After a fairly decent 18 months the FTSE100, DAX and S&P500 swept into 2018 with some fairly decent annual gains with the FTSE100, gaining 9%, the German DAX gaining 12%, and the S&P500 up almost 20%.
All three indices went onto post new record peaks early on into 2018, but as we noted a year ago there were signs that the goldilocks scenario that the global economy experienced throughout 2017, may well have been starting to run out of steam.
Fears over rising populism appeared to recede in the wake of electoral defeats for parties who wanted to shake up the status quo for the more established political mainstream that had managed to hold sway across Europe for most of the last 20 years.
The election of Emmanuel Macron as a reforming French President albeit on a fairly low turnout was touted as a triumph of hope over pessimism, as an improving global outlook aided a strong economic rebound through 2017.
This meant that 2018 began with a lot more optimism than was the case at the beginning of 2017, despite some residual concerns about political stability in Spain in the wake of the Catalonia crackdown, while UK Prime Minister Theresa May’s fragile majority was always bound to be tested as the Brexit withdrawal agreement started to get fleshed out.
We even got a new German government after months of back room bartering as the old Grand Coalition of the CSU/CDU and SPD got stitched back together, with Angela Merkel once again back at the helm.
Even the tensions with North Korea, which had been a staple of 2017 took a back seat as President Trump turned his attention to trade, particularly with China, as well as a raft of tax cuts, in so doing introducing a significant fiscal stimulus to an already mature economic recovery in the US.
As can be seen from the graph above we’ve seen some big losses in the second half of the year with the DAX losing the most ground, closely followed by the FTSE100. US markets have outperformed but still look as if they could fall further, which if they do could prompt even steeper losses for already struggling European markets.
As mentioned earlier, we were starting to see some signs of fading momentum at the end of 2017, particularly with respect to European markets, however this turned out to be a little premature in the early part of this year as we got a last gasp rally in January before rolling over in February and then March, as the 'Beast from the East' brought Europe to a grinding halt.
This is where the divergence between US markets and European markets started to become really noticeable despite a rally from the March lows, which saw US markets outpace their European counterparts throughout the summer, as a Q2 recovery saw US GDP come in at 4.2%, while European growth lagged behind, as President Trump started to ramp up his trade rhetoric against both the EU and China by implementing a raft of tariff measures, starting with aluminium and steel tariffs.
This protectionist agenda also helped push the US dollar up as fears about an overheating economy prompted the US Federal Reserve to continue their policy of hiking interest rates, with three already this year and a potential fourth to come.
Usually a stronger US dollar would help markets in Europe due to a weaker euro and pound, however concerns about a slowing and deleveraging China, set against the prospect of an escalating trade war, helped put a brake on global demand, with a higher oil price also contributing as prices rose to a peak of $87 a barrel in October, having started the year at $67 a barrel.
When we looked at the Presidential scorecard at the end of 2017 and what markets had expected in that year the President hadn’t managed to deliver on any of his campaign promises of promising a fiscal boost, changing the tax code and changes to bank regulation.
This year he has managed to deliver some of these, fulfilling at least some of his mandate, while also looking to redraw the map when it comes to trade with the US’s trading partners.
Whether you agree or otherwise as to the effectiveness of his approach, investors can’t say they weren’t warned, and the volatility we’ve seen this year has been part and parcel of the President’s rather unusual approach. It’s a cowboy diplomacy of an entirely different sort, and something that is likely to continue despite the setbacks he suffered in the midterm elections.
As we look ahead to the scorecard for 2019 and look back at 2018 I think it’s safe to assume that the 'buy the dip' mentality that has been so effective over the last ten years may well now be over, given the declines we’ve seen in the last quarter or so.
The big question is whether the selloff we’ve seen in the last few weeks has further to go or whether we could be near a short term base?
One of many reasons why investors have got more than a little spooked is down to valuations, the outlook for global growth, as well as concern over the direction of Fed policy, which has seen US yields slide sharply after peaking at multi-year highs earlier this year.
Uncertainty over the future direction of Fed policy has seen US policymakers start to resile from expectations around multiple rate rises next year, though markets still appear to be clinging to the possibility of one rate rise next year.
This is a far cry from the three to four that were being priced in three months ago, but even now that could well be on the optimistic side, despite the optimistic tone from US policymakers about the prospect that we could see two more rate rises next year.
Much will depend on how the US/China trade talks and truce play out in the weeks ahead and whether additional tariffs get imposed, but this line of thought of two more hikes has more than an element of wishful thinking about it.
There is also concern about the direction of travel in respect of the European growth story with Italy in danger of falling into recession in the last part of this year, while the young pretender to Angela Merkel’s crown as the head of Europe, Emmanuel Macron appears to have fallen flat on his face by neglecting France domestic policies in his desire for a more closely integrated Europe.
This gilets jaunes protests which have blighted Paris are a classic case of political deafness to an increasingly squeezed middle that is fed up with fuel tax rises and cost of living squeezes, while the more mobile tax base benefits from tax reductions. To take the sting out of this, President Macron has embarked on a massive spending giveaway which is likely to send the French budget deficit to 3.5% of GDP in 2019.
We shouldn’t forget about events in Italy and the standoff between the European Commission and the new populist Italian government over a budget deficit which amounts to 2.4% of GDP. The EU commission is going to find it very difficult to justify sanctioning Italy while allowing the French government to get away with similar such spendthrift behaviour. Unlike 2016 it will not be as easy to dismiss and in a glorious irony the French finance minister at the time the last time France breached EU spending rules was none other than Pierre Moscovici, the current EU commissioner in charge of making sure Italy doesn’t breach its deficit targets. Et tu Pierre?
The EU also has to bear in mind that the Italian banking system remains far from fixed and rising borrowing costs could impact on the Italian banks ability to lend, while in Germany the concerns about the health of its biggest bank, Deutsche Bank (DE:DBKGn) aren’t likely to go away.
We continue to hear chatter about a merger with its biggest rival Commerzbank (DE:CBKG), where the German government has a 15% stake. It is becoming increasingly clear that Deutsche will struggle to cut its way back to health, and could well need some form of state support.
While state aid is considered illegal in the EU, in the face of its systemic importance any assistance is likely to be overlooked, however to combine two of Germany’s largest banks, each with their own set of unique problems strikes me as a complete act of folly, the equivalent of two drunks at a bar propping each other up. We saw in Spain a few years ago of the folly of rolling up failing or underperforming banks into one big bank, and how that ended up with Bankia.
A failure of Deutsche would be Bankia on steroids and something that could bring the European economy to its knees.
We also have the small matter of the dysfunctional politics of the UK as our political parties bicker and squabble internally as well as with each other as to what type of Brexit deal the UK can get with the European Union.
As things stand the withdrawal agreement remains on the table, with no majority in the house for it to pass, and all options on the table as to what might happen next.
It remains surprising that Theresa May is still Prime Minister despite confidence votes, cabinet rebellions, and multiple resignations. We still can’t rule out even at this late stage with the March 29th 2019 hard deadline looming of a government collapse, an extension of Article 50, a revocation of Article 50, another referendum, or even a general election.
If 2018 was the beginning of the end of the 10 year bull market, 2019 could well give stocks an additional shove to the downside.
We have already broken key levels this year on European markets with the FTSE100, CAC40 and German DAX all breaking below some key long term directional moving averages. We’ve also seen a death cross on the daily S&P500 and Nasdaq 100 daily charts, which has now only just this week been replicated on the Dow Jones.
If markets are unable to recover their momentum above these key technical break down levels then we could well see further losses as we head into 2019.
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