Global risk assets rally off their 2018 lows. What's next?

Following a sharp decline in Q4 2018, risk assets ended the year by putting in a bottom that ushered in a strong rally to begin 2019.  Given the precarious nature of foreign markets, January's post made it clear why it is imperative that the 2018 lows remain intact.  As long as that continues to be the case, it becomes much more likely that the Q4 slump was nothing more than a large correction in an ongoing secular bull market for US equites.  On the other hand, should global credit spreads start to widen once more with global equities breaking their 2018 lows as investors seek the safety of the US dollar and long-term treasuries, it opens up the very real possibility that the current ongoing rebound is a temporary counter-trend move in a new prolonged bear market.  To clarify these opposing possible outcomes, this month's entry seeks to review important intermarket relationships that have been present since the late 1990s/early 2000s in order to present a bull & bear case for 2019.

1.)  US nominal GDP growth, long-term treasury yields, oil, & inflation expectations continue to move together.

• As long-term treasury yields reflect the expected path of real short-term rates, expected inflation during the term of the security, and a risk premium due to unforeseen change, yields share very similar components to nominal GDP (total US dollar sales of domestically produced good & services).  The latter can rise when there is an increase in the volume (real production) as well as dollar value (price/inflation) of aggregate domestic output.  Thus, it should come as no surprise that both yields and NGDP have trended together.  
• Seeing as the 10-year yield peaked as of late, it increases the odds that the year-over-year pace of nominal GDP has too.  Following the Fed's 2016 pause and the anticipation of Trump's fiscal expansion, US economic activity saw an acceleration that began in early 2016 and lasting until the back half of 2018.  However by 2018 market participants were pricing in the effects of a Fed stance that was committed to rate hikes and balance sheet reduction (autopilot) to go along with a fading US fiscal impact and a weakening global environment. Under such conditions, it's understandable to expect that the rate of US nominal GDP will not have been able to maintain its strong pace when the latest figures are reported.

• With both nominal GDP and long-term yields encompassing an inflation component, it's easy to see why each have had a tendency to move alongside market based inflation expectations and the price of oil.  Inflation expectations and oil have both rebounded sharply following the China/Brexit scares of 2016.  Luckily, a Fed pause and a US fiscal response prevented a 2015-2016 slowdown from turning into something worse.  In doing so, this combination in part helped set-off coordinated global growth until a key trend change occurred in Q1 2018.
• Before discussing that, it's crucial to first note that past cycles came to an end when the Fed was unwilling to forcefully counteract a deteriorating domestic economic situation and instead opted to combat surging oil prices by either hike their policy rate or remain too tight.  This combination of restrictive monetary conditions and an oil price spike led to recessionary turns in 1974, 1980/81, 1990, 2000/2001, & 2008.   Fortunately, oil has been in a long-term downtrend after collapsing in 2008 and again in 2014-2016.  Moreover, oil's price advance from 2016 through 2018 had been largely erased by the end of last year.  This should give the Fed ample policy maneuverability going forward.
• Additionally, market based inflation expectations are sending the same message.  Even though the Fed has treated its 2% symmetric inflation target more as a price ceiling by favoring preemptive hikes over allowing inflation to first remain above 2% for a substantial enough period before acting, the decline in inflation expectations should provide them with another reason to tread cautiously for the time being.
  

2.)  The US dollar trends in the opposite direction of emerging markets.

• That major trend change in 2018 was the US dollar.  By the end of the first quarter of last year, the USD had formed a base and then proceeded to make a 6-month high.  What followed was a greenback that saw multiple months of gains after that point.  Due to its role as an anchor currency in the global financial system, this persistent appreciation caused a tightening of financial conditions worldwide.  This was evident by the widening of global credit spreads and a persistent multi-month downtrend in international stocks.
• During this period, the Fed naturally reacted to strong US growth by restarting their plans to "nominalize" monetary policy to the misfortune of foreign economies.  2018 once again made clear that the Fed is the reluctant global central banker.  Their monetary policy decisions may be in response to the US economic and financial condition, but their actions spillover to the ROW via the FX and credit markets.
• For emerging market bulls, the optimistic scenario is that a less hawkish Fed will enable the double bottom being formed to hold.  From a technical perspective, should this be the case while the USD continues to press higher, this will set-up a possible conflict in the ongoing intermarket relationship.  The ultimate resolution could either spell trouble for the USD or EEM as it's unlikely that both will trend higher together for a prolonged period.  An eventual USD break below the red-line support that coincides with an EEM move above overhead resistance would help confirm a trend change in both.  Meanwhile, continued USD appreciation that happens alongside a break of support for EEM indicates that another leg lower in emerging markets may be set to occur.  

