Dealing with disconnections

Ten years after the financial crisis it is clear that the world continues to suffer from the fallout. The march of technology, changing demographics and sluggish productivity growth have conspired to make this a world of slower growth, lower inflation and correspondingly lower interest rates. Geopolitical tensions have also picked up as our rules-based economic and political system has come under pressure. Consequently, this can best be described as a world of mounting disconnections – in politics, as tensions mount across large parts of the Western world; in economies as different parts of the world operate at different points in the cycle, and in asset markets where pricing deviates from fundamentally justified levels. All of this points to a very uncertain period ahead for investors.

As we look ahead to 2019 it is worth reflecting that many of the risks we identified a year ago have moved onto the mainstream agenda. As a consequence investors have many good reasons to be cautious with regard to the market outlook. Perhaps the biggest cause for concern has been the ongoing rise in economic nationalism. The election of Donald Trump and the Brexit campaign, both of which occurred in 2016, continue to make their presence felt and will have further ramifications in 2019 particularly if the US-­China trade dispute is taken up a notch. The eurozone’s trials and tribulations are far from over as we head into 2019, with the European Commission and Italy involved in a dispute regarding Italy’s adherence to the eurozone’s fiscal rules. All this is taking place against a backdrop of overvalued equity markets where upside appears to be limited.

At a cyclical crossroads

At the end of 2018, fears mounted that growth in many parts of the industrialised world was losing momentum. Nonetheless, the US economic cycle is on track to beat the longest economic upswing in history. So long as the US does not fall into recession before July 2019, it will surpass the 120-month upswing between March 1991 and March 2001 as the longest on record (Chart 1). But the strength of each successive upswing is weaker than the previous one and policymakers continue to fret about the weakness of productivity growth, which is the key driver of living standards, compared to previous cycles.

Chart 1: Longer but not stronger

US GDP, trough of cycle = 100

Source: Commerzbank Research

Indeed, estimates of potential GDP growth – the economy’s underlying speed limit – across most parts of the industrial world point to much slower expansion rates compared with the 1990s. This is partly the result of demographics, with the baby boomer population bulge now beginning to fade. Weaker investment growth in the wake of the global financial crisis has also played a role by slowing the rate at which new technology diffuses through the economy. But the weakness of total factor productivity – the proportion of output not explained by capital or labour inputs – has proven to be one of the more enduring puzzles.

One explanation for this may be the widening gap between labour productivity growth in so-called global frontier firms on the cutting edge of the technological revolution, and non-frontier firms (the laggards). Empirical evidence conducted by the European Central Bank1 concluded that there was a sharp divergence between the leaders and laggards prior to the financial crisis, which temporarily narrowed around the time of the global financial crisis, but it subsequently continued to diverge further. It is not the whole story, of course, but it does suggest that there is a large tail of small companies that are not benefitting from the technological revolution.

Chart 2: The economic speed has slowed

Potential GDP growth

Source: European Commission

This adds to the complications faced by central banks. Undoubtedly, they wish to take away some of the emergency easing put in place to combat the financial crisis ten years ago. Indeed, the US Federal Reserve has now raised interest rates on nine occasions in the last four years whilst also running down its balance sheet. But the ECB is not expected to raise rates before 2020 and has only just stopped expanding the balance sheet, whilst the Bank of Japan continues to pump huge amounts of liquidity into the economy.

The Fed has made it clear that taking the funds rate to a range of 2.25% to 2.5% puts it very close to levels deemed to be neutral (i.e. neither expansionary nor contractionary). The neutral rate can be thought of as that which balances demand for capital and wealth. In our stylised representation in Chart 3, an ageing population results in increased demand for retirement assets (the yellow curve shifts to the right) whilst slower productivity growth has reduced corporate demand for capital (the black curve shifts to the left). In our stylised representation, this leads to a lower equilibrium rate. Much of the evidence suggests that the neutral rate is around 200 basis points lower today than in the 1990s which gives central banks in Europe some headroom but does not give the Fed much leeway.

