More than 20 years ago, the global economy faced a very similar situation to the one it finds itself in today. Tech stocks were soaring, the U.S. was growing at a robust pace, and a global expansion getting long in the tooth was beginning to wobble.
When the Fed Taps on the Brakes, Someone Flies Through the Windshield
Part of the problem was that after a long period of accommodative monetary policy, the U.S. Federal Reserve had begun to hike interest rates, raising borrowing costs and increasing the foreign exchange (FX) pressures on certain markets around the world. As QMA notes in its Q4 2018 Outlook Review PDF opens in a new window, there is a saying that when the U.S. Federal Reserve (Fed) taps on the brakes someone flies through the windshield. In 1997, it was the heavily indebted Asian Tiger economies of Thailand, Malaysia and the Philippines that gave rise to the Asian Financial Crisis. In the summer and fall of 2018, the most immediate signs of distress have been felt in Turkey, Argentina, Brazil and other emerging markets (EM) with high current account deficits and vulnerable currencies. Now, as then, a Fed tightening cycle is exposing the weakest links. The question, as always, is whether the damage can be contained before it spreads more widely.
Fed Rate Hike Cycles and Crises
Line chart showing the U.S. Federal Reserve Target Rate from January 1970 to September 2018. The chart highlights the following crisis periods: Franklin National in 1974, First Penn in 1980, LatAm in 1982, Continental Illinois in 1984, Black Monday in 1987, S&L Crisis in 1990, Mexico in 1995, Asian Financial Crisis in 1997, Russia/LTCM in 1998, Nasdaq Collapse in 2000, and Subprime in 2007. It also highlights Turkey and has a question mark next to others in 2018.
Source: QMA, FactSet as of 9/26/18.
QMA’s answer to that question, detailed in its Outlook, is yes. On balance, the firm’s Global Multi-Asset Solutions Team (GMS) believes that the underlying strengths are such that the global economy should be able to ride out the current problems emanating from EM and continue growing through 2019. But, as with a number of the factors the team is watching, this is not a slam dunk. They break down the odds roughly as follows:
|Scenario 1: Asian Contagion Redux (30%)|
|Scenario 2: Continued Stress but No Pandemic (70%)|
So, in sum, QMA sees more reason to believe that EM stress will not morph into a full-blown debt crisis. That said, QMA does note another parallel to ’97. When the Asian crisis caused markets around the world to tumble, the Fed halted its tightening campaign, and a year later it cut rates in response to the Russian sovereign debt default and the meltdown of hedge fund Long-Term Capital Management. In the short term, the move had the desired effect. Stocks recovered from a sharp sell-off and U.S. economic growth stayed firm. But it also wound up turbocharging the next (and final) leg of the dot.com bubble, which led to the tech wreck of the early 2000s.
While it is hard to imagine the Fed would return to cutting rates any time soon, if the current EM crisis were to somehow trigger more widespread financial damage, the Fed’s pace of tightening could very easily slow. Three or four hikes next year could turn into two. Or one. This, in turn, could prompt still-buoyant liquidity to flood markets segments with the strongest underlying fundamentals.
In other words, it is not beyond the realm of possibility that one way this bull market ends is with the FAANG stocks going parabolic for a time before a major crash circa early 2022. To be clear, this is not QMA’s most plausible scenario. However, it does play into why the GMS team, after dialing back risk a bit more in its portfolios, maintains a slim overweight to global equities relative to its policy benchmarks. Although economic uncertainty is increasing, the near-term risk of a global downturn remains low. Moreover, there continue to be scenarios under which the bull-market expansion goes on yet another semi-extended run.
To cite another common saying, history doesn’t repeat itself but it often rhymes.
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