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Commentary on financial markets – December 2018


  • G20 Summit
  • ECB ends quantitative easing


A good start to the last month of the year. At the G20 summit, US President Donald Trump and Chinese President Xi Jingping agreed to a temporary truce in the trade wars. Trump promised that tariffs on $200 billion would not be raised from the current 10% to 25%. In turn, China has committed to sourcing substantial amounts of agricultural products, energy and industrial goods from the US in order to reduce the trade deficit. China will also reduce tariffs on automobiles. However, the initial optimism of early December was short-lived. The exaggerated enthusiasm for a trade truce between the United States and China faded quite quickly and more significant market sell-offs followed.

One of the factors that contributed to the declines is the US yield curve, which went into an inversion (negative) position. This means that the interest rate on shorter-maturity government bonds is higher than on longer-maturity ones. While it was not the main benchmark, which is the difference between the yield on the 2-year and the 10-year US Treasury note, the falling spread between the 3-year and the 5-year note was enough to trigger the biggest sell-off on Wall Street since October. And that is a signal that the market is expecting a possible recession. After all, in the last 40 years it has indeed occurred, and in all cases where an inversion has occurred (most recently in 2005 and 1998). In fact, a simplistic interpretation of an inverted yield curve is that investors are worried about what will happen in the near term, and are more optimistic in the longer term, when by default it is much easier to predict (and be optimistic about) the near term future.

Negotiations are still ongoing in Europe over the impending Brexit. While British Prime Minister Theresa May has confirmed her position as leader of the Conservative Party in a secret ballot, the EU is already refusing to budge from the negotiated text of the treaty. There is thus very little room for manoeuvre for the British Prime Minister.
The ECB has ended its quantitative easing programme. Over its lifetime, it has bought around EUR 2.6 trillion worth of assets, bringing its balance sheet to EUR 4.7 trillion, almost 35% of GDP. The central bank itself estimates that the quantitative easing programme will contribute 0.4 bp a year to eurozone GDP growth and inflation between 2016 and 2020. After the programme ends, the ECB plans to reinvest the funds raised from maturing bonds. The ECB does not plan to raise interest rates until the summer of 2019, so EMU monetary policy will remain accommodative.
The whole year ended negatively for equities, with the US market writing off -6.2% and the European market doing even worse, ending with a loss of -13.2%. But the biggest loser is China, which is bleeding in the trade war with the US and lost -24.6%!

The outlook for this year is not very optimistic. Trade wars (especially between the US and China), high labour costs, falling demand for cars (a big threat to the Czech Republic) and rising interest rates remain the biggest threats to equity markets. Conversely, opportunity could lie in a significant decline in equity prices in late 2018. However, for long-term investors, nothing changes; crises and asset price declines are a normal part of cyclical economic development.

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