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3.2.2020 - Edgar-Walk

Equity markets: Good chances for positive start to the year

Bond markets: Moderately rising yields expected on both sides of the Atlantic

European bond markets recorded losses in the fourth quarter. According to the JP Morgan indices, German Bunds lost 3.2% while government bonds from the euro zone lost 2.9%. This was due mainly to a rise in yields on ten-year German Bunds from -0.57% at the beginning of the quarter to -0.19% by the end of the quarter. The diminishing risks of a "no-deal Brexit" and the increasing signs of a de-escalation in the trade conflict between the USA and China made the "safe haven" of German Bunds less attractive. Furthermore, most economic data in the euro zone was surprisingly positive, so the risks of a recession decreased noticeably. Financial market players changed their forecasts regarding the further course of the European Central Bank (ECB) accordingly; instead of expecting more key interest rate cuts, they now assume the ECB will not be changing its monetary policy any time soon.

In our baseline scenario, we assume that global economic growth momentum will stabilize initially but will pick up moderately as the year progresses. At the same time, we anticipate stable inflation. In this climate, there is no need for action by the US Federal Reserve (Fed) or the ECB; they can thus both adopt a wait-and-see stance. This applies particularly to the USA, as the Fed certainly does not want to jeopardize its political independence by making an interest rate move in a hotly contested election year. In addition, we expect political risks emanating from the USA to subside in the run-up to the presidential elections. As a result, yield on ten-year US and German Bunds could rise moderately by 0.3–0.4 percentage points this year, because the attractiveness of these “safe haven” investments is likely to decline further.

We see an unexpectedly strong revival of economic growth in the USA as a major risk scenario for the bond markets that could even bring the unemployment rate down to 3.0%. The ongoing labor shortage would undoubtedly lead to a substantial increase in wages and thus to a surprisingly sharp rise in inflation.

Equity markets: Good chances for a positive start to the year

In the fourth quarter of 2019, the global equity markets recorded a marked gain. The MSCI Europe gained 4.5% and the MSCI World even posted a gain of 7.6%. The MSCI Emerging Markets index was the biggest winner with a gain of 9.6% (all in local currency). Since the sum arrived at by adding corporate profit growth and the change in valuation (price-earnings ratio) must correspond to price performance on the equity markets, this relationship can be used for analysis and forecast purposes. With stagnating corporate profits in almost all regions in the fourth quarter, rising equity prices were thus exclusively attributable to higher valuations that probably were caused largely by declining political risks and the lavish monetary expansion of the central banks.

At the beginning of the year, economic indicators suggested that growth momentum in the global economy has bottomed out and the risks of recession have declined noticeably. Provided there are no new political jolts, there is a good chance the economy will pick up this year. Our analyses show, however, that corporate profits are likely to stagnate, at least in the first quarter of 2020. Nevertheless, the ongoing balance sheet expansion of the US Federal Reserve (Fed) and the ECB, i.e. the ample flow of central bank liquidity, could also contribute to another moderate rise in valuations on the equity markets in the first quarter of 2020. All in all, there is thus a good chance the year will get off to a good start even though our analyses show that share price performance is currently heavily dependent on central bank policy and the associated low yields on the bond markets. Any sign of a turnaround in monetary policy could put pressure on equity prices, but we do not see any reason for this at the moment.

Moreover, political developments remain a risk factor. For example, experts at Goldman Sachs believe the US presidential elections in November are a risk factor for the US equity markets. If a Democratic candidate wins and the Democrats take over the majority in the Senate at the same time, higher corporate taxes would loom on the horizon. According to Goldman Sachs' calculations, this could cause prices on the US equity markets to decline by up to 20%. In our view, even if the Democrats win just the presidency, they will certainly use competition policy in an effort to tackle high corporate profit margins in the USA. 

Euro zone: Brexit clarity boosts growth substantially

The risk of a "no-deal Brexit" was noticeably heightened in the fourth quarter of 2019 and, like the trade dispute between the USA and China, it left a substantial mark on economic data throughout Europe. The purchasing managers' index for the overall economy and the expectations component of the ifo index both reached a trough in September and have recovered only marginally since then. In our opinion, Boris Johnson’s clear election victory in December and the adoption of an exit treaty in the House of Commons have reduced the risks of a “no-deal Brexit” considerably. The UK and the European Union still have to conclude a trade agreement by the end of the year, but we believe a solution can be found.

