As investors enter 2019, the two largest economies in the world, the U.S. and China, both face challenges. First, will U.S. financial markets have a soft, bumpy or hard landing following the peak earnings and growth cycle seen in 2018? Second, will stimulus policies in China stabilize growth conditions in the year ahead?
Resolutions for both will have significant global implications for economies and financial asset prices alike. Will the U.S. economy have a soft, bumpy or hard landing when it happens?
Consensus expectations is for full-year growth to slow to 2.6% in 2019, however, on a 12-month rolling basis—fourth quarter 2018 to fourth quarter 2019—growth is expected to trough at 1.7%, a level equal to potential growth. If the U.S. Federal Reserve engineers a soft landing and growth temporarily falls only to potential, then this will produce a positive outcome for financial assets. This is the soft-landing scenario. If growth slows to levels slightly below potential and is perceived as transitory, lasting only a few quarters before rebounding to above 2%, this could be considered a bumpy landing. However, growth levels falling to below potential for what the market perceives to be an extended period—which may include a recession—would result in a hard landing. In that scenario, and possibly even the bumpy one, the Fed would likely to ease policy. Which scenario comes to pass depends on how inflation evolves. If inflation remains well-behaved, meaning rising gently (or maybe not at all), the probability for a soft or bumpy landing rise significantly.
Corporate growth and earnings in 2019 will directly impact credit asset performance. High levels of leverage in the post-quantitative-easing (QE) era—where the Fed is no longer buying Treasuries—have left corporate credit especially vulnerable. Although a U.S. recession isn’t the base case scenario in the next couple of years, the risk premia for corporate credit has risen and will likely rise further, widening the spread between government and corporate bond rates to reflect the increased weighting of this risk. But this also assumes corporations won’t change their behavior. If credit conditions deteriorate further, it’s hard to believe corporates will do nothing.
The credit cycle is intricately linked to how Fed policy will influence the economic landing in the post-peak growth and earnings period. Investment-grade credit is particularly sensitive to this, given the increased level of leverage in the aftermath of QE policies. A simple, somewhat oversimplified rule of thumb might be to expect a soft economic landing if the Fed ends its rate-increase cycle with policy rates at 3% or less, bumpy from 3% to 3.5%, and hard if rates spike to above 3.5%. Market concerns right now seem skewed to the worst-case scenario.