Chart 3: Shifts in demand for capital and wealth result in lower equilibrium interest rate
Source: Commerzbank Research
Markets are also out of whack

It seems that every year, we point out that markets are out of line with economic fundamentals but markets continue to defy expectations. Price-to-earnings ratios in the US equity market are particularly hard to justify, with the 10-year trailing P/E on the S&P 500 trading at 30x earnings versus a post-1945 average of 19x. In a world of ultra-low interest rates the P/E ratio may not be a very useful valuation metric. But it has barely moved despite the Fed tightening of recent years, which suggests that something may be amiss. In part, of course, US markets have been given a lift by the tax cut at the beginning of 2018 which lifted earnings per share by almost 30%. This will not be repeated in 2019 which is likely to take some of the steam out of equities.

The market has also been dangerously dependent on tech stocks. In early October, the market cap of the S&P 500 was up 7% year to date whereas that of the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) was up 27% whilst non-FAANG stocks were up just 4% (Chart 4). But the collapse in FAANG valuations significantly depressed the overall market. This is partly the result of product dependency fears with concerns that demand for Apple products is slowing. It is also the result of cyclical factors as growth concerns mount, and the sector is also in the front line of the global trade war. But whatever the reasons it is clear that reliance on such a narrow base of stocks will raise market volatility in future, particularly given the speed of ascent in recent years.

Chart 4: The S&P has relied heavily on FAANG stocks

Indices of market cap. 1 Jan 2018 = 100

Source: Bloomberg, Commerzbank Research
Has globalisation passed the high-water mark?

Although some of the heat appears to have gone out of the US-China trade dispute following the G20 summit in December, many of the issues which prompted the dispute in the first place remain unresolved. In what appears to have been a truce in trade hostilities, China made some trade concessions that prompted the US to hold off from raising tariffs on a wider range of goods. But China continues to skirt around the fact that the expropriation of copyright technology as a precondition for US firms – and indeed those of other nations – to do business in the domestic Chinese market remains a live issue. To the extent that the trade ceasefire is conditional on eliminating this problem, we cannot say with any certainty that trade concerns will not resurface in 2019.

Perhaps one of the biggest concerns as we look ahead is that the rules-based architecture on which global prosperity has been based is threatened in a way we have not seen since in many decades. Over the last 70 years, US import tariffs have gone in only one direction and it is notable just how low US tariffs are today compared to the pre-1947 era (Chart 5). This reduction in tariffs in the world’s largest economy has been one of the key reasons why there has been such a rapid increase in global living standards in the post-1945 era.

Chart 5: US import tariffs at historical lows

Tariff revenue as percentage of US dutiable imports

Source: Historical Statistics of the United States, US International Trade Commission

The Trump administration takes a zero-sum approach to trade: if the US is losing, the rest of the world must be gaining at the US’s expense. But the principle of comparative advantage, outlined by Adam Smith in 1776, makes it clear that all parties benefit from trade. If the US imposes import tariffs these represent a tax which will have to be paid by the US consumer – they certainly will not benefit US voters. Moreover, there may be long-term consequences associated with the policy. The fact that China will lose out in the initial stages of any tariff war, since it exports far more to the US than it imports, suggests that it is in its interests to call a truce. But in the longer term, as the Chinese economy continues to grow more quickly than the US, it will surpass it as the world’s largest economy and ultimately be in a position to set the rules to its benefit at the expense of the US.

The lessons of the 1930s clearly suggest that tariff wars are an inefficient way to resolve trade disputes and the World Trade Organization (WTO) exists as part of the institutional framework to prevent them from escalating. Unfortunately, the Trump administration is sceptical that the WTO will act in favour of the US. However, the empirical evidence2 says otherwise and an analysis of WTO cases brought against China indicate that ‘there are no cases where China has simply ignored rulings against it’ – in contrast to the US which ‘has not complied with the WTO ruling in the cotton subsidies complaint brought by Brazil’.

