In early May, US President Donald Trump said a deal with China was “95%” complete. Yet barely two weeks later, Trump had raised tariffs on US$200 billion of Chinese goods, threatened to extend these imposts on all Chinese imports, and blacklisted Chinese telecom Huawei from operating in the US or receiving US-made parts.
Trump’s U-turn on China (that he blamed on Beijing reneging) matched the about-face of the Federal Reserve in January when the central bank reversed its thinking and said it was unlikely to raise the US cash rate in 2019. While Trump’s reversal undermined stocks, the Fed’s change of mind triggered a four-month rally.
Such are the events that have influenced global stock markets over the first half of 2019. Given how haphazard developments can be, when we are assessing the outlook for equities over the next 12 to 18 months, we frame our thinking around the prospects for the three main drivers of equity prices. These are earnings growth (proxied by global growth), interest rates and the level of uncertainty (which can be viewed as the extra return attached to stocks to compensate for their greater risk).
While we always acknowledge that unforeseen events can ruin any forecasts, let’s step through these three lenses to explain why we are cautious about equities, starting with the outlook for global growth.
Prospects for the world economy softened in 2018 because central banks tightened monetary policy, international frictions intensified and the stimulus from the US tax cuts of 2017 faded. However, central bank and other government actions have been more pro-growth of late so the risk of a severe contraction has reduced. We see that the biggest determinant of what happens to the growth outlook will be the US-Chinese showdown.
A détente between Beijing and Washington is challenging because a row over trade has widened into a long-term clash over global power where, as with all such disputes, Presidents Trump and Xi are constrained by domestic political factors. We see that there are four possible outcomes of the China-US clash in the next year or so.
The first is a ‘treaty’ that ends the battle and ushers in an extended period of cooperation. While this would be the best outcome for global growth, it looks to be the least likely. It would require Beijing to slow its modernisation plans while Washington would have to give up some of its global power to a country it views as a long-term rival. Hardening domestic political views – particularly in the US where even Democrats are determined to confront China – prevent the leaders of both countries making the concessions needed for a treaty.
The second outcome of a ‘ceasefire’ is more likely. That Trump and Xi would benefit from a ceasefire whereby both make concessions (such as China buys more US goods while the US removes tariffs on Chinese imports) suggests a truce might be more likely than not. Any ceasefire would most likely see the outlook for growth stabilise at a modest level. Achieving more vigorous growth would probably require fresh fiscal or monetary stimulus but partisan politics and the fact that monetary policy is already loose limit the ability of policymakers to spur their economies. A clear threat to the durability of a ceasefire, however, is that Trump, having benefited from a ceasefire-driven rally in stocks, could see political benefit in breaking the truce ahead of the November 2020 election. In that case, the outlook for global growth would be just as uncertain as it is today.
The third outcome is an ‘escalation’ of hostilities should talks fail. It is difficult to imagine that the global growth outlook would improve under this scenario – but it is also hard to predict how large the deterioration might be. That said, we believe the more caution exercised by policymakers in the past six or so months has reduced, but not eliminated, the likelihood of a recession.
The final option is the ‘skirmish’ between China and the US continues – essentially, the talks take longer than expected to reach the pivotal point. Under the skirmish scenario, the drag on growth would be less severe than under the escalation scenario.
As ever, the outlook for interest rates depends on the prospects for growth and inflation. The growth outlook just described – most likely modestly below-average to average growth depending on whether or not there is a deal – is broadly consistent with interest rates staying where they are today.
The inflation outlook, however, is a greater source of uncertainty for interest rates. While US inflation, which is about 2% now on multiple measures, looks to be under control, we are alert to the possibility of a wages-driven inflation scare that triggers a spike in interest rates. The US labour market is still tight – the jobless rate is around 50-year lows – and growth is fast enough to squeeze it even further. To be sure, the softer growth outlook has slightly reduced this risk. But it hasn’t gone away.
A worrying development in the past year has been Trump placing pressure on the Fed to ease monetary policy. While we don’t know how much this contributed to the Fed’s change in stance at the start of the year, we know that it could only have worked in this direction. This means that interest rates would be slightly lower than they otherwise would be – as long as inflation stays under control.
Uncertainty is unlikely to decline over the next 12 to 18 months. Trump’s behaviour is likely to remain unpredictable, worsening inequality could fan more political flashpoints similar to Brexit, and disharmony is rising in the EU where Italy’s finances remain a threat to the euro. International flashpoints (trade wars, the Middle East, North Korea) are other sources of uncertainty, though worst-case developments seem unlikely.
These factors should feed economic uncertainty, which will be reinforced by the fact that the Fed has returned to its estimated range for interest rates where they are neither pro- nor anti-growth. Policymaking is relatively easy when tightening from loose settings and more challenging when moving to a restrictive stance.
The result of this analysis is that we identify three potential market scenarios over the next 12 to 18 months. The first is that there is no significant increase in US inflation or a sharp slowdown in global growth, with further rate cuts likely. Broad equity indexes would most likely provide satisfactory returns. We think there is about a 50% probability of this scenario.
In the second scenario, global growth slows to a level that forces central banks to respond more aggressively. The size of the policy response depends on the depth of the slowdown, which makes the impact on equity prices difficult to predict. But clearly the more growth slows, the worse it is for equity prices. We place about a 25% probability on this outcome.
The third scenario is that inflation fears produce a spike in interest rates. This scenario has become less likely but nevertheless remains about a 25% probability. A spike in interest rates would weigh on the growth outlook and lift risk premiums, potentially triggering a 20% to 30% fall in equity prices. Much is at stake as the US and China clash continues, and the Fed ponders its next moves.