In LNWM’s Q1 2019 Economic Outlook, Chief Investment Officer Gino Perrina presented five factors he and his team will be watching closely in 2019, in addition to corporate earnings growth. Here are the five factors:
Central Bank Policy. December 2018 demonstrated how sensitive the markets are to central bank policy, especially that of the Federal Reserve. But it isn’t just the Fed. Sensitivity to central bank policy exists globally, including moves by the European Central Bank and the Bank of Japan. The Federal Reserve finds itself in an unenviable position as it tries to reduce the large amount of fixed-income securities on its balance sheet and to normalize US interest rates without derailing the economy. We think a pause in US interest rate increases is likely and justified in 2019, given price stability and tame US inflation. Current market pricing is implying the same. Other central banks find themselves in an even less-desirable position, with similar balance sheet issues but economies that are not growing as quickly.
Europe (Brexit, France, Italy). With the looming Brexit deadline quickly approaching – March 29, 2019 — the UK parliament has yet to approve a strategy. The lack of clarity could cause significant price swings in UK assets with secondary effect for European assets. It’s clear that the honeymoon period for France’s Macron is over given his 23% approval ratings. He seems unable to implement the additional necessary reforms to move France forward. Italy’s budget deficit, lack of growth, and lack of willingness to reform will continue to be a headwind for Europe.
Credit-Driven Concerns. For many years, cheap credit was available to corporations, consumers and governments alike. We have long said that corporations with healthy balance sheets did the right thing by increasing the debt while reducing equity. However, debt has become more costly given the rise in yields, and it will only take one or two significant defaults to cause contagion in credit markets. It will be no surprise to see defaults this year in lower-quality credit, which is covered by loose or no covenants. Consumer balance sheets are relatively healthy, although student loans will be an increasing concern in the coming years. Foreign government debt has long concerned us, but in the near term it should only be an issue for countries with other fiscal problems, i.e. Italy, Greece, and to a lesser extent, France.
Asset Price Correlations. The 4th quarter of 2018 was troubling on many fronts but the change in correlation among asset classes was perhaps the most troubling and could easily lead one to question the benefits of diversification. In other words, assets that were supposed to zig when others zagged, didn’t. We saw some reversal toward normalcy late in December. We continue to believe in the principles of diversification and will maintain diversified portfolios. In fact, we think recent volatility will demonstrate the benefits of active management (as opposed to index investing) more so than in the past.
US-China Trade. As one of the largest and fastest growing economies, there is no dispute of the importance of China in the global economy. Since the beginning of the trade tensions between the US and China, the Chinese equity market has sold off more than 20% and recent data show signs of slowing economic growth in China. While the US economy is actually more isolated (less dependent on trade), we will certainly feel the effects of an ongoing trade war. We believe market reaction will force both countries to the table in 2019 to iron out a solution, although it is very difficult to assess timing.