The world economy: watch but don't panic

The violent correction of the fourth quarter of 2018 took the year’s stock market returns negative. After commodities sank and, over the course of the year, bonds failed to offer a safe haven, this rounded off a grim year for investors. The losses may not have been so large, but there was nowhere to hide. Cash really was king.

As well as being bearish, markets felt very volatile—but in reality they were not. The Vix index (a measure of expected US stock market volatility) averaged 16.6, which is on the low side of the historical distribution. Last year only seemed volatile because 2017 was so exceptionally calm, with the lowest average Vix since the index began in 1990. There is at least a chance that things could get choppier again.

As 2019 gets going many are fretting about global growth—and US expansion—petering out, and what that could mean for asset markets. These concerns are reasonable. The longest continuous US expansion on record was the 120-month run from March 1991 to March 2001, so the current expansion (which began in June 2009) could enter the record books in the middle of the year. Expansions don’t go on forever, though, and the US is heading for uncharted territory.

But economic expansions need not die of old age. In the traditional model they are killed off by the Fed raising interest rates to cool inflation and slow the economy. Much market chatter in the second half of 2018 was focused on fear that the Fed would “hike until something broke.” Since then though it has sought to clarify that rates are not on a pre-set path; the US central bank remains, in the jargon, “data dependent” and will adjust rates in line with the economy’s performance. While the US labour market has steadily tightened, there are few signs of any immediate pick-up in inflation, and the Fed is not in a mood to upset things.

The problem with the traditional tale of how expansions meet their doom is that it doesn’t really fit the last three US recessions, which emerged from problems in the markets: the savings and loans crisis of the early 1990s, the dotcom bust of the early 2000s and the subprime debacle of 2008. All looked more like sudden cardiac arrest than old age.

The much-watched US yield curve (the difference between the yield on a ten- and a two-year government bond) has flattened significantly over the past two years. Normally, the government pays more to borrow money for longer. The “inverting” of the yield curve—the moment when two-year bonds start offering a higher yield than ten-year ones—suggests investors seeking a safe harbour for prolonged shelter. Historically, it has been a sign that recession is close. This financial warning light is not yet flashing red but has turned orange.

Add in the ongoing slowdown in China and the recent weakness in Europe and it is clear that global growth has come off the boil. Investors are right to be cautious. But they should not be too cautious. Selling assets six months too early is often as painful as selling them six months too late. The final stages of the cycle usually offer decent returns. Like central banks, investors should be data dependent in 2019.