Right now, the most likely scenario is that the parties will initially agree only on certain areas and continue to negotiate open points after the deadline. The UK is seeking complete regulatory independence from the EU which means tariffs and bureaucratic trade barriers are inevitable. The essential question is what will dominate: the negative effects of the trade barriers or the positive growth impulses from deregulation. If the UK becomes a successful model, this will clearly expose the growth-damaging consequences of excessive EU bureaucracy. At least for 2020, economic growth is expected to accelerate noticeably in the UK due to Boris Johnson's announcement of significant increases in government spending that could add up to around 0.5 percentage points of gross domestic product (GDP).

Furthermore, the reduced uncertainty about Brexit should put an end to the persistent investment weakness in the UK, transforming the UK from a burden to a plus factor for Europe. It therefore comes as no surprise that first leading indicators, e.g. the ZEW Index, have already improved significantly. In this environment, the Bank of England and the ECB should see no need for action and are likely to adopt a wait-and-see stance.

US economy: Economic prospects have brightened again

Last year’s three key interest rate cuts by the US Federal Reserve (Fed) contributed to a decline in yields on corporate and high-yield bonds and to rising equity prices, thus noticeably improving general funding conditions and confirming the great influence of central bank policy on financing supply. Economic growth going forward will now depend on the extent to which companies and private households use the improved supply of equity and debt capital to increase spending. Experience shows that positive effects on growth can be expected, especially since political risks have recently eased and should decrease further in the run-up to the presidential elections.

Wages in the lower income brackets have also risen recently by around 4.5%, significantly faster than in the overall economy (about 3.0%). Ongoing positive developments on the labor market could accelerate wage growth in the lower income brackets even further – where the consumption rate is traditionally high. Prospects for the US economy in 2020 have therefore brightened, which means our current growth forecast of 1.6% could turn out to be too low. This brings us directly to the topic of inflation risks. Macroeconomic data shows that, in accordance with national accounts, US companies have so far been unable to pass on higher wages in their prices and have had to accept declining profit margins. If wage dynamics accelerate even further this year, companies could be forced to raise prices in an effort to maintain margins. However, we believe there is a good chance that productivity will also improve at an accelerated pace as digitization continues, so unit labor costs and inflation should remain more or less stable.

The presidential elections in November are also already making their mark. At present, it looks like a close race. According to a survey of fund managers by BofA Merrill Lynch, the elections represent the greatest global risk for 2020 due to the polarization of the political parties.

Asian economy: Japan in a structural upward trend; significantly better prospects for growth in China

Will Japan be able to return to its status as a country of high productivity growth, thus overcoming three lost decades? Numerous structural reforms – an important component of Abenomics – seem to be slowly taking hold. For example, the unemployment rate has declined from 4.3% to 2.4% since Prime Minister Shinzo Abe began to implement policy changes. Moreover, the Japanese government limited legal overtime severely last year, thus exacerbating the labor shortage for companies even further. The government attempted to counteract this by increasing the maximum number of foreign workers permitted from about 600,000 in 2012 to about 1.5 million in 2018.

However, structural reforms have also forced Japanese companies to improve their return on equity significantly, and according to Goldman Sachs calculations, they have succeeded in doing so. Average return on equity has risen from around 5.4% in 2012 to 8.9% most recently. Obviously, it has become more attractive again to invest in one's own company, especially since the shrinking workforce needs to be replaced by robots and software. We therefore see a structural upward trend in corporate investments – intended not so much to build new capacity but to maintain existing capacity. In our opinion, Japan has a good chance of soon achieving better productivity figures and thus high rates of per capita economic growth.

China's economy should also benefit from the ceasefire in the trade conflict with the USA. After conclusion of a first trade agreement, we basically foresee a long phase of negotiations between the two countries with an uncertain outcome. The mere prospect that the trade conflict might not worsen any time soon should reduce uncertainty and thus initiate recovery of investment spending by Chinese companies. This is especially true since monetary and fiscal policy has been eased several times in recent months, adding significant stimulus to the pipeline. The chances are thus good that Chinese economic growth will level off at around 6.0%. In absolute terms, this equals an increase in economic output of around USD 1,000 billion within one year.

Edgar Walk, Chefvolkswirt Metzler Asset Management
Edgar Walk

Chief Economist , Metzler Asset Management

Edgar Walk joined Metzler in 2000. As Chief Economist in the asset management division, he is responsible for formulating our global economic outlook. Due to his close cooperation with the portfolio management, he focuses on capital market themes as well as on global economic analyses. Mr. Walk holds a master’s degree in economics from the University of Tübingen in Germany and spent a semester at the University of Doshisha in Kyoto, Japan. In addition, he completed the program “Advanced Studies in International Economic Policy Research“ at the Institute of World Economy in Kiel, Germany.

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