Out with the old, in with the new. Last year, the US economy evolved broadly as we expected. Growth was 3%, or near enough as makes no difference. Core inflation rose steadily, at least through the first half of the year, before disappointing towards the end, and thwarting our forecast for the year as a whole. Nevertheless, we stuck to our four hikes view — a strongly out of consensus call when we made it at the start of the year — and the Fed duly delivered. Back in November, when we finalised our Global Economic and Markets Outlook for 2018 Q4, we expected more of the same this year: well-above-trend growth; further increases in core inflation towards 3%; and four more rate hikes. Taken in the round, this position is looking increasingly untenable. Investors have undergone something of a reappraisal in recent weeks, and so must we.
As 2017 gave way to 2018, we felt that strong cyclical momentum, combined with valuations that were widely perceived as stretched across all major asset markets, would deliver heightened equity market volatility through 2018. And this call came through in spades (for a full review of our performance last year — our best calls, and our worst calls — see ‘Fathom’s 2018 scorecard’, by Erik Britton). What we did not foresee, however, was a sudden slowdown in economic activity towards the end of the year, particularly in Europe. Nor did we expect such a dramatic reappraisal of Fed policy, reflected in a flattening of the yield curve, and a 40 basis point reduction in the two-year US Treasury yield from its peak in mid-November. Where does all of this leave our 2019 call?
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The reassessment of global economic prospects that took place during the final months of last year, in the minds of investors at least, looks to have been driven by:
- Fears that there would be an end to cheap money, as the Fed continued to tighten at a steady pace
- Fears that escalating trade disputes would seriously harm global growth
- Fears that a sharp, domestically-driven slowdown was in train in China
As a consequence of the above, and although there remains some disagreement regarding the cause, the idea that there will be a global recession, either this year or next, is now close to consensus. We have warned clients of just such an outcome for almost a year. Specifically, we have been concerned that an overheating US economy would trigger a monetary policy tightening sufficient to tip the US into recession. With the policy tool cupboard almost bare in most major economies, the rest of the world would follow suit. The fact that the consensus has shifted so decisively in our direction has caused us to pause for thought.
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In an environment of heightened asset market volatility, where inflation is below target, if close to it, it is hard to imagine that any FOMC member who put at least some weight on growing fears that a global recession might be just around the corner, would feel a pressing need to tighten policy. Consequently, and as prefaced in ‘Fathom’s 2018 scorecard’, we have changed our Fed funds rate forecast. We no longer look for four hikes this year, and instead expect only two, probably in June and December.
If we are right, then fear number one on our list disappears, for now at least. Fear number two has always been overdone, in our view. In our previous quarterly forecast, we set out why it would take a severe escalation of the current dispute to trigger a global recession. Not only would the US and China need to levy still more tariffs against each other, but other parties, such as the EU, would need to join with equal enthusiasm. That remains a remote possibility for now. That leaves just fear number three. China’s economy is slowing, but the authorities in Beijing are working hard to arrest the decline. In our judgement, their actions will be sufficient to prevent a hard landing, for this year at least.
If the FOMC does slow the pace of tightening, as it has indicated, then we could see a meaningful rally in equity markets during the first half of this year, as fears that escalating trade disputes would seriously harm global growth start to fade. In this world, there is time for one last party. Indeed, the party may already have begun.
