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A World of Financial Gloom and Doom?

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Michael Heisi

2018 was not a good year for investors. Not only did the global equity markets end the year with losses, there was also little money to be made from investments in commodities, gold or high-yield government and corporate bonds.

One main lesson that ought to be learned from 2018 is that following majority opinions among analysts and market participants does not guarantee investment success at all.

In particular, the widely held view that U.S. markets – although already highly valued – would continue to outperform other markets is likely to have caused considerable losses for many investors in recent months.

With the latest signs of a moderate economic slowdown in the United States, U.S. stocks have drastically lost value. On Wall Street, 2018 has seen the worst December performance since 1931.

What about the risk of recession?

What will happen in 2019 and what about the risk of a recession? Current business cycle data does not indicate an economic downturn at the moment. Although important indicators have declined significantly, they are still at a relatively high level.

We know, however, that economic indicators can change very quickly and that they only provide a snapshot of the situation. It is therefore important to investigate more closely whether we can find any parallels to earlier downturns in the current market environment.

In the past, the triggers for deeper, not purely cyclical recessions have often been financial market crises that followed phases of exaggerated valuation gains and strong increases of debt levels.

Lessons learned

In contrast for example to the so-called subprime bubble in 2007, or the dotcom bubble at the end of the 1990s, the current situation appears to be much more stable.

In particular, after the price corrections that shares and corporate bonds experienced over the past months, it is hardly possible to speak of gross mispricing across the board of markets.

In addition, banks are generally much better capitalized. Corporate indebtedness is a particular concern in the United States and some emerging markets, but it is not at a critical level in Europe.

And yet, this view is far from issuing an all-clear signal. Economic crises can also be triggered by adverse developments in the real economy, irrespective of the financial market cycle.

In the late phase of a cycle, capacity utilization is often very high, which dampens productivity gains and pushes up unit labor costs. Inflationary pressures then arise, prompting monetary policy to step on the brakes with higher interest rates.

However, looking at what’s ahead in 2019, this is not a very plausible scenario. Monetary and fiscal policy will tend to remain expansionary in most important economies including the United States.

Positive outlook for 2019

Therefore, the year 2019 might well be significantly better for the economy and for the financial markets than recent asset price performance signals.

Moreover, a significant amount of skepticism has been priced into markets. That leaves some room for some positive surprises.

For that to happen, however, policy makers would also have to help by contributing some positive news from the hotbeds of conflict in trade policy or from the Brexit process. Let`s see what happens on those frontlines.