Below, we itemize seven risks we see on the investment horizon – and offer our best guesses about the probability that they will come to pass.
Risk #1: Slowdown or Recession?
While we haven’t listed our risks in order of importance, recession is the #1 worry in our view. Given somewhat average valuations – we don’t find a lot of assets particularly rich or cheap today – underlying macro and earnings trends are paramount to thinking about future returns. The global economy is clearly decelerating, but in the wake of the Q4 selloff, markets should be set to move higher again if this is just a mid-cycle return to slow-but-positive growth. However, if the slowdown devolves into recession, markets are not prepared for this shock as neither investor sentiment nor asset prices appropriately reflect this risk.
For this reason, recession risk could be categorized as “all that matters,” as future returns could probably withstand any of our other risk scenarios provided the economy doesn’t fall off a cliff. Conversely, the absence of those risks will not save markets if the economy does falter significantly. Based on current data, we estimate the likelihood of a global recession in 2019 at 25%. For the subplots, we think the risk of a 2019 recession in the US is 20% while in Europe it’s closer to 35%. China, from our view, has virtually no chance of recession this year, but that isn’t the correct yardstick. For China, the risk is a sub-6% real Gross Domestic Product for the year, which we think is about 30% likely.
Risk #2: US-China Trade Tensions
This risk seems to rise to the top of everyone’s list, but we’re a bit less worried, primarily because we think the market has (at least partially) already priced it in. First, as US-China relations got trickier in the second half of 2018, global stock markets discounted much of this bad news. Second, businesses have already begun taking steps to adjust production, build inventory, and develop new supply chains.
We concede there is still some upside/downside surprise risk here. The downside risk is that negotiations fail and the two countries engage in painful tariff hikes and retaliation (25% probability). The “upside risk” is that Trump and Xi magically negotiate a comprehensive agreement that immediately satisfies both parties and they stick with it – also pretty unlikely in our view – 20% probability. We doubt the US and China can completely agree to anything as Trump’s “Make America Great Again” (MAGA) agenda is diametrically opposed to Xi’s “Made in China 2025” plan. Likewise, we think a complete breakdown in talks is unlikely as jittery markets (along with the slowing US and Chinese economies) will continue to keep both parties at the bargaining table.
The most likely scenario (55%) is that US-China trade negotiations bumble along throughout 2019 with no definitive success or failure. This makes trade tensions look more like a “risk in progress” than a specific event. In the short run, we believe equities will be buoyant on days that see trade progress and deflated on days that see setbacks. Don’t read too much into it. Even a “final” trade deal will be inherently inconclusive as monitoring and verification will prove challenging.
Risk #3: A Central Bank Mistake
There is a fairly pervasive fear among investors that central banks may “overtighten,” prompting the next recession. In one sense, we’re a bit less pessimistic. Given the market weakness in the fourth quarter, the US Federal Reserve has turned sufficiently dovish that forward action (raising rates and/or balance sheet roll-off) is unlikely to bring recession. So we rate the risk of the Fed inducing a recession this year at 10%. But here’s the rub: As everyone knows, monetary policy changes have a long lag time. It may actually be just as likely (10%) that the Fed has already overtightened, “winter is coming”, and we just don’t know it yet. The die may already have been cast.
To be clear, there is no doubt that the next recession will occur eventually. We think this is more likely to happen in 2020 or later and we remain in the “slowdown, not recession” camp for now. Regardless of when the recession hits, the Fed’s tightening to this point will be a handy scapegoat regardless of their actual culpability.
Risk #4: A Messy Brexit
Prime Minister May’s initial failed Brexit vote narrowed her options significantly. However, her latest parliamentary “victory” appears to be a path to nowhere as the EU isn’t likely to renegotiate the Irish Backstop – which stipulates there will be no hard border between Northern Ireland and the Republic of Ireland following Britain’s EU departure. These recent developments increase the chance that the UK will crash out of the EU without a deal. Even so, we still believe this worst-case scenario has only a 40% chance of being realized. The risk here would be a “policy accident” – somehow tripping into a disastrous break with the EU.
A final word on Brexit: While the situation is very fluid, for now it remains our highest probability risk. A delay in the withdrawal process – walking back Article 50 or a second referendum – is still more likely (60%). However, as the situation deteriorated through January, our hope that the unthinkable would be avoided may be clouding our judgment.
Risk #5: US Policy Gridlock – Shutdown & Debt Ceiling
Having endured the first 35-day shutdown, we doubt Republicans in Congress are looking for any more bad publicity. We expect that budget resolutions will pass in mid-February to keep the US government functioning and that the economic fallout from the Dec-Jan shutdown will be modest. Probability of another material shutdown in February? About 15%.
However, the political gridlock that triggered the shutdown has far graver implications for the US debt ceiling limit which is fast approaching. As with Brexit, the unthinkable – a breach of the debt ceiling causing a “technical” default – could only be classified as a colossal policy accident. Historically, partisan brinksmanship over the debt ceiling has been standard operating procedure, so it inevitably creates short-term market noise but never comes to pass. However, with the precedent of the longest shutdown in history, we’re less certain that raising debt ceiling is a non-event. Is the risk low? Yes – maybe 5%–10%, but it’s not 0%. They’re called “accidents” for a reason.
Risk #6: US Constitutional Crisis
As 2019 rolls on and the findings of the Mueller investigation eventually surface, we have no idea how serious the damage to the Trump administration could be. Given the record of convictions and pleas exacted by the special counsel, we suspect there is at least some fire to accompany all the smoke. The chance of impeachment by Democrat-controlled US House of Representatives is at least 50%. However, conviction (and removal) by the Republican majority in the Senate is far less likely – again depending on what Mueller actually finds.
Does either of these scenarios – impeachment with or without conviction – present a serious threat to the market? Doubtful. To be sure, an ugly partisan food fight would not be good for markets in the short run. No one likes uncertainty. But over the next two years, we see little risk of a rollback to the tax cuts or deregulation that have captivated the minds of US equity investors since Trump’s election. In the most extreme outcome, the president would be replaced by Vice President Mike Pence, who would most likely continue these equity-friendly policies for the remainder of the term.
However, US policy risk rises considerably in 2020 if Democrats can mount a clean sweep. If the tax cuts were rolled back, US equities would feel the brunt, in spite of lower overall risk premia (i.e., the absence of the Trump Uncertainty Factor). For 2019, we see the brawl between Mueller, Democrats and the Trump administration as a volatile distraction, but not the impetus for a bear market, which we give only a 25% probability.
Risk #7: Data Privacy and Regulation
Globally, 2019 may be the year that governments begin cracking down on the use of personal data. US congressional inquiries along with the EU’s General Data Protection Regulation (GDPR) illustrate how seriously countries are taking this issue. “Big data” only has value if you can monetize it, either by selling personal information or using it to micro-target advertising dollars. Increasing government scrutiny may make it harder for businesses to profit from this data in the future.
While the probability is low that regulators would stifle the big data bonanza, maybe 20%, the impact would be significant. This risk is under-appreciated because data privacy issues apply to nearly all companies in the major indexes, extending well beyond just the biggest names in the tech sector.
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