Global stocks kicked off 2019 with a rally, rising over 3% in the first two weeks of the year. That uptick reflected renewed optimism over US-China trade relations, signs of flexibility from the Federal Reserve on monetary policy, and a strong US jobs release for December. Some investors may also have been tempted by cheaper valuations after an 11% decline in global stocks over 2018. The S&P 500 now trades on 15 times forward earnings, down from 18.5 at the start of 2018. And falling government bonds yields have made equities look more attractive relative to fixed income.
The question now is whether this relief bounce in stocks will turn into a more sustained rally. Investors can't expect the same tailwinds that pushed equities higher in early 2018. US earnings growth is on track to slow from over 20% to around 4.5% in 2019. And for the first time since the 2008 crisis, top central banks will end the year with smaller balance sheets. So to gauge whether the rally will gain traction, we will be looking for several key developments:
1. Converting a fragile cease-fire on trade into a more durable agreement would help underpin the stock rally. The news in recent weeks has been positive, with President Donald Trump touting solid progress. Late last week China's Commerce Ministry said that discussions in Beijing had established a foundation for resolving the dispute, with progress on such vexing issues as forced technology transfers and protection for intellectual property rights. US negotiators, meanwhile, were encouraged by China’s promises to purchase "a substantial amount" of products and services from the US. We now believe that talks will make sufficient progress by the 2 March deadline to avert a threatened increase in tariffs on USD 200bn of Chinese goods. But the rivalry between the US and China is deep-seated, and a renewal of trade brinkmanship could harm the global earnings outlook and send the equity rally into reverse.
2. The Federal Reserve needs to follow through on its more dovish rhetoric. Chair Jerome Powell and his colleagues can claim much of the credit for the early 2019 bounce. The S&P 500 climbed 3.4% after Powell said policymakers were "listening carefully" to the market and would remain flexible on further tightening. And the minutes of the Fed's 18-19 December meeting showed policymakers felt they could "afford to be patient about further policy tightening."
This supports our view that the pace of rate hikes will slow from once a quarter, to just two quarter-point increases in 2019. Investors now need the Fed to continue using this reassuring language, and to deliver on their promise of flexibility.
3. Forward looking economic indicators will need to stabilize, especially for the world's two largest economies. The most reassuring economic release so far in 2019 has been from the US labor market. A 312,000 increase in US employment for December was more than double expectations, and wage growth of 3.2% matched the highest level since 2009. However, payroll growth is seen by economists as a lagging indicator. Leading indicators – such as purchasing managers' index readings – have been lackluster in both the US and China. China's manufacturing PMI reading fell into contractionary territory in December for the first time since February 2016. A fully-fledged recovery will require a leveling off in such data.
4. Political risks need to remain under control. Both the US and UK are facing political crunch points, with the former embroiled in a clash over the budget and the latter a key parliamentary vote over its departure from the EU. Neither situation poses an immediate risk to global markets, but a significant deterioration in either could become a source of uncertainty. The partial federal shutdown is now the longest on record. If no agreement is reached on a budget, the debt ceiling will be reinstated on 1 March. That would store up trouble for later in the year, potentially making it hard for the government to pay its bills by around August, according to reported estimates. Meanwhile, continued uncertainty over Brexit poses risks both for the UK and European economies and markets.
The bottom line is that the rally, while encouraging, could prove fragile. So while we remain overweight global equities, we also recommend investors continue to hold countercyclical positions and, where appropriate, consider hedging. Volatility remains elevated, and investors should not expect it to subside any time soon.
The recent rally, while encouraging, could prove fragile. We will be looking for several key developments for signs that the rally will gain traction, including a more durable US-China trade agreement, a more dovish Fed, better forward-looking economic indicators, and political risks staying contained. So while we remain overweight global equities, we also recommend investors continue to hold countercyclical positions and, where appropriate, consider hedging. Volatility remains elevated, and investors should not expect it to subside any time soon.