It is now the time of mid-year reviews, so I thought a little recap was warranted. Recent Market action provides a good time to reassess some of the drivers of global growth and returns going into the second half of the year and look ahead to 2019. Key questions remains about the macro damage from rising rates and selected capital outflows, rising oil prices and especially trade conflict. All of these trends but especially trade uncertainty are likely to reinforce a cyclical moderation of growth globally (returning closer to potential). This post highlights a few key assumptions and the catalysts I’m watching in the coming weeks to help identify opportunities and risks going forward.
Bottom line: global economic and trade growth are likely to slow in 2019, weighing on equity valuations, especially once the one-off payoffs to investors are completed. Stronger energy prices bring winners and losers, within and between countries, suggesting some outperformance of oil-linked FX and equities. Core interest rates should edge up in a non-linear way, as global central banks stick to their plans in the face of greater issuance. This should provide select opportunities for stronger countries. Among regions, Latin America should continue to lag, as the capital outflow pressure dampens the recovery, while Asian countries look more resilient to higher interest rates.
I look in more depth at
- Trade scenarios: Best case looks to be a continued rollercoaster which makes planning difficult, bringing a modest drag on growth, rather than a more meaningful one. A deal with China or something proclaimed as one still seems likely, but broader U.S. macro policy (fiscal) and recent market correction make closing the trade gap even harder.
- Global Monetary Policy: softening from selected EM and peripheral risks is unlikely to be enough to shift the global central bank trajectory – slowly tightening
- Europe: Peripheral risks are likely to recur, but ECB exit may not be under-anticipated. These developments may reinforce cyclical weakening.
- China: Policy settings still relatively supportive, limiting slowdown of global economy. No signs of major deleveraging.
- Energy outlook: Key questions remain about likely readjustment of OPEC+ output, which are likely to add volatility in the near-term and depress North American blends. Higher prices are likely to dent but not reverse demand growth. OPEC+ may wait to see how much Iranian oil can be displaced suggesting a more gradualist approach.
- EM pressure: EM Flows are likely to remain differentiated, higher rates likely to keep Latin America from much of a growth revival, and Asian countries more resilient despite the commodity rally. Oil-linked countries should receive some respite, led by government spending.
Trade rollercoaster to continue: Tariffs and threats complicate investment.
The U.S. trade policy trajectory remains a major risk to market sentiment, a trend that’s unlikely to end any time soon. That U.S. policy shifted from mere rhetorical threats to more specific ones is no surprise, but the ultimate goal of what would be deemed a success remains unclear, aside from the goal of reducing the trade surplus, something that other macro choices at home and abroad (fiscal and monetary) make more difficult. While the U.S. may strike some mercantilist deals, including with China, I would anticipate that the trade policy risks will linger well into 2019, undermining corporations ability to make decisions. So what are the key scenarios?
The tariff announcements have come fast and furious from the U.S. followed by lists of possible retaliation targets from trading partners. The tariff threats intersect with and are designed to crystallize attention on ongoing coercive trade negotiations, where the aim seems focused on reducing the U.S. trade deficit, rather than necessarily any measures on improving the quality of growth. In this way there is a risk that This trade and investment rollercoaster is likely to continue through the fall and possibly into next year, raising risks of price increases and just making it harder for businesses to plan.
At this point, there seem to be two key scenarios
- a base case in which there is continued uncertainty and modest tariff application, that adds moderate costs through the supply chains and makes it harder to assess profits, but which lacks broad-based trade restrictions. In this scenario, businesses find it harder to plan, deferring some investments, especially if other domestic policies foster greater uncertainty. In this scenario I’d expect some mercantilist deals, perhaps tied to security policy goals, but lingering restrictions in key areas. China and NAFTA remain the key negotiations to watch, with some temporary agreement likely with the latter.
- A second, worse scenario, would involve greater volume of trade being effected, and price increases hitting demand and leading to temporary supply shortages. Tariff implementation would likely add to FX volatility as that would likely be the primary transmission chain.
- Note that a third scenario of a positive feedback loop from moderate, modernizing trade policies seems less likely at this point. In this scenario, trade policy might be neutral to positive, with broader monetary and fiscal policy providing a bigger driver to growth.
Countries and sectors heavily reliant on trade, especially with the U.S. as end buyers including parts of South East Asia, Korea, as well as Canada and Mexico, would likely to face more vulnerability, though currency adjustment to the tariffs might alleviate volume declines.
