a socialist economy with a few wealth creators paying for the many takers. Now the chickens have come home to roost. Belgium and Netherlands are now seeing their own version of Gilets Jaunes protests.
I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. Since the close on November 8 (the last meeting), the SPX is down over -9%. That’s the biggest decline in between Fed Days since the -8.17% drop between the December 2015 and January 2016 meetings. Recall, that the current hiking cycle began at the December 2015 meeting which sparked a -10% sell-off.
I still recommend an overweight position in equities with a bias to US equities and sectoral bias to – Industrials (XLI), Technology (XLK), Financials (XLF) and Healthcare (XLV). Despite the news of a yield curve inversion at the front end (2 year and 5 year), I put the probability of a recession in the US next year at very low. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.
The risk of GDP growth is more daunting outside the US and any further tilts to protectionism and nationalism will make matters worse. The backdrop for Emerging Markets (EM) is certainly better given the de-rating relative to the US equities (chart below) and the anticipated reduction in the pace of rate hikes from the Fed. Besides a combination of continued US growth and a modest upturn in the Chinese economy would alleviate many concerns. The result could be a meaningful rally in pro-cyclical EM assets – bonds and equities.
I was bullish on floating rate bonds through last year but I do not feel the same now for the reasons mentioned above – fewer rate hikes. I would recommend reducing the weight of floating rates bonds in the portfolio gradually. The yield on fixed-rate bonds is getting attractive enough to hold them outright.
As for currencies, traders are already very long US Dollar, implying the upside to USD is limited. However, for the USD to weaken, global growth has to improve. The interest differential still supports the US Dollar. I do not expect any meaningful upturn in the Chinese economy until late Q2 of 2019. As Chinese economic activity weakens, European growth will sputter. Therefore, I expect the EUR/ USD to trade below 1.10 in the first half of 2019.
On that note, I wish you and your family all the best for this holiday season as well as a very Happy New Year. And if you celebrate Christmas – have a lovely Christmas!
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital