Tightening financial conditions will cause banks to pause, providing investors some relief.

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Luc de la Durantaye, chief investment strategist and CIO, multi asset and currency management.

What makes the current situation tricky for market participants to read, I think I see a lot of puzzled faces from investors because 2018 was not a bad year from an economic perspective in the sense that growth was healthy, inflation was still under control. Yes, towards the end of the year there was a slowing of economic activity, but certainly not to the degree that would’ve foretold the poor financial market performance across the board. Whether you look at equities or fixed income, it’s been a very difficult year for investors.

The challenge is there’s been many cross currents in the financial markets other than the pure economic data. You’ve had continued the fallout from trade tension, led to policy uncertainty. You also had unusual events like Brexit that are still ongoing, the Italian budget negotiations that created some uncertainty in Europe. And also most importantly, I think the migration of many of the major central banks, moving away from unconventional policies. And so that’s, I think, created a lot of noise and made it very difficult to read the environment.

Certainly as we start 2018, the correction that we’ve seen in the equity market, the rally that we’ve seen in fixed income, the sovereign quality bonds if you will, and the spread widening from credit spread and high yield spread. All of this is combined in a measure that we call financial conditions. Financial conditions have been tightening, have been essentially doing the central bank’s job in terms of having equity markets correcting quite a bit, having credit spreads widening so corporations have more difficulty financing, or their financing has become more expensive. We’ve had also some tightening in terms of the fiscal impulses will likely wane over the course of 2019.

All of that is contributing for central banks to take a pause, and I think we’ve seen that in the Federal Reserve. We’ve seen that from the Bank of Canada just recently, and the ECB, the European Central Bank, has also demonstrated more prudence in terms of the way that they plan to renormalize their policy.

We also have to think, particularly in the U.S., that the economy nevertheless needs to slow down in order to limit the risk of overheating. We know that the unemployment in the U.S. is at least three-quarters of a percent below most estimates of full employment, and the inflation is already at or very close to their target, around 2%. That certainly gives the central banks ammunition to really be more prudent in their renormalization of policy.

And then so from that perspective, we do see, and the main theme of our perspective at the start of the year is central bank pause, which is we think they will be a lot more patient and being data dependent at the start of the year. That may provide some relief to investors.

From the Federal Reserve perspective, the Federal Reserve does have to deal with a tight labor market, but that may not translate so much into higher inflation, but rather given that inflation expectations are fairly well anchored, corporations may have difficulty passing on higher wages, and higher wages may translate into lower profit margins, which will continue to put pressure on corporate profits.

And so you may continue to have financial conditions in the U.S. being tight: an equity market that remains relatively flat and underperforms given that profit margins are going to continue to decline, which is going to lead to an under performance of equity markets, which will keep the Fed relatively prudent.

The Bank of Canada is also facing some weakness in the consumer given the level of debt that the consumer has. Plus oil prices have declined to a good degree. And so, those are two of the growth engines of the Canadian economy that are going to be sort of going in slow motion for 2019. That will allow the Bank of Canada to also be relatively slow in hiking interest rates, so we see potentially one to two hikes by the Bank of Canada at the most.

The ECB is in a similar situation where the economy is decelerating and inflation is quite low relative to its target. And so they will have to continue to remain very accommodative.

And finally, the Bank of China is … The cycle in China is bottoming, but inflation is still very low. Given the trade tension, China is still in a mode of supporting growth rather than slowing it down. So we see the Bank of China actually easing its monetary policy to a certain degree over the course of 2019.

So, at the start of the year, a pause expected, and perhaps towards the second half of the year, continued mild renormalization from the Federal Reserve, would be our scenario for the next 12 months.

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