Editorial

The era of asset price disinflation is nigh

Brexit, trade talks, the Italian budget. These are the major political risks currently weighing on the market. A slowing Chinese economy and its fallout to the euro area are among the economic risks discussed at the moment. And while forecasting the outcome of a political risk has proven to be far more difficult than projecting the outcome of the toss of a coin, the economic risks are expected to abate later this year. In light of these looming risks, another factor has received too little attention for now – the risk of asset price disinflation. As the Fed cuts its balance sheet, the European Central Bank ends net asset purchases, and the Bank of Japan is buying less and less bonds, a constant liquidity drain will be felt. With also an increasing amount of US Treasuries offered at an attractive rate of 3%, the reversal of the hunt for yield should be the dominating story for markets once political uncertainty has become certainty. Credit is likely to be the prime casualty in this scenario, allowing equities to still perform over 2019.

A first taste of asset price disinflation

Dismal developments dominated the asset classes this year. Interest rates rising into 2018 weighed on the performance of fixed-income investments early in the year. The slump in equity markets in the aftermath of the rise in rates evaporated risk budgets too quickly for the liking of many investors. Investing in emerging markets (EM) wasn’t a good idea either, at least strategically, and following the strong decline in the oil price in the fourth quarter of 2018, the last asset class that still carried a decent positive total return joined the club (Chart 1). The weakening euro cushioned the losses for global euro-based investors. Among euro-denominated investments, only safe-haven government bonds turned out to be positive. This feels like after years of great abundance, years of famine will follow – that the era of asset price disinflation has started, suggesting that 2019 will not be significantly different from 2018.

Chart 1: Lacklustre returns for all asset classes, 28 November 2018. A weakening euro cushioned the losses for EUR investors

Total EUR returns (in percent)

Source: Bloomberg, Commerzbank Research

The idea behind asset price disinflation is pretty simple: after numerous years of very expansionary monetary policy, which – contrary to previous cycles – was not limited to cutting short-term rates but involved direct interventions in many fixed-income markets and across different maturities, the stimulus is now being withdrawn, and investors that were forced out of their preferred asset classes into riskier ones are now returning. That monetary support is indeed withdrawn becomes not only evident when looking at short-term interest rate changes over the past 6 to 12 months, but also in particular when looking at the balance sheets of G4 central banks (Chart 2). The Fed’s balance sheet reduction is no longer covered by more expansion at other central banks – the size of the global balance sheet is set to decline further in 2019.

Chart 2: The global central bank balance sheet is set to shrink in 2019

Aggregated central bank’s balance sheet of G4 plus Sweden; year-on-year change

Source: Bloomberg, Commerzbank Research
US deficit spending – boon or bane?

Apart from declining central bank balance sheets, which already requires other market participants to pick up some extra assets, the expansionary fiscal policy of – among others – the US needs to be financed by the market. The Congressional Budget Office estimates the 2019 US federal fiscal deficit at roughly USD 980 billion. Some USD 390 billion is net interest payments, which might be reinvested in US debt securities. However, this still leaves a funding gap of USD 590 billion. Adding to that circa USD 270 billion maturing on the Fed’s balance sheet in 2019, as well as some of the funding needs of local and state governments, at USD 230 billion in 2019, one arrives at public sector net funding needs of circa USD 1,090 billion. US personal savings, however, averaged USD 1,074 billion in the first and second quarter of 2018 (annualised); the latest figure from the Bureau of Economic Analysis revealed an annualised savings rate of USD 975 billion in September. Bottom line: the US is just saving enough to finance Donald Trump’s spending spree – but hasn’t got a dime left for other asset classes (Chart 3).

Chart 3: US Treasury financing 2019 – where does the money come from?

Estimates of US public financing needs via the market

Source: Federal Reserve, Commerzbank Research

This money became available because of the artificial demand created by the ECB (EUR 285 billion in 2018 up to the end of October) and the Bank of Japan (increasing the monetary base by JPY 30 trillion). However, with the expansion of global central bank’s balance sheets coming to an end (Chart 2), markets will have to source the money for US Treasury investments from somewhere else – and riskier assets are likely to be among the principal victims. This points at a pretty numb picture for overall asset class performance, and it is our conviction that these facts will be a major headwind for decent risk asset performance in 2019 – and could well justify taking an overweight in cash at some point in 2019. It is close to impossible though to forecast where and when the effects will be felt the most. We continue to believe that the asset class that should be preferred the least is credit. It should have been a primary beneficiary of portfolio rebalancing, making it the first asset class to feel the pain as quantitative easing is being reversed. Spreads have already started to rise, and as Chart 4 shows, credit spreads are likely to lead equity markets.

