Moving into 2019, financial markets are trading with elevated volatility. Central banks tightening monetary policy, the ongoing US/China trade dispute, a global growth slowdown and Brexit uncertainties are all key reasons why markets have been served up a very turbulent few months for traders and investors. It may not be surprising to hear that many of the key issues that have helped to define 2018 will not be packed away with the Christmas decorations or the January detox. Looking ahead, what can we expect to see in the major markets in 2019?
Will the dollar correction finally take off?
Turning the clock back 12 months, the talk was of how the dollar would struggle amid expected tightening by the European Central Bank and the Bank of Japan, driven by supposed relative economic recovery. It was seen that the Fed would not be the only hawkish leaning central bank and the dollar would suffer as yield differentials tightened. However, markets did not factor in the economic impact of a significant lurch towards protectionism from US President Trump in Q2. This drove money out of emerging Asia and into the US with the higher yield, safer haven of the US dollar. However as we sit, the argument is that this dollar bull run is increasingly questionable, and likely to reverse.
The dollar negative arguments in 2019:
- The Fed hikes in 2019: one or none – From possibly even four hikes in 2019 just a few months ago, these expectations are now being steadily pared back. At the December FOMC meeting, the Fed guided for two hikes in 2019. This still seems to be a lot, and looking at Eurodollar futures, the market is struggling to price for one hike. The reaction in the wake of this December FOMC would suggest that the market sees this as a policy mistake that the Fed will need to rectify. The December FOMC meeting was one in which they had to hike, but the global economic outlook for 2019 is looking far more hazy now. Growth expectations are being cut, inflation expectations are falling and the yield curve is flattening and close to inverting through the belly (2s/10s spread at around 10 basis points). The Fed will be facing deflationary pressures from falling commodities prices – the Thomson Reuters CRB Commodities Index has fallen by 9% in the past six weeks to a 12 month low. This is a significant warning signal because if it is demand driven then this is a real concern for prospects next year.
The graphic below shows Eurodollar futures which reflect the market expectations of future rate hikes. The table suggests limited expectations for rate hikes in 2019.
- The trade dispute between US and China dissipates in a meaningful way. The rhetoric has improved since the G20. From 1st January, tariffs on US autos imports into China fall from 40% to 15%. Furthermore, China has started to buy soybeans again for the first time since the dispute began in April. Whilst this 1.13m tonnes purchase is still way off the normal annual purchase of 30m to 35m tonnes, this is a key policy shift from China. Additionally, it is apparent that there is a willingness for the two countries’ trade delegations to meet again in order to speed up negotiations. The situation could come into increasing focus as the 1st March approaches (when the 90 day period of deferral comes to an end, however, it seems as though there is a willingness for progress. The dollar has gained strongly on its safe haven status from the trade dispute, this could begin to reverse in 2019.
- Yield differentials pointing to a dollar correction – If there are serious expectations that the US tightening will end in 2019, then US yields have likely peaked. The 10 year hit 3.26% and with the Fed possibly calling to a halt below 3%, yields could struggle for traction higher. This is likely to mean that the dollar will no longer find bull traction in yield differentials in 2019. Bund/Treasuries differentials point to EUR/USD upside, along with JGB/Treasuries differentials also implying the dollar will struggle. The direction of Treasury yields will be key.
Euro looking for a mild recovery
At the December meeting for the ECB, Mario Draghi seemed to try his hardest to remain upbeat. However, aside from a bit of wage growth, the growth picture was revised lower and inflation remains stubbornly low. “Continued confidence with an increasing caution” is going to be a phase to sum up the euro well into the second half of 2019. Having ended the Asset Purchase Programme, the prospect of actually tightening rates in 2019 could be a difficult trick to pull off.
If the economic conditions for the market to consider a tightening cycle could not come to fruition in 2018 when the global economic outlook was far more rosy, this is even harder to envisage coming into 2019. The current expectation is for the ECB to hike the deposit rate possibly in Q4 2019 with the full rates corridor not raised until 2020. Looking at the somewhat concerning forward looking PMI data for the Eurozone, whilst the deterioration in the German Ifo Business Climate continues to be a harbinger for slower growth in Germany. This is backed by the German Ifo institute itself, which is anticipating growth in Germany, the euro-area’s primary economic powerhouse, will cool further from 1.5% in 2018 to just +1.1% in 2019. Germany has been hit throughout 2018 as exporters have felt the pinch of slowing global growth and trade protectionism.
However, the Eurozone Current Account improved further in December and yield differentials reflect the euro performing better than the dollar into 2019. This suggests that whilst the euro may start to advance, substantial gains may be limited.
EUR/USD may subsequently manage to drift higher into the range $1.15/$1.20 in 2019 but not manage traction beyond there. Furthermore, it is difficult to see any gains to be driven by anything more than slippage on the dollar.
Sterling volatility, Brexit drives it all
Brexit is the crucial factor in looking at the prospects of sterling this year. Literally anything could happen then. To keep things relatively straight forward (and trying not to delve too deeply into the path to these eventualities) but there are four possible scenarios that I see playing out on Brexit: The Withdrawal Agreement passes, no deal/hard Brexit, a General Election, a Second Referendum.
