Nine predictions for ‘19

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While frequently attributed to Yogi Berra, and sometimes to Danish physicist Niels Bohr, apparently this remark should be attributed to an unnamed Danish politician from the 1937/38 Parliamentary session in Copenhagen. That being said, predicting is certainly a fraught activity.  Yet despite this warning, at this time I will endeavour to make nine forecasts of things to expect in 2019.

Forecasts for December 2019:

  • EURUSD – 1.0500 (-8.0 per cent)
  • GBPUSD – 1.2000 (-7.0 per cent)
  • USDCNY – 7.5000 (-8.0 per cent)
  • US 10-year Treasury yield – 2.75 per cent (-35bps)
  • German 10-year Bund yield – 0.00 per cent (-40bps)
  • S&P 500 Index – 1750 (-35 per cent)
  • Stoxx 600 – 250.00 (-30 per cent)
  • WTI - $55/BBL (-17 per cent)
  • Bitcoin - $4500 (-30 per cent)

Foreign exchange

At the beginning of 2018, the prevailing view was that the dollar’s rally had run its course and that by the end of this year, it would be materially lower vs. most of its counterparts.  The underlying thesis was twofold; first that the structural issues facing the US, namely the expanding budget and current account deficits, would deter investors from holding dollars with the result being a sharp decline.  Second was that the market had already priced in all the tightening by the Fed and that robust global growth would force other central banks to tighten more aggressively than markets had priced.  This combination of events should have, by rights, weakened the dollar.  Of course, with the evidence now in, it seems the pundits were wrong.  Or at least they focused on the wrong things.  There was a key cyclical factor that helped support the dollar, the fact that the Federal Reserve continued to tighten monetary policy and withdraw dollar liquidity from markets all year long more aggressively than the market had priced back in January.  This idea was not part of the general narrative, but as the market absorbed it, the dollar benefitted all year.

So has anything changed for 2019?  Arguably not!  While the structural issues remain, and if anything have become more acute, with the US budget deficit heading to new records, the cyclical factors also appear to be intact.  As of Q4 2018, the market has yet to fully price in the rate trajectory that the Fed itself sees going forward.  (Of course, the Fed is subject to getting its forecasts wrong as well, so the jury is still out on this dollar support.)  This leads to a look at three key currencies for next year, the euro, the British pound and the Chinese yuan.

EUR – European economic activity continues to lag that of the US, with growth on the Continent forecast by the IMF to be 2.0 per cent in 2018 (vs. 2.9 per cent in the US) and 1.9 per cent in 2019 (vs. 2.5 per cent in the US).  While ECB President Mario Draghi continues to tout strong Eurozone growth, the numbers belie those statements, at least relative to the US. 

Beyond the simple growth metrics, there is another entirely different issue that has only recently begun to crop up, and which does not appear to be part of the global narrative at this time.  This issue is the renewal (or repayment) of Targeted Long-Term Refinancing Operations (better known as TLTRO-II’s).  This was a program enacted by the ECB in 2016 that was designed to allow banks access to cheap funding for loans, often at zero or negative interest rates, in order to help the Eurozone economy recover from the recession induced by the sovereign debt crisis. 

Well, these loans will be maturing in 2020 and 2021.  Currently, these borrowings are considered as part of banks’ regulatory capital, and an important piece of their overall capital structure.  This remains true as long as more than one year remains until the loans come due.  However, once they fall below twelve months, they are no longer seen as acceptable long-term funding capital, and banks will need to replace them.  If they do not do so, they will have difficulty passing the annual stress tests. 

And that’s the problem.  Starting next year, these loans will begin falling inside the one-year mark and force banks to address their capital issues.  With the ECB hell bent on ending QE in December and raising rates next year, Eurozone banks will not be able to access funding nearly as cheaply.  There are two possible outcomes here: first, it might lead banks to call in the loans these TLTRO’s funded, which would impede growth, and likely delay any ECB tightening.  Or, second, the banks may just go to market to refinance these loans at higher rates, either increasing their customer’s borrowing costs or suffering significantly reduced interest margins and earnings.  Either of these will have the effect of slowing Eurozone growth, along with any incipient inflation, and thus the ECB would be forced to delay any tightening of policy. 

