Via Goldman Sachs,
As we head into year-end, Goldman’s Allison Nathan continues the firm’s tradition of taking stock of the big themes in a crossword.
On the heels of a 2017 characterized by low volatility, robust growth, and strong performance across risky assets, 2018 has (unfortunately) delivered the reverse. Political, economic and technical factors contributed to some eye-popping spikes in volatility, from the equity sell-offs in Q1 and Q4 to the blowout of Italian sovereign bond spreads in June and the recent moves in oil prices. Episodes like these have raised questions about market liquidity and fragility, and have only intensified the deterioration of risk sentiment going into year-end. Indeed, 2018 is closing on a pessimistic note, with most major asset classes posting negative returns for the year. (For those who missed it, even the optimism over cryptocurrencies has faded, with bitcoin down a whopping 73% year-to-date.)
While far from being the only driver, trade tensions have undoubtedly contributed to market anxiety. President Trump’s trade agenda gained steam throughout the year, with productand commodity-specific actions followed by several rounds of US-China tariffs and the US threat of measures on foreign autos. Despite the current pause in US-China tensions, trade risk remains in the cards next year. We see further escalation as slightly more likely than not before Washington and Beijing reach a long-term deal. And while auto tariffs are not our base case, we expect other measures such as quotas or export restraints in 2019 (but, on a more positive note, we also expect NAFTA’s replacement to become law).
Nowhere has trade uncertainty been more important than China, especially amid further signs of slowing growth. But with targeted stimulus now kicking into gear, we think growth will recover somewhat by mid-2019, taking risky assets in the region (and China-exposed commodities) with it. That said, trade will continue to pose headline risk, particularly for the yuan, which would likely breach 7.0 vs. the US dollar if talks collapse (but should remain below 7.0 while they’re ongoing).
The other major investor concern has been the growth slowdown, which has extended well past China, raising fears around recession risk. Indeed, our global CAI has declined to about 3.5% so far in December from nearly 5% at the start of the year. That, in turn, has driven the ongoing sell-off in equities (leading to a substantial tightening of financial conditions—a growth headwind in and of itself). As a result, markets have reduced their expectations for Fed hikes next year to just half a hike (vs. about two earlier this fall); and, amid the drop in oil prices, the bond bear market that characterized much of 2018 has reversed course, with 10-year Treasury yields down ~45bp from their October peak.
We too have adjusted our Fed view, and now expect a pause in March. However, we maintain that further tightening remains necessary to avoid labor-market overheating. On a probability-weighted basis, we forecast 1.6 net hikes next year, slowing growth to roughly our estimate of potential—1.75%—by the end of the year. But with financial imbalances broadly in check and no obvious catalyst in sight, we believe the risk of a US recession in 2019 remains low (10%).
We also don’t see major risks resulting from US midterm elections, which yielded the expected outcome of a divided Congress. We expect the overall direction of policy to remain intact, with little in the way of change on taxes or infrastructure. But investors should still keep an eye on healthcare, as Democrats will probably pursue legislation on drug pricing and other issues. In addition, concerns about data privacy could prompt new action on tech regulation. Also key to watch: the deadline for raising the debt limit—most likely in August 2019—which could prove disruptive, and perhaps even more so as the federal budget deficit tops $1tn in FY2019.
But as contentious as the US fiscal situation might become, Europe has arguably already won the prize for fiscal concerns. After months of tense negotiations, Italy has reached a deal over its budget with Brussels. But we’d take the news with a grain of salt; until Italy’s government officially scales back key policy promises or confirms spending cuts elsewhere, we remain cautious on the country’s outlook. In the meantime, investors are also watching France’s promises of fiscal easing in response to the populist “yellow vest” movement. Indeed, between President Emmanuel Macron’s weak approval ratings, the possibility of snap elections across the continent, and Angela Merkel’s decision to step down as German Chancellor in 2021, political risk in Europe shows no sign of abating.
On that note, let’s not forget Brexit, where UK politics have left all options—an orderly Brexit, a disorderly Brexit, or no Brexit at all—still on the table. Given the lack of a unifying alternative, our base case remains the first of these; but the weeks leading up to the UK Parliament vote on the deal (now set for mid-January) will prove decisive… stay tuned.