European Risks: Peripheral risks to stay active, but not sway ECB
Italy’s deadlocked cabinet formation and some less problematic politics in spain led their yields to recent heights and reignited concerns about a euro-exit. This still remains unlikely any time soon, but the lack of growth in Italy and an unsustainable debt burden suggests that there are no easy political solutions. On net, the rising costs (partly a function of the ECB steps towards tapering which allow market actors to look more closely at fundamentals) are likely to increase savings rates in Europe, especially if more austerity is mandated. In the last half decade, debt profiles of peripheral countries have become more concentrated nationally, which makes addressing this issues harder.
Europe was headed towards a cyclical moderation of growth after over potential growth for parts of the core over the recent period. Overall macro trends are likely to keep ECB on course, which will in turn gradually bring more focus on the fundamentals of the credit profile.
The transatlantic divides don’t help of course with both the trade risks and the implementation of sanctions on Iran (and to a lesser extent Russia) complicating matters within the zone by increasing divides. For example, Italy, France and Greece are among the most exposed to Iranian crude, and include some of the more energy intensive countries. By contrast Germany and CEE are more exposed to U.S. tariffs directly (small) or via diversion from China. Expect more of these macro and security policies to remain linked.
Emerging Market pressure: Differentiation likely but borrowing costs edging up
The reversal of some of the extensive capital flows is likely to drive differentiation across the EM space, with oil producers outperforming, along with those with manageable inflation outlooks, and external surpluses. Growth is likely to slow sharply or fail to recover in a few most afflicted countries, forcing external deficits to narrow (Turkey, Argentina), but central bank responses are likely to selectively revive the carry trade. I don’t see a major drag on global growth, but rather a limited growth acceleration.
In aggregate, EM have experienced capital outflows from equity and bonds, and most FX have weakened. However the selloff this year has been highly concentrated in a few countries – Turkey, Argentina, Brazil and to a lesser extent sanctioned Russia. All three have meaningful policy vulnerabilities that investors only remembered when U.S. yields began rising – including external imbalances (Turkey, Argentina), wide or widening fiscal or quasi fiscal spending (all three), policy uncertainty post 2018 elections (Turkey, Brazil). CEE countries, which previously benefited from the ECB bid to reduce yields, have also suffered more than in the taper tantrum.
By contrast many Asian FX have been more resilient – notably India and Indonesia, partly because they reduced short-term FX liabilities, and central banks have been responsive. On the margins the end of most EM monetary easing will constitute a modest drag on growth, but not a major one. Chinese policy is key to assessing the broader response – the focus on selective small corporate defaults and limited deleveraging, and extensive overall credit is likely to keep underlying demand decent.
As mentioned in last month’s EM Q&A, I don’t see a lot of pegs to break, a difference from past crises. Most of the lingering pegs and quasi-pegs remain among oil producers, and the improvement in trade outlook is likely to reduce pressure compared to the last two years. In fact countries like Nigeria would arguably have an appreciating currency. GCC pegs even invulnerable Bahrain and Oman, look much more manageable than even six months ago.
Oil Rebalancing: OPEC+ actions Bring Volatility and New Price Band.
The OPEC+ group cuts and desire for profits among shale producers have brought the oil market closer to balance, helped by massive economic implosion in Venezuela which has led the broader group to overcomply with cuts, boosting prices, especially of Brent and products. The increase risks denting but not reversing demand growth including from key emerging markets.
Logistics issues are likely to limit the ability of North American producers to take full advantage of this demand and price dynamic, keeping the WTI-Brent and other discounts like Western Canada select weaker, even as production costs begin to increase. Production will continue to increase, but so will backlogs and some production costs.
This months OPEC meeting and seminar is a key catalyst to watch. Markets are expecting some increase in production, at least to take the group back to compliance not over compliance and possibly to net increase as demand has picked up more than expected. Key questions include whether the producers group will
- focus on reallocating among existing producers,
- increase overall targets
- avoid an increase but look the other way as key producers increase (Saudi Arabia, Russia, UAE, Kuwait are some of the few with notable spare capacity)
At this point, expectations of new additions of up to 1mbd may be overly optimistic and may only follow actual cuts to Iranian oil (see my recent piece for more on the Iran elements)
Beyond OPEC, two Latam countries, Brazil and Mexico have elections that might be key to energy production going forward. Both Brazil and Mexico are net importers of hydrocarbons meaning they are buffeted on both sides by oil price volatility. While an AMLO government is unlikely to have the margin to be able to reverse reforms there are some policies that might slowdown new developments. Brazil’s strike of recent weeks, highlights some of the challenges in passing on higher costs to end users. I’m not optimistic about the ability of Brazil’s new government to maneuver both their fiscal adjustment and new infrastructure investment. The country has been a source of under performance on the supply side. Watching not only election results, which may be deadlocked, especially with congress, but also new leadership of Petrobras will be important.
Ziemba Insights 