In this early May, the US president Donald Trump said a deal with China was “95%” completed. However, Trump raised tariffs on US$200 billion of Chinese goods in two weeks later and banned Chinese telecom Equipment Company Huawei from operating in the US or receiving the parts made in US.
The change in Trump’s attitudes towards China matched Reserve Bank said that it was unlikely to raise the US cash rate in 2019. While Trump’s row back undermined stocks, the Federal change of mind triggered a four months rally.
These events have influenced global stock markets over the first half of 2019. When we are assessing equities over the next 12-18 months, we figure out the three main drivers of equity prices, namely, earning growth, interest rates and level of uncertainty.
While as uncertainty can ruin any forecasts, let’s focus on these three main drivers and explain the reasons why we are cautious on equities.
As central banks tightened monetary policy in 2018, the world economy softened more during the year. Although central bank and other government actions have been more pre-growth of late so the risk of the contraction has reduced. We see that the biggest determinant of what happens to the growth outlook will be the US-Chinese confrontation.
The relationship between Beijing and Washington is challenging due to row over trade has spread into a long-term clash over global power where, as with all such arguments, President Trump and Xi are constrained by domestic political factors. We see that there are four possible consequences of the US-China clash in the next year or so.
The first consequence is a “treaty”. It would require Beijing to slow its modernisation plans while Washington would have to give up some of its global power to a nation it views as a long- term contender. Hardening domestic political views – particularly in the US where Democrats are determined to confront China – prevent the leaders of both countries from making the concessions needed for a treaty.
The second result of a “ceasefire” is more likely. That Trump and Xi would be benefitted from a ceasefire by which both make concessions ( China purchases more US goods while the US removes tariffs on Chinese imports) suggests a truce might be more likely than not. Any truce would most likely see the angle for growth stability at a modest level. Reaching more sturdy growth would probably require fresh fiscal or monetary policy to allow the policymakers to stimulate their economics. Trump has already got benefits from a ceasefire-driven rally in stocks, could see political benefit in breaking the truce ahead of the November 2020 election. In that case, the outlook for global growth would be just uncertain as it is today.
The third outcome is an “escalation” of hostilities should talks fail. It is tough to imagine that the global growth angle would improve under this scenario, however it is also difficult to predict how large the deterioration might be. We believe that more vigilance exercised by policymakers in the past six or so months has reduced, but not eliminated, the likelihood of a recession.
The final option is the “skirmish” between China and the US continues- fundamentally, the talks take longer than expected to reach the significant point. Under this scenario, the drag on growth would be less severe than under the escalation scenario.
The angle for interest rates depends on the prospects for the growth of inflation. The inflation outlook however is a greater source of uncertainty for the interest rate. The US inflation which is about 2% now on multiple measures, looks to be under control, we are alert to the possibility of a wages driven inflation scare that triggers a spike in the interest rates. The US labour market is still tight. The jobless rate is around 50 year’s lows. Admittedly, the softer growth outlook has faintly reduced the risk, nevertheless it hasn’t gone away.
Uncertainty is unlikely to decrease over the next 12-18 months. Trump’s behaviour is likely to stay unpredictable. Disharmony is rising in the European Union where Italy’s finances remain a threat to the Euro. Internal flashing points such as trade wars, the Middle East, North Korea are other sources of uncertainties.
These factors should feed economic uncertainty, which will be strengthen by the fact that the Fed has returned to its estimated range for interest rates where they are neither pro – nor anti – growth. Policymaking is relatively easy when strengthen from loose settings and more demanding when moving to a confining position.
The outcome of this analysis is that we recognize three potential market scenarios over the next 12 to 18 months. The first is, there is no significant increase in US inflation or a sharp slowdown in global growth, the potential exists for further interest rates cuts. Equity indexes would most likely give acceptable returns. We think there is about a 50% probability in this scenario.
In the second scenario, global growth slows to a level that imputes central banks to reply aggressively enough to make up for the political restraints on governments that slow fiscal impetus. The size of policy response depends on the depth of the slowdown, which makes the influence on equity prices tough to predict. However, it is clear to see that more growth slows, the worse it is for equity prices. We place about a 25% probability on this outcome.
The third scenario is that inflation fears produce a spike in interest rates. This scenario has become less belike, however still remains about a 25% possibility. A spike in interest rates would weigh on the growth angle and lift risk premium, potentially generating a 20% to 30% decline in equity prices.