• Since the relative strength of SPY vs EEM moves positively with the USD, SPY should keep outperforming EEM as long as the dollar remains in its current uptrend.  Although USD strength has been a headwind for US equities since the late 1990s, it has weighted more heavily on emerging markets.  Therefore, a possible dollar peak is likely to bode well for US as well EM stocks but more so for the latter.  With that said, the USD remains in an uptrend and this must still be respected. 

• EEM isn't the only asset class that closely moves inversely to the greenback.  Gold does too and it can be used to confirm the next direction in EEM.  Gold is either in the process of forming a large multi-year base that will either see its decline continue should it falter or a reverse after breaking overhead resistance.
• For now, it's interesting to note that gold did make a 6-month high in Q4 2018.  Whether or not the dollar eventually follows by topping out is yet to be determined especially considering gold has experienced multiple failed rallies since roughly 2014.
  

3.)  US monetary policy expectations relative to other major developed currency zones drives the dollar.

• The above blue line is the 6-month US treasury rate, six months ahead compared to the Euro LIBOR equivalent.  This can be used to understand how market participants are pricing in the Fed's monetary path relative to the ECB's.  
• Starting in 2011 through 2015/16, markets correctly anticipated a tighter US monetary path when compared to that of the Eurozone.  This sent the US dollar 20% higher.  Since that period the USD has been in a sideways trading range that has coincided with a stop/start global growth backdrop.  
• Interestingly, this rate differential bottomed midway through 2017 ahead of the USD's 2018-19 uptrend that took risk assets lower.  This rate spread has since reversed downward starting in the summer of 2018.  Are market participants anticipating an impending dollar decline or will the rate differential begin to edge higher with the USD again?
• As Eurozone domestic demand remains muted, European growth has been increasingly dependent upon external demand to support EZ nominal GDP by way of export sales.  This is particularly the case for Germany.  They have largely been able to escape the European economic malaise by benefiting from a weak Euro to sell abroad.  This made Europe's largest economy very sensitive to global economic prospects.  As a result of the global deceleration, German real GDP topped in Q4 2017 at 2.8% and has slowed to .64% within one year.  
• Finding itself in such a precarious situation, it is very unlikely that the ECB will be able to raise rates anytime soon unless Eurozone economic prospects greatly improve.  This puts the onus on the Fed to act with caution.

Concluding remarks

To summarize, accelerating US economy in 2018 in large part due to expansionary fiscal policy caused the Fed to resume their tightening cycle.  This took the dollar higher and global growth & risk asset prices lower.  Now the Fed is signaling that they are again willing to pause as they did in early 2016.  The question and biggest risk to global markets is whether the Fed's response will be sufficient enough to offset the current weak global economic picture.  If yes, we are likely repeating the same positive patterns that took place in 2011/12 and 2016.  If not, deteriorating economic prospects could prove to be too much for the Fed to overcome which would certainly bode very poorly for global risk assets.

Bull case for 2019:

• The pace of US nominal GDP decelerates enough to justify a more accommodative monetary stance by the Fed but not to the point where risk aversion sets in.
• Long end of the treasury yield curve reflects this likely moderation in the pace of NGDP.
• The US dollar tops and breaks its September 2018 low which would confirm a change in trend to the downside.  The greenback is still in an up move that began in Q1 2018.
• Following the dollar, global credit spreads continue to recede from their 2018 highs.
• Emerging market equities put in a confirmed bottom & begin to outperform US equities.
• Commodities particularly oil rebound but remain in a long-term downtrend or sideways consolidation that keeps the Fed from tightening too aggressively in the months/years ahead.
• Similarly to oil, inflation expectations recover while staying low enough to keep the hawkish impulses of the Fed at bay. 
• Growth outside of the US bottoms and eventually accelerates.