- The Withdrawal Agreement passes – It may seem a long shot, given the terrible state of UK politics, but imagine if Mrs May pulled a miracle and got her deal through. It would be one of the greatest political achievements of all time if she was able to get enough concessions from the EU to allow an orderly Brexit. Sterling would shoot higher, possibly into the mid $1.30s. Removal of the uncertainty would increase consumer and business confidence again, allowing fiscal stimulus to be released from the no deal disaster fund. It would also allow the Bank of England to hike rates with confidence. However, back to reality, (sorry to burst the bubble of positivity), unfortunately for Mrs May, the EU will not be that kind to her. She will flounder in her re-negotiations. My belief is that the EU will calculate that a second referendum would likely win through for remain. (Probability 20%).
- A ”No Deal” disorderly Brexit – There is no appetite for no deal in Parliament, however it could still come about on a technicality. The likelihood of this has diminished with the motions passed in Parliament, giving the power over Brexit back to Parliament on 21st January should there be no agreement on the path forward. However, the UK is legislated to leave the EU on 29th March, with or without a deal. Unless Parliament gets its act together and either asks the EU-27 for an extension to Article 50 or simply revokes it (which is possible following the ECJ ruling and is vastly more preferable to a disorderly no deal scenario) then the UK could accidentally leave the EU with no deal. (Probability 10%)
- A General Election – With Parliament in deadlock, Labour could issue a vote of no confidence in the Government. It would take a simple majority and need the Northern Irish DUP to end their “confidence and supply” arrangement and vote against the Government. The Labour Party would then have 14 days to form a stable government but the DUP despise the Labour front bench and would not vote with them. This would inevitably mean another election. (Probability 30%)
- A Second Referendum – There is an another increasingly possible scenario where in order to break the deadlock in Parliament, Article 50 is extended in order to conduct a second referendum or so called “People’s Vote”. The path to getting a second referendum is complicated, but it would need Labour to call a vote of no confidence (which they then lose as the DUP are still likely to vote for the Government) and then only option left as Parliament fail to agree, could be a second referendum. This could then take us well into Q2 or even the summer. In this scenario, it is increasingly likely (albeit marginal) that the country votes to remain again (according to latest opinion polls). Quite what that would do to calm the debate over Brexit is anyone’s guess. (Probability 40% and growing)
The graphic below shows that support for a second referendum is growing and the potential is that it would be a “Remain” victory (although this is before the format of the referendum can be known).
Scenarios for GBP/USD in 2019
- Withdrawal Agreement passes: Sterling rallies to $1.3500/$1.4000
- No Deal: Worst case scenario for sterling, big sell-off to below $1.2000
- General Election: A difficult one to call as the polling between Conservatives and Labour is broadly neck and neck, however the prospect of a Labour government would be negative for sterling and would mean a move to the low $1.2000s
- Second Referendum: The potential is that the UK remains in the EU and would be sterling positive possibly above $1.3500/$1.4000 (however, how civil unrest and subsequent political risk going forward could ultimately hamper gains).
Gold recovery to continue
Gold has recovered in recent months. Elevated levels of volatility and reduced risk appetite helps a positive outlook for gold. Inflation expectations have continued to deteriorate markedly (in the US, China and Eurozone) whilst a clutch of major growth indicators are also in decline (US growth moderating as the impact of Trump’s tax reforms drops out; Chinese growth, industrial production and retail sales; Eurozone GDP forecasts downwardly revised). This is all gold supportive.
However, the path of the dollar is still a key factor for gold on a longer term basis. It is interesting that in recent weeks, as risk appetite has plummeted, the correlation between the dollar and gold has flipped from its usual negative position, to a far more positive one. The longer term correlation suggests that this will not last though. In the wake of the December FOMC decision, this longer run correlation seems to be threatening to kick in again.
If the dollar is going to struggle in 2019, then it could be a good year to be long gold. With the Fed pulling back on rate hikes, inflation expectations diving and Treasury yields under pressure, it looks like the latter will be the theme at least in the first few months of 2019 at least.
Equities at least stable but could stage a recovery in 2019
The Fed yield curve inverting would get some serious air time and it looks as though this is increasingly likely now. The implications for a US recession are statistically a serious concern and as the US Treasury yield curve has continued to flatten this year, fears of this have grown. However, historically the time between flattening on the curve and recession tends to be around 18 months. This would suggest that 2019 will still be a year of growth and if this comes with the prospect of less tight monetary policy from the Fed, it could be positive for equities.
There are a number of factors that could set us up for a rebound in equities in 2019:
- US/China trade dispute dissipates – In the wake of the G20 meeting, there seems to have been a change in tone suggested by China opting to cut tariffs and renew soybean purchases, alongside a general appetite to step up negotiations to end the dispute. There is clearly some way to go, but the desire may now have changed for the better. If this is the case then a major driver of risk aversion and also dollar strength could reverse in 2019. This would allow a better environment for equities to outperform again.
- The Federal Reserve takes a step back in its tightening – Equities suffered as the Fed has been tightening into the bearish implications of sliding global growth indicators. If the Fed hikes just once, or perhaps even not at all in 2019 then equities would feel the benefit.
- A Brexit resolution could drive better conditions for European equities – Brexit uncertainties remain and this issue will (hopefully) be resolved on 29th March, one way or another. If Theresa May somehow gets her EU Withdrawal Agreement deal through the UK Parliament then the prospect of a chaotic “no deal” Brexit will have been averted. This would free up a pot of billions of pounds that the UK Treasury has put aside for “no deal” planning and they can put that into positives for the UK economy again. Not only would this benefit the UK, but also Eurozone. This would remove one of the key risk aversion factors that has contributed to equities being hit so hard in 2018.