Of course, the ECB can simply roll them over at current rates, but that is directly opposite the objective of ending QE, and would insure that ECB monetary policy remained relatively easy compared to the Fed for another four or five years.  In every case, the ECB will be shown to have easier monetary policy than currently anticipated, and the euro will suffer accordingly.  My estimate is a further decline of between 8 per cent and 10 per cent to a year-end rate between 1.00 and 1.05.

GBP – The story in the British pound is far more straightforward, and it is largely binary.  Brexit will be the driving factor in the pound’s value at the end of 2019.  If the UK and EU manage to come to an agreement that avoids a “hard” Brexit, one where the UK reverts to WTO trading rules with the bloc, the pound will benefit relative to today’s levels.  In this situation, look for an initial rally in the pound of 3 per cent-5 per cent which is likely to fade slowly over the ensuing nine months as the dollar’s inherent benefits take hold, and result in the pound finishing somewhere near 1.30-1.35. 

However, if no deal is agreed, then the pound will suffer a more ignominious outcome, with an immediate decline that could easily approach 10 per cent.  From that point, however, I believe that the UK will be diligent in finding other trade opportunities, notably with the US and Canada, and we shall see the pound recoup a portion of those initial losses.  In the end, look for pound Sterling to trade near 1.20 at year’s end.

CNY – This situation has several moving parts that are not readily observable to outsiders.  Will the Chinese government be willing to utilise their currency to gain advantage in their ongoing quest to become the dominant global hegemon?  Perhaps.  Does the official data released by the Chinese government accurately reflect the economic situation there, or is it massaged to look better?  It’s not clear.  Something that seems certain is that the Chinese economy continues to increase its leverage while its growth trajectory slows.  That is not a healthy situation.  Additionally, for a mercantilist economy like China, the slowing growth trajectory in Europe, its second largest export market after the US, is also a concern.  Meanwhile, the trade fight with the US is serving to slow its activity here.  The PBOC has reversed its recent course of tightening monetary policy and is now very clearly easing.  When weighing the evidence, it seems clear that the yuan is set to decline further in order to help alleviate some of China’s homegrown problems.  While there is no reason to expect movement to be sharp, a gradual decline to 7.50 by year-end 2019 seems appropriate.

Interest rates

10-year Treasury and German Bund yields – In reverse order, Bunds have every reason to rally in 2019 based on three factors.  First, Eurozone growth is starting to fade; even German growth has fallen such that Q32018 showed a 0.0 per cent growth rate.  For the economy that is supposed to drive the Eurozone rebound, that is a poor portent.  Second, the situation in Italy has all the earmarks of a crisis in waiting.  The populist coalition of 5 Star and the League are unlikely to be persuaded to change their confrontational approach to EU dictates on the Italian budget.  This is because it is playing extremely well at home.  As investors evaluate the situation and continue to unload Italian government debt (BTP’s), the risk of contagion with other economies like Spain and Portugal will grow, while a flight to safety will result in substantial bidding for Bunds.  Finally, the probability of a hard Brexit continues to rise, and though the impact on the UK will be worse than the impact on the EU, Germany will be one of the hardest hit in the EU given the UK’s prominence in its export hierarchy.  This will also serve to slow German growth, reduce inflationary pressures, and support Bund prices.  These issues, not to mention the pressure on the Eurozone from refinancing the TLTRO-II’s will lead to a safe haven bid in Bunds and look for yields to be back at 0.00 per cent come next December.

Treasury yields, on the other hand, are a much different story.  Based on the expected strong growth impulse in the US, the Fed’s continued shrinking of its balance sheet, removing the ‘price insensitive’ bid from the market, and the substantial increase in Treasury issuance that will come with the growing US federal budget deficits, all signs point to higher yields in the future.  That is certainly the classical analysis that has held true for decades.  However, nothing happens in a vacuum, and there are likely to be additional consequences of those three items, namely a substantial correction in the equity markets and a move to safe havens.  And there is no safer haven in the market’s collective eyes than US Treasuries. 

With this in mind, I expect that while Treasury yields will climb for the first part of 2019, by the end of the year, a significant equity market correction will have helped the 10-year yield back down to 2.75 per cent.

