This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
What exactly went wrong in 2018? Markets started the year full of optimism. The US economy delivered stellar performance, buoyed by tax cuts, which caused a surge in both growth and corporate earnings. The unemployment rate hit an almost 50-year low.
The upward drift in inflation was gradual, so there weren’t many surprises from the Fed, which hiked rates by 25 basis points per quarter. Global quantitative easing wound down, beginning a reversal of the great search for yield. This challenged fixed income across the board, but not dramatically so.
What proved considerably more disruptive in 2018 was US foreign policy. Undeterred by the threat of higher costs for US consumers and businesses, Washington ramped up trade tensions. It seems that there is considerable political appetite among the US electorate, and as a result both Republicans and Democrats, to reconsider US trading relationships, with China very much at the eye of the storm. This trade aggression hit the Chinese economy at a point when growth was already slowing rapidly in response to tighter policy from Beijing.
The emerging markets have thus endured the double whammy of slowing growth in China and rising borrowing costs as a result of higher US interest rates. Emerging market equities and debt took a significant hit in 2018. Europe has been caught in the crossfire. Although early tensions between the US and EU over auto tariffs have dissipated for now, European demand has been battered by a downturn in global trade.
European Political Challenges Remain
European corporates are plagued not only by geopolitical uncertainty but also by political challenges at home. There is still considerable uncertainty about UK prime minister Theresa May’s ability to pass the Brexit deal through UK Parliament. Our baseline assumption is that the threat of either another referendum, or a general election, will eventually bind a majority in the House of Commons together and the deal will pass. Beyond Brexit, there remain challenges for the European authorities in 2019.
Centrist politicians are still struggling to head off populist parties. With critical European Parliament elections coming up in May, the risks are rising that Eurosceptic alliances will take a greater share of the vote. In which case, investors may become sceptical about both the longer-term prospects for integration as well as the ability of Brussels to provide meaningful leadership in the next downturn.
The stand-off between Brussels and Rome also looks set to continue. Italy is likely to be placed under an Excessive Deficit Procedure, but this is not a particularly rare occurrence. France has been in equivalent monitoring for 15 of the last 17 years. We don’t expect Italy to consider leaving the euro, but the eurozone’s third-largest economy is slowing sharply as credit conditions tighten.
These political fragilities, together with a more lacklustre pace of growth, could limit the ECB’s ability to lift interest rates in the second half of the year in line with their current guidance. In which case, negative interest rates will continue to pose a challenge for the profitability of Europe’s banks for some time yet.
Although the eurozone domestic economy in aggregate looks fine for now and wages are rising, ongoing weakness in global trade is likely to deter firms from hiring, in the same way as they are slimming down investment intentions.
However, the recent collapse in the oil price is supportive for Europe, and consumers are still showing appetite to spend, so we expect European growth to hover at around 1.5% for much of 2019. That will be enough to see a sizeable narrowing between the performance of the European and US economies over the course of the year.
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