More about our views on Brexit, Fed, Climate change, Trade war, Venezuela, China
1. A second Brexit referendum results in a No Brexit and the UK stays in the EU.
At the time of writing, it remains anyone’s guess as to how the Brexit saga will conclude. However far from likely, a second referendum that results in Brexit being cancelled is a possibility, and one whose odds ticked up following Prime Minister May’s announcement that she would put rejection of a no-deal and extension of the Article 50 deadline to a House of Commons vote in the same week as the opposition Labour party formally backed a second referendum. If the British populace were to U-turn on their 2016 decision, we could expect the pound to rally, possibly returning to its pre-referendum levels (the day before the June 2016 vote, sterling fetched around USD1.48; today it is closer to USD1.31). Inflation would come down with EU trade agreements keeping a lid on rising import costs and gilt yields would possibly move lower. The UK economy would resume strength and domestically-oriented UK equities would rally. Conversely, internationally-oriented UK equities could suffer from a strong pound. The Bank of England’s direction on interest rates would depend on inflation, keeping them low if inflation were to remain muted. The euro would strengthen.
2. A demand-driven inflation spike leads to a second Fed U-turn, resulting in a US recession.
Despite steadily rising wages, US inflation has so far remained low, giving the Fed breathing space from its rate hiking cycle. However, should inflation return, the US central bank would be forced to resume its programme of interest rate rises to prevent the economy from overheating. The US yield curve would steepen and long-term rates would rise well above 3.5%. Equity markets would suffer a serious correction and high-yield spreads would widen as markets turned risk-off. The USD would weaken.
3. Extreme weather triggered by climate change leads to extreme food shortages and soft commodity prices surge.
The 10 worst climate-driven disasters of 2018 alone chalked up a bill of USD85 billion, according to a report by UK charity Christian Aid. We can safely expect that 2018 will not prove the exception that breaks the rule in this case. With many of the world’s soft commodity (coffee, cocoa, sugar, cotton, etc.) producers in the low-latitude regions particularly vulnerable to climate change, should weather-related disaster strike, we could see soft commodity prices soar. This would send interest rates up across the board. All yield curves would steepen, especially in the US and Europe. Within equity markets, consumer companies would suffer as their margins are hit. Rising prices would be negative for consumption more generally as consumers’ disposable incomes are hit at the same time. Meanwhile, soft commodity exporters, which are predominately emerging markets, could stand to benefit from the price surges.
4. Earnings growth for US equities enters negative territory.
EM performance decouples from the US. US equities, at around 16x 2019 earnings, already look expensive. If earnings growth were to enter negative territory, US equities would become very expensive. Developed-market equities would suffer relative to emerging- market equities, which face a lower base effect hurdle following their 2018 underperformance. The US dollar would weaken, while the euro, which tends to move opposite to the US currency, would strengthen. A strong euro would be negative for European equities, further reinforcing developed- market underperformance. US high-yield bond spreads would widen as investors turn risk-off.
5. A war on waste erupts after Southeast Asia closes its ports to others’ waste, leading to waste crises around the world.
To address its air pollution, China abruptly shut its doors to imports of recycled material for processing at the end of 2017, after previously receiving over half of all global plastic waste exports. Because most countries produce more waste than their recycling capacity can handle, much of it ends up being exported to countries like China, previously, and now increasingly those in Southeast Asia, like Malaysia, Thailand and Vietnam. If they were to follow suit, however, the West could quickly face an overwhelming accumulation of waste, resulting in higher tensions – both domestic and international. This would lead to a rally in such safe-haven assets as the US dollar and gold, while emerging markets would suffer. A stronger USD would be negative for global trade, suppressing global growth. The result would have a potential positive impact on long-term US government bonds and gold, given their status as the safest assets on earth.
6. The US imposes auto tariffs on European exports and the EU launches a coordinated fiscal stimulus to avoid a recession. The euro appreciates above USD1.30.
Given that the US threat to impose tariffs on European autos is live at the time of writing, this ‘surprise’ may not turn out to be so surprising. Initially European growth would fall, especially in Germany. Assuming European governments would launch a coordinated fiscal stimulus programme in response, a mounting fiscal deficit would lead to higher European sovereign yields. The euro would appreciate but, in this case, large European exporters may correct as well as the more domestically-oriented companies that are often their subsidiaries. This would have a marginally positive impact on gold because of the weaker US dollar and political tensions between the US and the EU would rise further. Italy’s deficit would be a growing cause of concern.
7. Maduro administration ends peacefully and Venezuela’s oil market reopens. Oil falls below USD50 per barrel.
Today, 50 countries officially recognise Juan Guaido, Venezuela’s opposition leader, following the 2018 elections that are widely considered a sham. If Maduro were to step down peacefully, Venezuela’s oil market would reopen with the removal of US sanctions, driving oil prices lower. If oil prices were to fall below USD50 per barrel, energy companies would be hit as would the US economy, which is a major oil producer. This would lead to lower investment in US oil-related industries. We could expect high-yield spreads to rise, especially in the US, where energy makes up around 17% of the US market. This would be positive for oil importers, notably emerging markets like China and India.
8. Chinese stimulus policy fails and EM underperforms DM again this year. Large-scale protests in China result around the 30th anniversary of Tiananmen.
If stimulus were to fail to revive the Chinese economy, some issues around financial stability in China would surface, particularly around second tier banks as non-performing loans would start to rise in their books. If Chinese growth were to slump it would be negative for commodity prices. Tensions within China could potentially rise, particularly as this year will mark the 30th anniversary of the Tiananmen Square pro-democracy demonstrations. This would likely prove positive for gold and emerging markets would massively underperform developed. It would likely also prove more negative for European than US equities, with the former being more exposed to China by revenues.
For now, the biggest surprise so far in 2019 is the very strong performance across markets that followed the recent dovishness of global central banks. This has resulted in an environment of lower credit spreads, higher equity valuations and lower global volatility. For investors, it would be risky to assume that such an environment can last as new challenges arise when the economy is slowing.