What a difference a year makes! And why should the calendar matter so much, if at all? Many investors began 2019 with their performance in shreds, bracing for the worst. They finished 2019 boasting that global stock markets had posted their best year since the aftermath of the financial crisis a decade ago, as investors shrugged off trade tensions and warnings of slowing growth in major economies. The MSCI World Index, which tracks stocks across the developed world, jumped by almost 24 per cent during 2019 – the strongest performance since 2009. A surge in US technology giants and a strong recovery in eurozone and Asian stocks drove the rally. So, 2020 will be more of the same?
That isn’t the view here at Economic Perspectives. We’re in the business of bounded reality, not unbounded optimism. We envisage that 2020 will be the year when chickens come home to roost, reminding us of unresolved problems, unsatisfactory remedies and unstable politics.
The good news, possibly, is that national governments and their agencies remain dead set against an end to this mature, yet faltering, global economic expansion. The bad news is that the global credit system has an infection which is spreading rapidly, with life-threatening implications for the global economy. We expect the early year hopes of cyclical recovery to be overtaken in short order by the unintended consequences of long-standing lax credit and monetary policies.
Over the course of the past 12 months, the US Federal Reserve has become an embattled institution, whose policy responses have diverged substantially from those of an independent monetary authority. The Fed’s supposed independence has been challenged in four dimensions. First, by the US president who has spent the past 2 years criticising Fed decisions, questioning its motives, undermining its authority and launching ad hominem attacks on its chairman. Second, by the Chinese Communist Party, that has demonstrated its power to destabilise the US traded goods economy and the US Treasury bond market. Third, by the “debt vigilantes”, who warn that higher interest rates will crush the economy. Fourth, by the “financial plumbers”, who warn that failure to resume QE, let alone any attempt to revoke past QE will have disastrous consequences for financial stability, in the context of complex new financial regulations.
The Fed has responded as any embattled institution would, to protect its reputation, to forge new friendships and alliances and to avoid making difficult and controversial choices. Sadly, it has doubled down on Yellen’s model-based mission to “run the economy hot”, in an attempt to send ripples of prosperity towards “left-behind” communities and win the plaudits of the liberal media. However, the Fed’s new-sworn oath to “first, do no harm” should be understood as a myopic and tunnelled vision. It betrays an unwillingness to acknowledge how hot certain parts of the labour market are already and, more seriously, how damaging another episode of financial instability would be to growth and living standards. The Fed, ECB and Bank of Japan are toying with further easing measures, especially balance sheet expansion, in the misguided belief that they can fight the credit infection by boosting financial asset prices and making credit even more readily available.
At our October seminar, ‘The coming collapse of corporate credit’, we laid out our thesis of the bifurcation of credit pricing. Elite and highly profitable corporations will continue to enjoy full benefit from the repression of nominal interest rates by central banks, because their borrowings are priced off the government yield curve. By contrast, other segments of the corporate sector will suffer rising borrowing costs and diminishing credit access as their creditworthiness is reassessed based on revised perceptions of default risk. In our December Global Credit Perspective, we conducted a comprehensive analysis of the leverage of the US quoted company sector, finding extensive balance sheet fragility of medium- and small-cap listed companies and disturbing leverage trends in the consumer, healthcare, IT and utilities sectors. As the credit infection spreads through the global corporate sector, business confidence will evaporate; hiring and investment intentions will dissipate.
To the surprise of some, advanced economy final demand held up in 2019. Employment grew, real incomes grew and, for the most part, credit remained available and affordable. Despite the chaotic disruption to the global goods economy from the threatened escalation of tariffs and the resulting spasms in global supply chains, downbeat readings from purchasing manager surveys did not generalise to full-blown global recession.
2020 will be a different story. A spontaneous tightening of the credit cycle for consumers and small businesses will puncture the bubble of consumer optimism and dampen final demand. A loss of momentum in the value of retail sales, new car purchases and so forth – experienced in multiple contexts – will provide the signal that the global economic expansion is ending, notwithstanding supportive stances from central banks and conciliatory messages on tariffs and trade.
Investors, as before, must weigh the scale and imminence of the fundamental threat against the likely policy responses of central banks and fiscal authorities. In 2020, we judge that investing to protect against the threat will generate better performance than investing to benefit from the policy response. In other words, equities are under threat as creditors call time on the moral hazard trade. The temptation to retreat even further into bond-land should be resisted. Government bonds have mutated into regulatory assets in this age of financial repression. Ironically, the relaxation of the Fed’s balance sheet constraint weakens the investment case for US Treasuries. A long-term study of the relationship of bond yields to the nominal environment (see our December Global Inflation Perspective) suggests that 10-year yields will continue to normalise toward the 2 to 2.25 per cent range.
We suspect that currencies will be more volatile in 2020 and the rewards to prudent currency positioning could be material. The US Dollar and Swiss Franc appear to be the dearest currencies among the majors while the Japanese Yen, Australian Dollar and the Nordics are the cheapest. The underlying analysis is contained in our December Market Focus.
For more information on the thinking and analysis behind these views, please contact us at info@economicperspectives.co.uk
