Banking: Is it time for central banks to pause?

Monique Frederick, Butterfield

It is hard to believe that the 9 percent return on the S&P 500 Index as at the end of September has now completely vanished. U.S. equity markets are now in negative territory for the year to date. Recent market turmoil has investors pondering if benefits from the Trump tax cuts are wearing off. Despite a robust U.S. economy with GDP growth of 4.2 percent and 3.5 percent in the last two quarters, sentiments about future growth prospects are shifting.

How did we get here?

Certainly, the reason for the market downturn is not limited to merely one element; rather it is a confluence of factors. The U.S.‐China trade stand‐off continues to drive market action, forcing companies to curtail their forward earnings guidance in their attempt to assess the potential impact to their bottom lines. The dramatic drop in oil prices to a twelve-month low has only added fuel to the fire, with widening credit spreads further fanning the flames of volatility.

When Germany, the world’s third largest economy, reports a contraction in its economy for the first time in three years, there is undoubtedly cause for concern. Not only are we witnessing a slowdown in German GDP, business confidence also fell for a third month, and exports, related largely to the auto industry, are beginning to feel some pressure. Although Japan reported healthy second quarter numbers in the middle of summer, the third quarter witnessed a contraction of 1.2 percent. Facing an impending Italian debt crisis, currency turmoil in emerging markets, an unprecedented bailout of Argentinian debt and the ongoing Brexit saga all contributed to the heightened anxiety.

What’s expected in 2019?

Many market participants are calling for the Fed to pause their rate tightening cycle. That consensus is likely driven by expectations of a slowdown in the global economy. Notwithstanding, the objective of the tax stimulus was to encourage corporations to increase investment spending. To the contrary, many firms have opted to distribute dividends and optimize their capital structure with the tax savings. Likewise, corporations are not at all inclined to boost capital expenditure given the uncertainty surrounding the trade war with China. Furthermore, as rates increase and credit spreads widen, companies are facing rising borrowing costs, reducing the appetite to intensify capital spending.

Against the current economic backdrop, it may be time for the policy-making body to reassess its tightening strategy, potentially pausing after the December rate hike. That said, there is no scientific evidence of economic distress: unemployment is falling steadily, and we are not yet on the cusp of an inverted yield curve. Most likely, the Fed will deliver another 25 basis point hike in December; however, markets are expecting the Fed to hit the brakes in 2019 or, at a minimum, slow the pace of future rate hikes. Admittedly, it would require a lot more than President Trump’s critical rhetoric for the Fed to stop raising rates. With unemployment at historic lows, it would take a severe slowdown for the Fed to halt the upward interest rate trajectory away from rate normalization.

The situation in Europe actually appears gloomier than at first glance. The slowdown in Europe, coupled with the Italian budget impasse, is presenting a challenge to the European Central Bank’s (ECB) growth strategy. Despite the disappointing data coming out of Europe, President Mario Draghi and the governing council believe that inflation will push higher as a result of domestic demand, creating pressure on wages. Although the ECB is scheduled to end its asset purchase program in December, monetary stimulus is expected to continue through reinvestment of maturing bonds. With so much at stake, all eyes will be on the ECB for any clues on changes to their short-term outlook following a challenging quarter.

Despite all the aforementioned concerns, economic forecasters are not calling for a U.S. recession. Regardless of the path chosen by central banks, it would behoove investors to remain cautious by being defensively positioned. In fact, a rotation into the defensive sectors has already begun, as evidenced by the outperformance of utilities versus the technology sector since the recent sell-off. 2019 will undoubtedly be a year of continued market volatility, requiring investors to mentally prepare for the journey. Although the cliché rings true that “you cannot participate unless you are invested in markets,” selling low to repurchase high is never a winning strategy.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.