2019 Outlook - Global economy

2018 has been a year of turmoil with weakness in the bond markets and two significant sell-offs in equity markets. In between there were crises in Venezuela, Argentina and Turkey; ongoing Brexit negotiations; a strong rise in the price of oil; and disruptions created by US President Donald’s Trump’s repeated trade measures — all set against a backdrop normalising US interest rates. However, 2019 promises to be much calmer, in my view.

Though individually damaging, it is my view that these geopolitical events will prove to be no more than waves on the surface of the tide which is the record breaking expansion of the US business cycle.

United States
US monetary policy is becoming less accommodative, but the Federal Reserve (Fed) is not “tightening,” only “normalising” policy. The current “normalisation” phase is analogous to the mid-course corrections in interest rates that occurred in 1994-95 and 2004-05. The important point about those episodes was that the business cycle continued to expand for several years after the completion of normalisation, and the equity and real estate markets also peaked considerably after these rate hikes were completed.

I believe there is a strong probability that the Fed will be successful in positioning the US economy for several more years of expansion after 2019 or 2020, when the federal funds rate is expected to reach the “neutral” level — i.e., the rate that is neither expansionary nor contractionary, but consistent with steady-state expansion. This would mean that by July 2019, the current expansion would exceed the longest recorded expansion in US financial history — the 10-year expansion of March 1991-March 2001.

There are two broad strands of thinking in the financial markets that run contrary to my view and imply that the US economy is on the cusp of overheating and a resurgence of inflation:

  • The first theory points to tightness in the labour market - as indicated by the low  rate of unemployment. These analysts rely on the “Phillips curve” to argue that when the unemployment rate has fallen in the past, wages have generally risen, and higher inflation has followed. The problem with this theory is that while it has worked sometimes in the past, it has not worked during the last three business cycles. The theory only worked when money growth was rapid, giving rise to overheating and inflation.

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