2019 Outlook: Worlds apart – something has to give

The disruptive divergence we called for in our last Outlook is playing out as expected. The US economy moves full steam ahead while China continues to slow, despite renewed fiscal and monetary easing. Since global monetary policy is by-and-large determined in Washington while global growth is still largely driven by China, this divergence means trouble for markets. The consequence is that monetary conditions driven by a strong US economy are becoming too tight for the global economy as a whole. We therefore expect the global slowdown to continue. In that context, the correction in October is a reminder that risk assets’ pain threshold with respect to broader monetary conditions is within reach and the peak in equities is getting closer. Risk assets should remain under pressure in H1 2019, while the second half might offer some relief for investors as bad news becomes good news: The tailwinds for the US economy should fade as external risks build, allowing the Fed to put tightening on hold.

When the two biggest economies move out of synch, the world has a problem

As the global economy is moving past peak growth, two key features are characterising the current slowdown phase: First, the growth/inflation trade-off continues to deteriorate, resulting in monetary headwinds gathering pace. Secondly, the slowdown is taking shape in the form of a disruptive divergence scenario, outlined in our Autumn Outlook. The US economy is currently leaving everybody else for dust, while China continues to slow as growth in Q3 hit the lowest level since the financial crisis. Slower growth does not in and of itself sound the death knell for the equity bull market as long as monetary conditions do not become too tight. Naturally, the market’s focus is therefore increasingly shifting towards broader monetary conditions, as it normally is overtightening from the Fed that causes something to break.

It is exactly in this context the divergence between the US and the rest spells trouble for the world economy and financial markets. The problem is that global growth is largely “made in China”, as the 2nd biggest economy is still delivering the biggest contribution to global growth. Meanwhile, global monetary conditions are mainly driven by the central bank in Washington, as the US Dollar is the world’s reserve currency. This is not an issue as long as both economies move in synch. But when business cycles in China and the US are out of synch, problems arise. More concretely, US strength and Chinese weakness implies that monetary conditions driven by a worsening growth/inflation trade-off in the US are becoming too tight for the world ex-US. Hence, more divergence means (over-)tightening of monetary conditions in the shape of a triple whammy: Higher US interest rates (RHS chart below), a stronger US Dollar and the Fed’s balance sheet shrinkage. The latter is now withdrawing USD 50bn liquidity pr. month, approximately the same size as the liquidity injection when Q/E was running at maximum speed.


Divergence spells trouble: A strong US Dollar driven by widening interest rate gaps (LHS) is painful for USD borrowers (RHS)


Sell into strength

For now, divergence and the resulting tightening monetary conditions are likely to continue. According to our indicators, monetary conditions have now just about reached the levels consistent with a big top in global equities within the next six months. The signal is not particularly strong yet, but confirms our long-held view that February marked the start of a topping process in markets. The signal is also consistent with the uncomforting similarity between the equity sell-offs in February and October, both pre-empted by spiking US interest rates driven by a higher term premium. Baring the possibility of a tactical bounce in risk assets after the sell-off, this means the narrative has changed from “buy-the-dip” to “sell-into-strength” within risk assets. Given the headwinds described above, the benefit of the doubt is gradually removed as the market becomes “less forgiving” towards e.g. political risks (Italy) and disappointing earnings.

From an asset allocation perspective, we expect developed markets and defensive sectors to outperform within equities in an environment of continued US Dollar strength and negative earnings revisions (RHS chart). Safe havens and high-rated bonds should increasingly be sought after as the big top is getting closer. Sell-offs in core bonds like the one we saw in September should be viewed as buying opportunities (see LSH chart below).


Peak growth means peak earnings enthusiasm (LHS). Banks or bonds – who’s right (RHS)?


The ultimate question for 2019: What will give?

Looking at the next 6-12 months, the key question for markets is whether we see the rest of the world catching up to the US or the US “catching down” to the rest of the world. Catch-up would lead to “risk-on” 2017 deja-vu, whereas a catch-down implies a risk-off environment. We stick to our view that a “catch-down” is more likely. The drivers behind US strength are mostly temporary (tax cuts, jobs act, bipartisan budget act and higher oil prices), and are likely to fade in 2019. And as it has to get much worse before the Fed pauses, higher interest rates are beginning to bite as reflected in the recent housing weakness. China’s headwinds, on the other hand, seem more structural in nature and, therefore, persistent. Lastly, financial risks are rising as we speak, and in the current late-cycle environment, causality can easily change, implying the market place becomes the biggest risk for the economy, not the other way around.

As it becomes clear that the half-life of stimulus in China becomes shorter resulting in less bang for the buck, the focus continues to be on the Fed to deliver some kind of positive circuit breaker. This is as such nothing unusual in the very late stage of the business cycle. But as this cycle arguably is the most liquidity driven in recent history, the Fed’s role is also becoming more crucial. A Fed on hold would increase the likelihood of the catch-up scenario described above facilitated by easier financial conditions. In our view, this becomes increasingly likely in the second half of 2019 as the US decelerates and financial risks increase. In other words, bad news will become good news from a market perspective at some point, but it probably has to get worse before it gets better.

Note: This is a NAM macro view, not the official Nordea view.

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 216.8bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 311.5bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.09.2018

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