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The party is coming to an end. For 10 years, central banks fuelled the good times with a combination of low interest rates and quantitative easing to boost the global economy following the financial crisis of 2007-08. It was a period of unconventional monetary policy that lasted much longer than virtually all experts predicted, leaving global markets with a bigger hangover than anticipated.

In the last four months, markets seem finally to have woken up to this new dawn of fading central bank support. Investors seem unsure how the global economy will fare in a higher interest rate environment sparking the market volatility we have seen across both the equity and bond markets.

Music stops in the US

The US economy in particular is under scrutiny but growth, in my view, remains supported for at least another year by Donald Trump’s $1.5 trillion package of tax cuts which delivered sizeable reductions in both corporate and individual tax rates. The issue, of course, remains the pick-up in US wage growth due to tight labour market conditions.

The unemployment rate, at 3.7 per cent, is at its lowest level since December 1969 while wages recorded their largest annual gain in 9 and a half years in October 2018. In this context, I would expect the US Federal Reserve to continue its policy of measured interest rate rises, in part also to offset the increase in the US budget deficit coming down the line. 

The Italian question

Europe’s economy will muddle along, delivering enough growth in my view for the European Central Bank to be able to raise interest rates next year for the first time since 2011.

The ‘Italian question’ though hangs over the euro zone. The country’s populist government has clashed with European authorities over its plans to boost spending in its 2019 budget; the move is viewed as reckless given Italy’s outstanding public debt has reached around 133 per cent of GDP, far higher than any of the other major euro zone nations.

A stand-off between Italy and the EU could lead to a full-blown crisis that would have the capacity to break up the euro zone. Not that I would expect that to happen. European officials are masters at cobbling together last-minute deals – that’s how the euro zone has always worked.

Muddling through might well be the ‘mot du jour’ across the Channel as the UK prepares to leave the European Union. While I believe the British underestimated the complexity of the exit process at the time of the referendum, few are under any illusions now about the difficulties that lie ahead. Brexit is a worry, but the British are adaptable and we will likely find a way to make it work. Ultimately, however, we are only a medium-sized island off the coast of Europe – the world has other and bigger problems.

Potential trade war escalation

One of the biggest is the intensifying rivalry between China and the US, the world’s two economic superpowers. Given the unpredictability of the current incumbent at the White House, it is difficult to say whether trade war tensions will escalate or ease in 2019.

We do know however that a continuation of relatively frictionless global trade ultimately determines the economic wellbeing of the rest of the world. Emerging market economies in particular have been great beneficiaries of free trade so this new wave of protectionism, backed by a resurgence in nationalism, could prove damaging. That said, I remain positive about the prospects for these economies over the medium to long term.

In 2018, with the notable exceptions of Argentina, Turkey and Venezuela, emerging market economies have shown some financial resilience despite a rising US dollar raising concerns about the ability of nations and companies in the region to pay back what are significant amounts of US dollar-denominated debt. As long as the US dollar continues to tread water around current levels, or better still falls, and that the price of oil, an important factor when gauging the prospects for emerging market economies, remains stable, the year ahead could prove positive for them.

Curb your enthusiasm

If we take a longer-term view of asset prices and markets, we can see there are long periods of range trading; to expect that as a central case for 2019 therefore is not unreasonable. This is often a favourable environment for bottom-up fund managers – those who focus on company fundamentals – to add value. However, with valuations towards the top-end by most historic measures, we will need to temper our expectations of seeing significant returns.

This article was previously published on Morningstar.co.uk

 

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