Equity markets

S&P 500 and STOXX 600 – It’s over, the bull market that is.  Or at least it will be by the end of 2019 (and probably well before that).  The valuation story has been the bears’ only hat to wear for the past three years, explaining that whether looking at the Shiller CAPE, the Buffet Index, or Tobin’s Q Ratio, all of them have been at levels only seen twice before, in 1929 just before Black Monday, and in 2000 just before the tech stock meltdown.  In fact, all three of these are higher than levels just before the 2008 financial crisis.  But valuations are not enough to drive markets by themselves.  Other catalysts are needed as well, and in 2019 those catalysts are set to appear.  The biggest are rising interest rates and reduced liquidity courtesy of the Fed’s monetary tightening.  It cannot be overstated just how important QE and ZIRP were for driving equity markets higher during the past ten years.  But in addition, we are experiencing trade problems, which will undoubtedly drive inflation higher, as well as be an earnings issue.  2018 earnings have been flattered by the corporate tax cut, which showed comparisons to 2017 in a very favourable light.  But in 2019, the comparison will be significantly more difficult, and earnings growth will be much lower, likely single digits at best.  And that is assuming there is no recession.  Another recession will be along again, and my fear is it will occur before 2019 is out.  Equity markets have historically fallen sharply during recessions, more than 40 per cent on average, and there is no reason to expect that this one will be any different.  In fact, a case can be made that because of the extreme length of the current recovery, where imbalances have had a chance to build significantly, this recession could well be deeper than 2007-8.  And that is why I foresee a significant correction in the stock market in 2019, not just in the US, but globally.  So look for stock markets in both the US and in Europe to suffer significantly, as well as those elsewhere around the world. The S&P 500 at 1750 would simply take valuations back to long-run averages, not even a discount.  The STOXX 600 at 250 will be a little cheaper, but given Europe’s weaker growth, deservedly so.

 

Oil

 

WTI – Keeping with the theme that 2019 will be the year that the recovery ends, oil will be similarly impacted as other key markets.  The competing issues in the oil market are really all on the supply side.  For instance, the question of whether Saudi Arabia, Russia and increased US production will be sufficient to offset the decline expected to be seen from Iran (because of renewed US sanctions) and Venezuela (as the infrastructure continues to crumble).  The answer, at least as we enter Q4 2018, is that it is expected to do so.  If this remains the case, and there is every reason to believe it will, then a supply shortage will not be there to support the price of oil.  However, on the demand side, if the forecast of slowing global growth and an incipient recession are correct, look for demand for oil to slow substantially, tipping the balance and resulting in a price decline of between 15 per cent-20 per cent.  My call is for WTI to be trading at $55/BBL at the end of 2019.

Wildcard

Bitcoin – Finally, in this new age of financial technology, it seemed appropriate to take a look at Bitcoin, the father of all cryptocurrencies, and the one with the largest following by far.  By now, everyone is aware that in 2017 it exploded higher in a manic bubble at the end of the year, trading just below $20,000, before reversing course, declining ~65 per cent and settling in the $6000 - $6700 range since the summer began.  Trading volumes have declined significantly, and interest in the entire cryptocurrency space seemingly has waned.  So the question is will we see this trend continue, or if my forecast for increased volatility in traditional markets is correct, will Bitcoin serve as a sort of “digital gold” and be seen as a safe haven asset?  The evidence points to the former.  At this time there has been a significant increase in the amount of interest in the underlying technology of Bitcoin, blockchain, with virtually every major corporation and financial institution involved in a blockchain initiative of some sort.  But the buzz over Bitcoin itself has been greatly diminished.  Last year, it seemed like an amazing idea, and as it rallied sharply it drew new investors out of the woodwork.  But despite the advent of Bitcoin futures markets, and the nascent Bitcoin derivatives markets, it remains a niche item, outside the mainstream for institutional trading.  Add to that the idea that if the economy does head into recession, it is more likely that retail investors will be simply selling everything they own rather than looking for something to buck the trend.  If Bitcoin loses the retail investor, then it has no one left.  All this points to a further substantial decline in Bitcoin, with my estimate being a year-end price of just $4500, another 30 per cent decline.  And if anything, I think I am being generous. 

So here are nine forecasts for 2019.  Almost certainly, exact prices will not be met, but I feel confident that the broad direction I have outlined, which is consistent across all products, is what lays ahead.

Andy Fately, Chief Strategist, 9th Gear
Image Credit: MK photograp55 / Shutterstock