2019: The Last Year For The Millennium To Be A Teenager

The year may be drawing to a close, but it is not clear that Annus Horribilis for investors will end. The projection of the 2017 synchronized growth upturn into 2018 hit the shoals of the business cycle. The fiscal stimulus gave the US an adrenalin rush, lifting growth to an average annualized pace of 3.8% in Q2 and Q3, but many models, based on market prices, warn of increased risk of a recession. Other economies have already faltered. Germany, Japan, Italy, Sweden, and Switzerland contracted in Q3, and the flash France's December flash composite PMI fell below the 50 boom/bust level. China's economy appears to be slowing, but because of the dubious quality of some of the economic data, it is difficult to know the extent.

The still fresh scar tissue from the Great Financial Crisis means that the end of the business cycle would trigger high anxiety over the possibility of another credit crisis. The leveraged loan market, the growth of passive investment, and student loans have been touted as new equivalents of the subprime mortgages. US Treasury Secretary Mnuchin recently attributed the increase equity market volatility on the Volcker Rule and high-frequency trading. After the WWII, US policymakers were also fearful of a return to depression-like conditions and policies were pursued at home and abroad to avoid it. Growth and rising living standards were also understood as the best bulwark against the spread of Communism.

It is not only the business cycle that makes this period so difficult.  Indeed, the political challenges are arguably even more daunting. Since 2016, the US has emerged as a revisionist power, insisting on reversing the country's globalist strategy. Could one even imagine another US President in the modern era that would proudly call himself the "Tariff Man?" In the following thirteen days, the S&P 500 dropped nearly 13.5%. Three things the US is doing are sources of instability: its trade policy, the unilateral withdrawal from the treaty with Iran, and the oil boom.

The US trade policy itself has three dimensions, and they will each likely intensify in 2019. The US-Chinese trade talks are set to reach some conclusion by March 1. It is difficult to see a meaningful agreement in such a short period. Lighthizer who is leading the US negotiations recognizes this, but what it means for the threat to increase the 10% tariff on $200 bln of imports from China to 25% and/or imposing a tariff on the remaining imports from China is not clear. China is likely to make more concessions, and there is some low hanging fruit. At the same time, it is clear that the problem is more in China's operational policy than declaratory policy--what it does rather than what it says.

In 2019, the US will also turn its trade attention to its Europe and Japan. Previous Administrations expressed various levels of frustration over the years with European and Japanese trade practices. The tensions were constrained by the Cold War and WTO. However, this administration has little time for ideological rivalries and is primarily interested in economic competition. In this sense, we have suggested that Trump is the first post-Cold War president. Despite a new trade agreement between the US, Canada, and Mexico, which appears to be mostly the old NAFTA plus some modernizing elements that had been negotiated in the Trans-Pacific Partnership (from which the US withdrew) and enhanced domestic content rules, Canadian and Mexican steel and aluminum continue to face tariffs on national security grounds.

The World Trade Organization itself is under threat. On the one hand, the Trump Administration argues that the rules are not designed for non-market economies like China. On the other hand, it is blocking the appointment of appellate judges, without which the important conflict resolution mechanism breaks down. There are normally seven judges, but it now down to three, which is the minimum for a panel to hear an appeal. This will slow things down and bring them to a halt one has to recuse themselves. The issue will come to a head as the term of two of these judges is over at the end of 2019.   Studies of WTO decisions finds the US wins more than 80% of the cases it initiates, which is better than most countries and brings the most cases as well.

The US withdrawal from the Iran Treaty speaks to the increased element of American unilateralism rather than isolation. In addition to the balance of power politics in the region, between Israel and Iran and Iran and Saudi Arabia, the US decision impacts foreign companies who also do business in the US, and this includes SWIFT, the international payments platform. While some commercial ties are disrupted, the fact that Belgium-based SWIFT will respect the embargo is particularly frustrating for Europe, who chafe under what Business Week recently called the Tyranny of the Dollar. The increased weaponization of access to the dollar rather than the "currency wars" over nominal foreign exchange levels, which captures the imagination of analysts and journalists, is an increasingly important exercise of US financial statecraft and projection of power but fuels a desire for an alternative.  

The US has not reached "peak oil." Output is projected to rise in 2019.  Exports may reach two million barrels a day. The simple geological fact of the existence of shale fields does not explain very much. Instead, the US carbon "revolution" is driven by technological change, which is ongoing and lowering the cost of production, access to cheap capital, which speaks to the depth and breadth of US capital markets, and a certain attitude toward the environment that is not universally shared even in the US, where New York State, for example, bans fracking.

To the extent that financing was achieved based on the value of the collateral (the price of the shale in the ground), the drop in prices poses fresh new risks. If the debt servicing acts as a fixed cost, some producers will find it in their interest to produce even at a loss. At the same time, the broader economic lift from that sector, such as capital investment, durable goods orders, and manufacturing, should be anticipated to be a headwind on the economy in H1.  

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Read more by Marc on his site Marc to Market.

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