Bob Baur

Market outlook: Is the monster rally over?

“Last month, I suggested the odds favored another market downdraft, something approaching December’s lows. Didn’t happen; stocks kept roaring higher. The S&P 500 Index soared 6.6% in December, 7.9% in January, and 3.0% in February, for a total 18.4% compound gain since Christmas. That’s an amazing run. Of the 46 world equity indices Principal tracks, none—not even one—had a negative return since Christmas. Well over half had double-digit returns.

“Is this the beginning of another long bull market? Doubtful. Central banks want to unwind the decade of suppressed interest rates and financial repression they oversaw. Stock and bond markets got used to that low-interest subsidy from central banks and the volatility in 2018 was the initial adjustment to that new monetary environment. In addition, world growth slowed in 2018 and the weakness persisted early this year. Markets are likely reflecting too much earnings optimism. Further, it often takes 12 to 18 months for the full impact of central bank tightening to become apparent. So, the 2018 Fed rate hikes and bond sales have not completely worked their way through the financial system – we’d stay cautious a while longer.

“Long-term, we may be close to the start of a radically new investment environment, one where real estate, value stocks, and commodities return to the fore after a decade of underperformance. It depends on wage growth. Notice the similarity of improving labour markets and a pickup in wage growth across major developed economies—U.S., U.K., Eurozone, and Japan. If this trend continues, central bank worries of deflation will evaporate, and inflation edges toward most countries’ targets. Long-term interest rates will reflect a little more inflation premium, which is good for financials. Businesses may find some pricing power, which is good for value stocks. Developed-country stock markets may stay bound within a range for some time as interest rates gradually work their way to more normal levels.”

Economic update

“We think the global slowdown is winding down. Global growth slowed in 2018 and it’s still braking a bit. China decelerated sharply but may pick up by mid-year. Idiosyncratic problems ranging from natural disasters and protests, to changing auto emission standards, dragged down activity in Europe and Japan. The U.S. economy resisted the weaknesses elsewhere, but first quarter growth is hiccupping. If official stimulus in China kicks in, world growth could pick up in the second half.”  

China: a pause in the structural deceleration

“Activity in China may be stabilising. Our proprietary growth indicator, based on a broad range of hard data, improved somewhat. Total social financing accelerated sharply in January, although there may be some noise associated with the Chinese New Year. Exports rose significantly but may be biased by the holiday. Business surveys were mixed; the official manufacturing index fell further while the private Caixin survey rose a bit. Both still show contraction. Surveys of service sector businesses rose handily, suggesting stimulus has started to stabilize growth already. We look for activity to pick up modestly in the second half of 2019.”

Japan: the expansion continues

“Exports plunged and industrial production contracted for a third straight month. Corporate profits declined in the fourth quarter as manufacturing companies feel the Chinese slowdown. Japan is part of the global supply chain that’s being disrupted by the trade dispute between the U.S. and China. U.S. auto tariffs loom for Japan and Europe as well. The labour market remains a bright spot with an incredibly low jobless rate of 2.5%. The ratio of job openings to the number of applicants is 1.63, around the highest since 1974, so there are plenty jobs for workers. However, the growth risk is likely on the downside; retail sales are struggling and a drop in profits may impact capital spending. Still, we look for 1% growth in 2019.”   

India and other emerging markets

“Easier financial conditions, a pickup in Chinese growth, and a weaker U.S. dollar should translate into less risk for emerging markets this year versus 2018. Risks will vary by country. For example, Fitch downgraded Pemex, the state-owned Mexican oil company, at the end of January, and bonds from South Africa may be in peril of a downgrade, too. Growth slowed in India in the fourth quarter to 6.6%. With the manufacturing survey index picking up to a nice 54.3, and the central bank liable to cut rates more, growth should move up above 7% as 2019 progresses.”

Europe: a trough in the slowdown

“European manufacturing activity remains weak but the services side of the Eurozone economy is better. Consumer confidence fell but remains mostly solid, likely because the labour market is holding up well. The jobless rate keeps dropping, now at 7.8%, down 0.8% from early 2018 and the lowest in a decade. This good job news is broad-based throughout the Euro area. That’s why wage gains are picking up and household consumption is driving growth.”

By Dr Bob Baur, Chief Global Economist

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