6th June 2019 | Flawiusz Pawluk | Financial Markets Expert

10 things investors should look for 2019

People are always curious about what the future may bring. However, predicting the future is the most difficult thing to do, if not impossible. But in the financial markets there is always a market consensus about the most probable things which might happen. We generally believe that the market consensus is sometimes right but more often wrong. So, we would like the present our view on key events expected in 2019 which are against the market consensus.

Why Brexit could be more damaging for German economy than UK one?

The market consensus expects that Brexit, in whatever form, will be very damaging for the UK economy, at least in the short term. We do not fully agree as, at least, it will most likely be partially compensated by the weakening of GBP vs. other global currencies and, in particular, USD. However, we think that the UK economy, which is very much consumer oriented, is likely to survive this turbulent time. One aspect to consider is that UK is the 5th largest export market for Germany, accounting for 6.2% of total German exports. Given that Germany is very export oriented and, in addition, has recently been inpacted from the Chinese economy slow down, the consequences of Brexit could start a deep recession in Germany. This negative impact could be also increased by appreciation of EUR vs. GBP.

So just to sum up:

  • We expect that Brexit might become a bigger problem for the German economy rather than the UK one, 
  • We expect that EUR appreciation vs. GBP is likely to increase the negative effect, 
  • Germany is likely to fall into recession in the 2nd half of 2019, 
  • German stocks tumble.

Overall, we expect that Brexit might be one the key triggers which brings a recession to the EU. We think that the current market consensus assumes that a recession in the EU is avoidable, at least in 2019, but in this case, we are much more pessimistic.  

Over the past few years, the EU has improved its trading position, especially vs. US. However, in the future, this could be a weakness. The UK was a vast importer of goods from the EU in the amount of over EUR 75bn in 2017 alone. After Brexit, the trade deficit is very likely to reduce which means more trouble for the EU than it does for the UK. 

Negative interest rates in US – again?

The changes which we have seen in the FED’s interest rate policy recently are enormous. In December the FED started to change its view on the US economy, expecting a less robust growth in GDP (gross domestic product) in 2019. However, after the FED’s March meeting, it was clear that interest rate cuts were more likely than rises and they may happen towards the end of 2019. So, what happened? The most common explanation is that that trade war with China and the slowdown in global economy had finally affected the real economy in the US. However, we do not agree with this view as the US economy is very much consumption oriented so why would the slowdown in China be so important for the US? We have an alternative explanation as we think that the most important trigger is a significant increase in non-financial debt to GDP, which has reached the record high level of 74% of the GDP.

Why is the high level of non-financial debt so important for US economy? 

The reason is that US economy is one of the most liberal and open in the world, whilst, at the same time, US companies are the most aggressive players worldwide. However, over the past few years, US companies decided to spend most of its operating cash flow on buybacks instead of investing in Research&Development. Subsequently, the debt burden increased whilst the competitive advantage over the rest of world diminished, which, in our opinion, will result in stronger price pressure in the future. Therefore, in our opinion, we observe such strong trade tensions between the US and China as the US is probably losing its competitive edge and needs to compensate this by the reduction of import tariffs in China. 

How this is likely to play out in the future?

Well, FED seems to abandon its hawkish policy sooner than anybody expected. But it is a bad omen, we think, as it implies that the GDP growth is more fragile than anticipated. Since US President Donald Trump introduced significant cuts in corporate tax rates, growth is losing momentum and we do not see any positive economic triggers on the horizon. On the other hand, public deficit is out of control so debt burden continues to increase but this time on the public side. With huge twin debts in public and private corporate sector, we believe that the US economy will be slowly moving into recession and the FED will have no choice other than to cut interest rates again to nil or even negative. This is actually positive news for investment owners of US treasury debt if we are right, however, rather bad news for equity owners. Although the lower interest rates makes stocks who offer high dividends very attractive again, this means that US companies will face a more challenging macro environment and subsequently it may be forced to reduce the level of dividends and buybacks in order to reduce the debt. 

From recession to depression?

“This time is different” - this very popular slogan may turn out to be very true but unfortunately not in the way most people expect. Our thesis is that this time we face not typical recession but depression. So, what are the key differences between recession and depression? Recession is a situation in an economy where we can observe a drop in GDP in two consecutive quarters. Recession typically doesn’t last very long, usually about 2 years, with a single digit drop in GDP. Depression is a special case of recession, where the drop in GDP is above 10%, is longer than 2 or 3 years and, although rare, happens once a generation.

Why we think that this time we may face depression not recession?

We have a couple arguments as to why we believe so. The key points are as follows:

  • This time the debt burden is high - not only in developed economies but also in emerging markets, which were key growth drivers of the current expansion period,
  • High debt is the problem of not only public finances but also private corporations. Only the financial sector seems to be in good shape,
  • We are observing significant development of new industries and services, such as electric vehicles and autonomous driving systems, all of which are likely to reshape the structure of the global economy and the logistic chains and offer an advantage to new players primarily from China,
  • The rise of new empires (China) always creates some economic tension and price wars or trade wars which are visible right now, 
  • Aging of the population in the developed world is likely to reduce consumer spending and increase public costs due to higher pension and health care costs, 
  • Finally, rising defence spending, which at the beginning usually triggers higher investments but later cause many economic problems.

Depression is very nasty beast as it usually causes deflation 

The Central Banks tend to counteract depressions by printing cash but, this time, it is quite likely, that this solution will not work. This is because corporations and consumers will not be able to take any new loans, despite very low interest rates, as they already have very high debts. So, the last line of defence is to increase the public deficit and consequently debt. Only a few countries (Germany, Netherlands, maybe US) will be able to increase their debt to the GDP ratio, however, only during the time when pension funds will be the net buyers of treasury bonds. However, in the next few years (maybe 2-3 years depending on the macro-economic situation) most pension funds will become net sellers of public debt reducing the probability of further debt escalation. From that moment, the Central Banks may step in again buying bonds from the market. But who is going to sell bonds with good yield if the future yields might be much lower?

How this scenario ends?

Honestly speaking I do not know. I can only imagine that this scenario may lead to global economic catastrophe if it is not averted by prudent economic policy and large incentives for new investors. But what is the meaning of prudent economic policy? In my opinion, the first step shall be an increase of the retirement age, which will take place in all the major countries. The next step is that we cannot allow for further increase in public deficits and public debts as they must be adjusted to expected GDP growth. And finally, lows of falling real interest rates are causing misallocation of the capital. Maybe the best approach is to keep real interest rates stable instead of adjusting interest rates to the expected economic activity or, in other words, continue the current “data dependent policy” by FED. We must keep in mind that currently the FED’s policy is effectively followed by all major central banks as no one wants to have higher interest rates than the US has.

Notice: Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication. All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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