Consequently, the trade issues which have echoed during 2018 matter to the extent that they represent the thin end of a wedge which implies rolling back the frontiers of globalisation. There is no standard measure of globalisation but one index worth noting is that created by the Swiss think tank KOF. Although the data currently only run to 2015, even on three-year old data, a slowdown in the progress of globalisation is evident. A more up-to-date proxy measure is the volume of world trade calculated by CPB in the Netherlands. This shows that world trade averaged an annual growth rate of 7% over the period 1992 to 2007 whereas in the last decade the average rate has slowed to 2.3%. There are numerous possible explanations for this, some of which are cyclical, but it is the structural factors that are particularly interesting.

There is evidence to suggest that global value chains have become shorter. One of the driving forces behind this trend may well be a rise in protectionism – or to be more accurate, the fact that the majority of trade measures introduced in the last decade have tended to raise trade barriers rather than lower them (Chart 6). Long production chains are also more vulnerable to exogenous shocks. For example, the eruption of the Icelandic volcano Eyjafjallajökull in 2010, which grounded flights across the northern hemisphere, emphasised the lack of flexibility in systems which rely heavily on cross-border trade. Another example is the floods in Thailand in 2011 which caused significant production disruptions for global companies dependent on Thai facilities. Thus, whilst the US-China trade dispute is a high profile and potentially damaging event, it serves to highlight that the process of rolling back the process of globalisation has already been underway for some time.

Chart 6: Most recent trade measures have tended to be harmful
Source: Global Trade Alert
Additional risks

There are two issues which particularly concern European investors. One is the possibility that the UK’s departure from the EU will turn out to be a disorderly affair which results in significant disruption to European trade flows. Our view is that this is such an undesirable outcome that politicians will do all they can to prevent it. But such has been the lack of economic rationality during the whole Brexit process that this remains a major tail risk.

Another problem is the ongoing dispute between Italy and the European Commission regarding Italy’s fiscal policy. In brief, the Commission has ruled that Italy’s budget plans are insufficiently tight to hold down the debt ratio, which is already at 130% of GDP, and has deemed that Italy is in breach of the eurozone’s fiscal rules. Whilst this may be the case, Italy is by far the largest European debt market, and the prospect of widening bond spreads, which threatens contagion across eurozone markets, keeps ECB officials awake at night. Italy is a far bigger economy than Greece and the eurozone would come under severe strain if this problem were to escalate. But here, too, we look for the Commission and Italy to agree some form of compromise but there is always a risk that events spiral out of control if either side fails to play ball.

In a world where the US has already tightened monetary policy and is likely to do more in 2019, emerging markets will continue to be squeezed. This is a particular problem for highly indebted EM economies which traditionally tend to suffer during a US tightening cycle. Part of the EM sell-off in 2018 reflects an adjustment following significant investment inflows in a hunt for yield during a period of very low rates in the industrialised world. Accordingly, EM asset valuations, particularly in equities, are no longer unattractive. However, this may not be sufficient to support EM assets during times of global market turbulence, and caution appears to be warranted.


The last 12 months have been characterised by turbulence as investors assessed the risks posed by rising levels of protectionism and political unrest against a backdrop of a prolonged market upswing and extended valuations. None of these issues have gone away – if anything they are more likely to be exacerbated in 2019. As the monetary easing which has supported markets over the last decade continues to be slowly removed, some of the tailwinds for equities are likely to diminish. Meanwhile, the one-off US fiscal boost will also disappear. Consequently, those investors who were reluctantly long in 2018 may decide that it will pay to dance closer to the door in 2019 in the event there is a stampede for the exit. As a result further bouts of market volatility can be expected to emerge from time to time.

The current sequence of events certainly feels very late cycle. But recall that in 1998 we thought the equity bubble had run its course only for it to continue another 15 to 18 months. Whilst there may still some juice to be squeezed from the lemon it will, however, become ever harder to extract.

1 ‘The slowdown in euro area productivity in a global context’, ECB Economic Bulletin, Issue 3/2017.

2 Bacchus et al (2018), ‘Disciplining China’s Trade Practices at the WTO’, Policy Analysis 856, Cato Institute.