For equity investors, China giveth and China taketh away

Brian Nick

The last week’s market highlights:

Quote of the week:

“Look on yonder wall and hand me down my walkin' cane/ 
Look on yonder wall and hand me down my walkin' cane/ 
I got me another woman, baby, yon' come your man.”
– “Yonder Wall,” by James “Beale Street” Clarke
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q4 Outlook:
  • U.S. economy: Still running ahead of its peers.
  • Global economy: Trade a bigger concern outside the U.S.
  • Policy watch: Trade risks haven’t bitten the U.S. yet, but that may change.
  • Fixed income: Continue to position for rising rates.
  • Equities: The price is right outside the U.S.
  • Asset allocation: Finding pockets of opportunity.

Policy watch: Will the Fed pause in 2019?    

If all goes as expected, the Federal Reserve (Fed) will raise the fed funds rate by 25 basis points (0.25%), to a target of 2.25%-2.50%, when it meets on December 19. Given the recent market turmoil, though, we think how the Fed conveys its future intentions will be more important than how it justifies a rate increase this week. A hike on Wednesday would be the Fed’s fourth this year and ninth in its current tightening cycle. Laying out a clear policy path for 2019 and beyond is where Chair Jerome Powell and his colleagues will have their communication skills truly tested.      
In our view, the Fed’s challenge will be reconciling mostly positive U.S. economic news with mostly negative market sentiment. Record-low unemployment, like that reported among last month’s jobs numbers, combined with continued healthy levels of inflation, call for higher rates. On the inflation front, the latest Consumer Price Index (CPI) readings showed that prices rose 2.2% in November compared to a year ago. Indeed, both headline and core inflation (which strips out food and energy prices), have now topped the Fed’s 2% target for nine consecutive months.
Meanwhile, investors have made it clear that they want the Fed to stop raising rates as financial conditions tighten. The Goldman Sachs Financial Conditions Index, a barometer of the health of financial markets that tracks changes in interest rates, credit spreads, equity prices, and the dollar, has been creeping up since September. Last week it hovered near a two-year high. This trend means that less money has been flowing through the financial system, a potential headwind to economic growth.  
Against this backdrop, Chair Powell’s public comments since the last hike in September have undoubtedly contributed to market volatility. On October 3, he stated that interest rates were still “a long way” from neutral—the level at which they would neither stimulate nor depress the U.S. economy. Markets interpreted his words as hawkish. Fearing that the Fed might accelerate its pace of interest-rate hikes, stocks began to decline sharply. The S&P 500 finished with a 6.8% loss in October.
Powell backtracked on November 28, saying that rates were “just below” neutral. Markets cheered his slightly-more-dovish tone, concluding that the Fed wouldn’t raise rates too quickly or by too much. The S&P 500, for example, responded with its best day in six months. 
This week, when the Fed announces its interest-rate decision and Powell holds his press conference, we expect markets will get at least some of what they’re asking for. Currently, the Fed’s median forecast is for four rate hikes spanning 2019 and 2020. But Powell and his colleagues may well scale back that outlook and call for just two over that time period—meaning the Fed could hit the “pause” button as early as March.

Global politics: More chaos than calm in the U.K., France and Germany

Last week, President Donald Trump vowed to shut down the federal government unless Congress funds the building of a border wall between the U.S and Mexico. But that threat seemed quite tame compared to the current political climate overseas. Let’s take the temperature of Europe’s “Big Three”:   
  • The U.K.: Amid ongoing Brexit negotiations with the European Union (EU), Prime Minister Theresa May won a vote of confidence in her leadership of the Conservative Party on December 12, even as more than a third of her party rebelled against her. As for the Brexit bill itself, May canceled the scheduled December 11 vote in Parliament, fearing the agreement wouldn’t pass in its current form. May has promised a vote on a revised bill in January; the deadline for the U.K. to being transitioning out of the EU is March 29.

    Against this tense backdrop, we think the odds of the U.K. “crashing out” (i. e., leaving the EU without a deal) have risen but remain low, at about 30%. In such an event, we would expect at least a minor recession in the U.K., a decline in its currency, the pound sterling, and rising inflation—in other words, a period of stagflation, which is historically rare. Bringing a revised agreement directly to voters via a referendum, which May had formerly pledged not to do, is far less likely. Our base case continues to be that the EU will make enough concessions to give May sufficient “ayes” to pass Parliament.

  • France: President Emmanuel Macron also survived a no-confidence vote. This followed weeks of protests led by the gilets jaunes (or “yellow vests”) that began over his proposed fuel tax increases but have since snowballed into a revolt over living standards. Even though Macron has scrapped those tax hikes and offered concessions, including a minimum wage hike, his approval rating plunged to 23%.

  • Germany: Chancellor Angela Merkel has already announced that she will not run for re-election in 2021 and will stand down as chair of the Christian Democrats. These decisions followed her party’s poor performance in October’s regional elections. Merkel has been widely perceived as a figure of stability on the European stage.
The populist wave is global but it’s crashed hardest in Europe, which has been mired in sluggish growth and uneven recoveries for over a decade. Social and cultural anxieties mutually exacerbate economic distress. Consequently, durable and stable European political regimes, which are few and far between, have been unable to accomplish much while in office.
What can we expect from Europe in the medium to long term? Perhaps less austere fiscal policies and less accommodative monetary policy. That’s what the U.S. has been striving for over the past few years with at least moderate success. Pulling this off, though, will be harder to achieve across the Atlantic, where: 1) fiscal policy expansion on the order of what the U.S. Congress has passed is politically impossible—though arguably more necessary; and 2) it’s not clear that tighter monetary policy is even required given Europe’s economic struggles. These struggles were highlighted most recently by data showing that business activity in the Eurozone had fallen to a four-year low in December, according to Markit’s Purchasing Managers Index.
Better economic news for Europe is certainly possible, particularly if China—its top trading partner—can shake its economic slump. Last month, China reported sharp slowdowns in retail sales and manufacturing activity. The Chinese central bank is expected to roll out further monetary stimulus in order to provide a spark. An easing of tensions on the global trade front would also be highly beneficial, as would a Brexit agreement prior to March 29.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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