Chart 4: Rising credit spreads: Likely to lead equity markets
Source: Bloomberg, MSCI, Commerzbank Research
Low-growth global growth cycle enters its 12th year …


Despite asset price inflation likely to strike in 2019, the economic picture should remain fairly bright. The global growth cycle enters its 12th year, and economists’ GDP forecasts do not immediately point at significant cooling. However, we need to stress a few aspects of global growth capital markets may put a greater focus on, hence producing opportunities for asset allocators in 2019.

Firstly, the acceleration in global growth seen in 2017 did not continue in 2018 – global GDP should have grown by circa 3.8%, which is slightly higher than the International Monetary Fund’s 2017 real GDP growth rate of 3.5%. For 2019, our economists are expecting a moderately lower global GDP growth of 3.5% – hence no significant change in the growth rate. This is in line with the decline in the OECD’s global leading indicator over the last 12 months (Chart 5). The current development resembles the period from 2014 to 2016, when the global leading indicator dipped below the 100 mark, but recovered thereafter. Drawing a parallel is tempting, but there is a large difference between now and back then, when the degree of monetary accommodation was still increasing globally. As noted before, the degree of global monetary accommodation is much lower. We believe though that the degree of monetary accommodation is still sufficient, thus the global leading indicator will again stabilise over the next few months, which could be around summer 2019. However, we are reluctant to call this just another mid-cycle slowdown – typical late-cycle features seem to be emerging, in particular for the largest global economy, the US.


Chart 5: Global leading indicator heading for a similar decline as in 2014–16 – but this time global monetary policy is less accommodative
Source: OECD, Bloomberg, Commerzbank Research
… with the US housing market slowing …

The backbone of the US economy have been strong personal consumption expenditures and non-residential fixed investment in 2018. One driver of growth in the past years has vanished though: housing is not expected to add to US growth this time. Since 2013, US fixed residential investment has been flat-lining in real terms. The reasons for this have been higher prices for construction materials and a strong increase in mortgage rates, which has already prompted mortgage applications for purchases to go down. And while we take note of the fact that a slowdown of the US housing market has been a harbinger of recessions in the past, we don’t want to call a recession just now, because the indebtedness of US households is significantly lower than when the housing bubble burst in 2008.


With regard to non-residential fixed investment, the growth in orders has recently disappointed market expectations. In real terms, new orders have declined constantly over the past two decades, just like capacity utilisation. In an increasingly automated digital world, this may be due to lower costs for capital goods, but could also be indicative of investment in software and human capital having grown in importance.

This leaves the risk of misinterpretation: if fixed asset investments have been generally on a downward trend since the dot.com bubble, we might need to look differently at overinvestment. It might not require too much investment before economic excess is built up (comparable to the decline in capacity utilisation levels over the past 50 years).

As a final remark (and a warning) on the US, it is worth looking at the federal deficit as a percentage of GDP: since the 2015 earnings recession in US equities, the US federal deficit has risen. While rising federal deficits are normal (and necessary) in recessions, it is quite remarkable to see that this time the deficit has been rising despite a booming economy (while it is true that the Trump administration has pushed the deficit into a new dimension, the trend change was already observable under Obama). The widening of the fiscal deficit works somewhat in the opposite direction to the Fed’s tightening: rather than aiming at preventing overheating, US fiscal policy is working against the efforts of the Fed, with a more aggressive Fed rate hike path one potential consequence of this.

… and the big question when manufacturing in the eurozone will bottom out

Since the beginning of 2018, the manufacturing industry in the euro area has known only one direction: down. The euro area manufacturing Purchasing Managers Index has declined from – admittedly very high levels – of 60.6 to 51.5; its services counterpart has also declined, albeit to a lesser extent. As a matter of fact, the services PMI has recently fallen to its lowest level since late 2016. With monetary policy still quite accommodative and global growth still fairly supportive, Commerzbank’s Early Bird indicator suggests that the downward trajectory of leading indicators should come to an end in the course of the first half of 2019 (Chart 6). A stabilisation of growth in the euro area should – apart from a continued accommodative monetary policy – require that current uncertainties for euro area growth start to dissipate.

Chart 6: Early Bird suggests a stabilisation of leading indicators in the course of H1 2019
Source: Bloomberg, Commerzbank Research
Summary

In 2019, asset price disinflation is likely to weigh on returns across the asset classes – despite a solid economic backdrop. Credit is the asset class which should initially suffer the most as investors return to their preferred habitats. Keeping an overweight in sovereign fixed income appears a prudent move.