We think there’s not as much going on, fortunately, as the recent market action may have you thinking. We see the correction as more about adjusting the elevated and misplaced expectations for the U.S. economy rather than anything fundamental in the global economy. It’s still the same old “Goldilocks” cycle—modest growth and modest inflation—that it has been since the global financial crisis, the stimulus and strong cyclical growth notwithstanding.
It wasn’t long ago that the global economy was in the throes of a synchronised expansion. Growth was sound, inflation was modest and as a result 2017 was a benevolent, banner year for the markets. In truth, the synchronised global expansion was little more than a historical accident, the result of the early 2016 bottoming in oil prices and the massive stimulus by Chinese policymakers. By early 2018, the U.S. tax cuts were arriving just as the impact of the Chinese stimulus was fading, and the expansion became asynchronous. U.S. growth took off (look no further than last week’s 3.5% real Q3 GDP print), while the rest of the world was slowing. As always, capital flows to where growth is strongest, and dollar-denominated assets outperformed meaningfully.
The narrative, however, that the U.S. economy is poised to sustain this higher level of growth was always hyperbole. For one, the U.S. output gap had already closed. Two, there was always the inevitable downsides of late-cycle fiscal stimulus including premature tightening by the U.S. Federal Reserve, higher interest rates across the yield curve, and a stronger dollar. It’s no surprise then that U.S. financial conditions are now tightening. Make no mistake, we still believe U.S. economic growth will slow in the first half of 2019. The slowdown is already showing up in the U.S. housing and auto markets. The equity market is simply pricing the slowdown in ahead of time with the highest-valuation sectors, including the information technology sector, selling off the most.
It is, however, not the end of the cycle. This cycle will ultimately end, as all others do, with 1) a significant policy mistake in the U.S., or 2) a significant deterioration in economic activity in one of the major economic blocs of the world.
- The Federal Reserve, with inflation largely under control and financial conditions already tightening, will back off their tightening stance. Rates will fall, the dollar will moderate, and credit spreads will tighten. A policy mistake could come by way of a full-blown trade war with China, but we expect greater clarity following the midterm elections, and we believe the ultimate impact of a new trade agreement on the global economy will be relatively small.
- The ongoing weakness in European growth bears watching. Europe continues to suffer from unending political concerns and was disproportionately impacted by the emerging market slowdown and capital flight. We expect Europe to stabilise in 2019 as its emerging market trading partners stabilise from a relatively modest slowdown.
Instead, this is the stage of the cycle when the U.S. reverts towards trend growth, converging with much of the rest of the world. As that convergence happens, capital will flow to where valuations are cheapest (emerging markets) and to those companies generating true earnings growth in a slow growth world (technology stocks for example).
Market corrections can be painful, but investors should view the downturn favourably. Stock prices are being rationalised and are not meaningfully overvalued. Policy is poised to become more accommodative. If anything, we are more convinced now, than we were in the beginning of the month, that this elongated cycle will continue indefinitely.
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