In this optimistic scenario consistent of slowing but still positive US NGDP, an accommodative Fed, a weaker USD, and an improving global backdrop, US equities would be set up to end this multi-year period of sideways consolidation by eventually making new all-time highs.  This possible outcome is strengthened by the fact that inflation, inflation expectations, and oil prices are likely to remain within a range even if they do rebound along with global equities.  Critically, this latter point must be emphasized because past expansions have ended when the Fed was reacting to an inflation scare and oil price spike by remaining tighter than a weakening economy could handle.  This is not the circumstances they find themselves in today.

Bear case:

• US dollar eventually trends above its 2017 high.
• Global credit spreads, especially outside the US, move sharply higher with the greenback.
• The double bottom in emerging market equities fails to hold.  Global equities lead US stocks below their 2018 lows.
• Commodities/oil suffer another leg lower taking inflation expectations down with them.
• The long end of the US yield curve sells off violently as global investors seek the refuge of safe haven US treasury bonds.

This pessimistic scenario presents a global growth scare that produces a degree of risk aversion that more accommodative monetary policy cannot easily (immediately) offset.  After a violent sell-off in Q4 2018, should global equities suffer a massive reversal below their 2018 lows after rallying so convincingly to start this year, one would suspect that global investors may panic.  A pronounced period of risk aversion as described above would likely turn what is a US nominal GDP deceleration into something much worse than currently anticipated.  Such a negative set of circumstances would only heightened political risks within the Eurozone and in the US-China negotiations.  It isn't very difficult to see that in today's geopolitical backdrop a massive global growth scare would very likely result in much greater geopolitical turmoil.

Given the US Dollar's role in setting global financial conditions due to the nature of FX markets & the level of foreign dollar denominated debt, it's one of the keys in determining whether the bull or the bear case takes hold. 

It's important to note the reflexive relationship between the dollar, dollar denominated debt, global growth, and the perception/expectations of market participants.  When investors fear that worse than expected outcomes may materialize for highly levered issuers of dollar denominated debt*, they begin to make protective/defensive portfolio decisions.  This causes the dollar and foreign credit spreads to rise.  The rise in spreads (sell-off in riskier bonds relative to safer ones) in turn increases debt servicing costs as foreign currencies fall.  Inevitably questions about how this will affect or slow global growth start to become an immediate concern and the cycle of worry continues.**  In part, market participants reinforce the very conditions which they fear.  Thus, dollar appreciation not only acts as a tightening of international financial conditions but is a symptom of increasing risk aversion among asset managers.

Now it's imaginable that US stocks could continue their secular advance in spite of a strong dollar and a weak global environment, but this would require a key change in current intermarket relationships along with a US economic decoupling.  It would essentially mean flipping back to the intermarket trends found before late 1990/2000 (dollar appreciation coincided with weak commodities, higher US equity & bond prices).  As market participants have yet to see signs of this and factoring in the much more globalized nature of today's financial markets and economies, this possibility appears to be remote.  However, it can't be entirely removed as a potential outcome down the road.  For now, it's much more likely that the US dollar will continue to be a headwind for US equities and definitely for EM assets.

To close, here is a look at the weekly and daily charts of the SPY.  As of right now, the 2018 bottom can be compared to the ones made in 2011 & 2016 as judged by the 50-week rate of change percentage.  If US equities are indeed in a secular advance, this low should prove to be durable with any subsequent corrections staying above this level.  On the other hand, if US equities stumble below those levels and the decline is confirmed by key intermarket relationships, it would serve as a strong indication that this present environment is evolving into something very different to the periods following 2011 & 2016.

• The 50-week rate of change rebounded above the white 0% line after declining by about -10% (green line).  This helped mark the bottoms in late 2011 & early 2016.  Will this hold true following Q4 2018?

• Despite the forcefulness of the current rally, it has only returned the S&P 500 back into the sideways trading range.  The index price is now just below the November & December 2018 highs which may serve as resistance.  Any future corrections should remain above the red line in order for the multi-year/long-term trend in US equities to remain intact.

Regardless of what may unfold, it is imperative that investors have a plan for either a bullish or bearish resolution as both are still very possible.  TBD