The Silver Bullet | Throw in the Powell

At the end of 2018, we called for political volatility but no recession in 2019. As markets increasingly priced in recession risks in Europe and particularly in credit, we pointed out value in the sector, although we were too early in positioning ourselves.

Today, markets are rebounding and some recession fears are fading. Central banks have blinked, moderating their hawkish stance. Will this be a dovish slowdown with above-trend growth, and what are the positive and negative risks?

Our base case scenario for 2019 is one of a benign, dovish slowdown.

1. Monetary policy: the cornerstone underlying our view is a more dovish approach from central banks

Central banks, starting from the Fed to the PBOC and the ECB, have started moderating their hawkish ambitions and are gradually switching the dial to pause or even back to stimulus.

With central banks leaning back towards easing and growth still above 2% in the US, 1% in the Eurozone and around 6% in China, last year’s recession fears appear overdone today.

As a result, many risk assets have staged a January rally – with credit moving from a liquidity air-pocket fall in December to a short squeeze. That said, we believe there are still opportunities, and many assets, particularly in Europe, remain priced for too-high tail risk.

Monetary policy, however, is only one supportive factor – and it is increasingly less effective. As a result, a late-cycle economic equilibrium with slowing growth supported solely by central bank put options is intrinsically fragile. The key to understand whether today’s dovish slowdown will last, or if it will have upside (or downside) risks is therefore fiscal and trade policy.

2. Fiscal policy: we see modest upside from China. European policymakers, instead, remain behind the curve

As fiscal stimulus gradually fades in the United States, China is preparing to implement a new round fiscal easing. The details will be fully unveiled at the annual party congress in March: what we already know is that this won’t be comparable to what China implemented following the 2008 crisis, when it poured 4tn yuan in the economy and doubled total social financing.

Overall, we see China’s stimulus as a counter action to stabilize a decelerating growth trend, rather than a source of substantial upside.

With political consensus and European elections as the primary focus, 2019 is likely to be a transition year in European policy, with limited scope for stimulus. That said, fears of extreme events, particularly in Italy and the UK, are proving to be overdone.

To sum up, we expect fiscal policy from China to be a further put against growth deterioration, rather than an aggressive boost.

3. Trade policy: certainty could be the biggest stimulus

If monetary and fiscal policy can help growth to stay around or above trend, trade policy is the key to determine whether today’s dovish slowdown is sustainable. Uncertainty around trade has delayed business decisions and compounded volatility in financial markets last year, consistent with what Mr Greenspan said – with the US government shutdown adding to already elevated geopolitical risks.

The combination of dovish monetary policy, China’s fiscal stimulus and a temporary thaw in trade negotiations should support our base case of a dovish, benign slowdown.

Risk assets should perform well in this dovish slowdown, as long as growth remains above or around trend. That said and given last year’s price action, on question remains open.

What could go wrong?

Beyond 2019: Recession Risks Are Overblown

What are the risks to our view? If dovish monetary policy, some fiscal stimulus and low energy prices can keep the cycle going, the counter-argument is often that imbalances are growing larger, and that these could destabilise growth and the financial system. Our sense here, as discussed above, is that markets may have been too pessimistic about the cycle. Below is our model calculating the market-implied probability of recession, which at the end of last year was around 15%, with daily jumps above that. This may seem a low number in absolute value, but it is close to what markets told you during other US recessions in the past, suggesting a high level of worry.

But rather than an imminent growth shock, there is another more worrying risk Western economies face: Japanification. Rising sovereign debt, stagnant demographics and a lack of response from fiscal policy mean central banks may be no longer in the economy’s driving seat.

Rise and Fall of Populists: The Flight of Icarus

Any economic forecast for 2019 depends on how geopolitical events will unfold. Populist governments and regimes have sprouted around the world, in part thanks to rising wealth inequality, something we have been flagging for years as a collateral effect of monetary policies. But populist regimes largely centred their narratives on migration and nationalism, often implementing unrealistic Icarus-like fiscal policies.

As in the legend of Icarus, despite the many warnings by experts, populist governments are eventually exposed by their own unrealistic economic policies. Once this happens, the incentive becomes clinging on to power – and how long populist leaders may be able to do so depends on a country’s resources as well the strength of its democratic institutions. In a good outcome, a period of populism may be followed by a return to orthodox policy. In a bad outcome, populists will try to retain power at any cost. A third scenario is for current populists to be replaced by new ones.

Several EM countries this year will face make-it-or-break-it political events, including Argentina, Ukraine and Venezuela.

Conclusions: European and EM Opportunities

Our outlook for 2019 is positive: we believe we are in a dovish slowdown with some tactical upside risk from fading trade uncertainty and fiscal stimulus in China. With lower oil prices and growth still around or above trend, risk assets should continue to perform well. In addition, as the Federal Reserve leans towards easing and China implements a new stimulus, last year’s relative outperformance in the United States’ vs the rest of the world may gradually reverse.

We believe European assets offer an opportunity now, as many investors have abandoned them on fears of tail events or political complexity. That said, the economic cycle is slowing, so we have narrowed our focus to national champion banks and free-cash-flow positive corporates, and positioned short on cyclical businesses with aggressive capital structures and a lack of competitive edge.

In emerging markets, we believe risk assets will continue to benefit from the Fed’s recent moderation. However, valuations are not cheap overall, especially in hard currency debt. We see US credit markets as relatively less attractive overall, having recovered more quickly from last year’s fall and being much ahead in the leverage cycle.

Beyond 2019, our focus is on politics and geopolitics. While central banks will likely have to reverse their normalisation course in case of a further slowdown, any room for easing will be limited. This will put politicians and fiscal policy in the driver’s seat.