As we close out 2018 and look out towards 2019, it appears that next year could shape up to be a year of political brinksmanship, with the three main global risk factors being the U.S., China and Europe.
In the U.S., the midterm elections resulted in a divided congress, which could cause gridlock.
Currently, the U.S. economy is on track for one of its best years since the end of the Great Recession. For this trend to continue, accelerated capital expenditure spending is needed, but gridlock might slow it down.
Capital spending tends to drop during times of uncertainty, and gridlock has historically raised political uncertainty. Case in point, in 2011 the U.S. lost its AAA rating after political brinksmanship over the debt ceiling brought the country close to a default. And with deep animosity between the two major political parties, the risk for escalating tensions to cause gridlock is high.
Additionally, the trade war with China continues. We have seen trade tensions affecting different countries in very different ways this year, with the U.S. generally experiencing fewer negative consequences than many other economies.
However, since September we have seen the correlation increase between equity markets in the U.S. and in other countries. This indicates that the markets no longer believe the U.S. can remain immune to a trade war-induced global slowdown.
It's likely that things on the trade front will get worse before they get better. However, the chances have risen that a near-term, soft deal will be reached that kicks the can down the road. Ultimately, I still hold the view that further market volatility is needed before an actual deal is reached.
Finally, Europe finds itself in the middle of another crisis — this time with Italy. Unlike past crises involving much smaller economies, Italy represents the EU's third largest economy — roughly 10 times larger than Greece. The Italian government initially rejected the EU's demands to lower its projected deficit. It now faces disciplinary steps from the EU, which could lead to further tensions.
Recently, Italian officials have shown increased flexibility, supporting our view that the issue will be resolved. However, with high public approval of Italian officials, the possibility remains for a long, drawn-out war of words driving market volatility.
My View: The period of low volatility that had previously categorized the markets appears to be a thing of the past. As we head into 2019, expect volatility to rise as a series of unrelated political events set the tone for the year.
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