So where does all this leave our asset views heading into 2019? In the near term, growth concerns and market pessimism may well persist. But over the medium term, we believe slower but still solid global growth will drive equity upside across the major indices, higher bond yields in the G10, commodity strength, and US dollar weakness. We also see a narrow path to performance for Emerging Markets (EM) after a difficult year.
That said, we expect higher volatility, growing macro headwinds, and increasing tail risks. We therefore recommend positioning for a potentially bumpy ride: shifting up in quality, utilizing hedges, and keeping an overweight in cash.
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Across:
4. A major sticking point surrounding Brexit is the Irish ____ (Issue 70).
7. Some market participants argue that increased ____ of trading in US equities has made the markets more fragile (Issue 68).
10. EM assets outperformed in 2004-2006 despite ____ consecutive rate hikes by the Fed (Issue 69).
12. US economic strength has historically coincided with ____ tightening, which makes this year’s loosening so unusual. (Issue 71).
14. Historically, the painful “trio” for Emerging Markets (EM) has been higher US ____, rising oil prices, and a stronger US dollar (Issue 69).
15. The sector that is likely to be most impacted by the Democrats gaining control of the House in the US midterm elections. (Issue 73).
18. During the June sell-off in Italian sovereign bonds, ____ seemed to exacerbate market moves, much like during the “flash crash” in US equities in 2010 (Issue 68).
19. Today, ____ balance sheets look healthier than corporate balance sheets, which is the reverse of what we saw heading into the Global Financial Crisis (Issue 72).
22. Many bond bears cite increased Treasury ____ to fund the US’s growing budget deficit as a reason to expect higher Treasury yields in coming years (Issue 65).
23. Some of President Trump’s actions on trade fall under US trade provisions that conflict with ____ rules (Issue 66).
24. European data privacy regulation that came into force on May 25, 2018, and can levy a fine as high as 4% of a company’s annual turnover (Issue 67).
27. According to Mohamed El-Erian, Chief Economic Advisor at Allianz, the fact that “____” investors outnumber “local” investors means capital outflows from EM will continue (Issue 69).
28. A cryptocurrency platform that allows for the creation of “smart contracts” (Issue 64).
29. A lower threshold for proving ____, the European equivalent of monopoly power, is one reason why Europe has generally been more active on tech regulation than the United States (Issue 67).
30. GS research shows that fiscal expansion in highly indebted countries like Italy does little to boost ____ (Issue 71).
Down:
1. Unlike most commodities, bitcoin requires little physical storage. Even a 3½ inch floppy disk can hold almost 30K private ____ (Issue 64).
2. Deliberate financial sector de-risking in China has slowed the flow of credit to the private sector, leading to a rise in ____ (Issue 74).
3. Observers cite the ____ of cryptocurrencies as an impediment to their broader adoption for use as a currency (Issue 64).
5. In the US, ____ has jurisdiction over foreign commerce, but has delegated much of its authority on trade to the president over the years (Issue 66).
6. The abbreviation for a market-making firm that typically posts orders to buy and sell in very quick succession (Issue 68).
8. Labor market ____ could be a trigger of recession (Issue 72).
9. Raising the debt ____ in 2019 could prove as contentious as in 2011 and 2013, when government/Congress was also divided (Issue 73).
11. Competition between the US and China in this sector is very likely to increase (Issue 74).
13. President Trump’s tweets this year turned the spotlight on this company’s postal rates and tax practices (Issue 67).
16. UK political expert Anand Menon has argued that a second ____ would only further complicate the situation around Brexit (Issue 70).
17. Paul Tudor Jones, co-chairman and CIO of Tudor Investment Corp., is not convinced that technological disruption will continue to bring ____ (Issue 65).
20. Policies intended to curb ____ banking contributed to the growth slowdown in China this year (Issue 74).
21. Substantial growth in the ____ debt market has sparked concern from regulators worried about systemic risk (Issue 72).
25. A “no deal” ____ of the UK from the EU might be a possibility if the UK parliament fails to pass the Withdrawal Agreement negotiated between UK PM May and Brussels (Issue 70).
26. Harvard Kennedy School Professor Carmen M. Reinhart argues that high ____ levels have historically been associated with lower economic growth (Issue 71).
Solution below (don’t cheat)
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We hope you didn’t cheat…
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