January has two faces. On the one side, a global market rally, on the other rising global risks.
There’s an obvious tension here. The rally seems largely based on investor expectations that these rising risks will slow the pace of US interest rate rises. But, 2019’s risks look broader and deeper than 2016, when we saw the last rate-pause rally. Can this really work again?
In this week’s blog we’re going to look what’s happened so far in 2019 and what the tension between rallying markets and rising risks could mean for companies navigating an exceptionally unpredictable year.
The picture that tells (half) the story
The New Year has brought a spectacular change of tone in global capital markets. Global equity markets saw their best month since March 2016. Risk assets have reversed loses. Global high-yield bonds are up over 3.5% in January after losing the around the same amount in 2018.
What could have caused such a change of heart?
It seems that hopes of thawing US-China trade relations and, in particular, changing expectations for US monetary policy have inspired the return of ‘animal spirits’. The Federal Reserve used the all-important ‘p’ word in their Wednesday FOMC statement, affirming market expectations that they’d be ‘patient’ in assessing the outlook for monetary policy.
In making it clear that they weren’t wed to their tightening timetable, the Fed signalled that the two-expected rate rises for 2019 weren’t a sure thing. This was enough for the S&P 500 to rise 7.9% in January, ranking as its best start to the year since 1987, and one of its 10-biggest on record, according to The Financial Times.
Of course, there’s a ‘but’…
Market rallies always need unpicking, especially in the age of loose monetary policy, when the lines between ‘good’ and ‘bad’ news are blurred. The reasoning behind the Federal Reserve’s pause is that global risks are increasing. It’s anticipating slower growth in major markets, including China, and heightened geopolitical uncertainty, including trade tensions and on-going Brexit uncertainties.
This caution echoes downgrades from major forecasting agencies. Last week, the IMF downgraded projections for global growth, warning about similar downside risks – including US-China trade tensions, which are by no means resolved. Meanwhile, the Eurozone, which was the growth story of 2017, almost flat-lined at the end of 2018. Italy is in technical recession and Germany’s growth is expected to hit just 1% this year.
…and it’s not 2016
As Gavyn Davies of The Financial Times pointed out this week, there are possible parallels with 2016, when growth fears stalled Fed action, promoted Chinese stimulus and created the conditions for a further extension of the bull-market. It’s a parallel that hasn’t escaped Federal Reserve Chairman Jerome Powell. What makes 2019 different is the range and depth of risks massing in the global economy – and the remedies available to address them.
Germany’s downturn is somewhat tied into the low level of the Rhine and the automotive issues we’ve outlined elsewhere, but it’s trade surplus means it vulnerable to a downturn in regional and global trade – where growth significantly boosted Germany in 2017. Protectionism is a much bigger force in 2019. There are also structural reasons for falling global trade, including China’s efforts to increase self-sufficiency. Crucially, Chinese stimulus on the scale of 2016 (or other years since 2008) isn’t on the agenda.
And then there is Brexit, which I hesitate to bring up, because what else can be said that hasn’t already been said? But, it can’t go unmentioned because – as we noted last week – Brexit-inspired uncertainty looms over the UK and European outlook.
The chart below shows the increasing mentions of “Brexit uncertainty” – and related word variations – in UK trading statements in the last two years.
What does it mean?
In simple terms, investors are taking more risks when risks are increasing in the hope that a slower than expected pace of tightening will at least provide one last hurrah. There is a little more nuance to the outlook, but there is a basic tension once again between the relatively buoyant now and the much less certain, probably less profitable future. How does this translate in practice in 2019?
Earnings: UK earnings expectations have fallen significantly since last autumn. There is, of course, a chance that 2019 may exceed expectations. A lifting of immediate uncertainties and tensions around Brexit, US-China trade, Italian debt combined with low inflationary pressures, which enables interest rates to remain low and sustain the rally and boost growth.
But many stars need to align for this to happen. Despite this lifting of market mood, companies still need to be prepared for a bumpy 2019 in UK markets and beyond.
Deals: A higher risk perception is affecting M&A. Deals will still go ahead out of technological, operational or financial necessity. Changing economic climates will inspire some deals, either to invest in new areas or shore-up finances. But, it’s tougher to agree on valuations when markets are rising and growth is falling.
Private equity still has a wall of money to spend, which could support valuations in some areas. There is, as we’ve noted before, a much stronger PE focus on defensive areas, like health and education. There are also signs that PE is looking ahead to a possible correction that will open up public-to-private opportunities.
Raising Capital We’ll discuss this topic in more detail next week, but it seems as if investors are looking beyond the rally. Standard & Poor’s said this week that the 12-month trailing default rate for speculative-grade European corporates could rise to about 2.6% through 2019 from 1.9% at end-2018. Still low by historical standards, but we sense a palpable change in attitude in some UK-exposed sectors.
Ultimately, 2019 looks like coming down to fundamentals beyond the hopes and fears around monetary policy. More on which in the coming weeks.
Edited by Kirsten Tompkins.