Man on beach looking at the horizon,

Financial markets were upbeat as 2019 ended, buoyed by the “Phase I” U.S./China trade deal announced on Dec. 13 and confidence that there’s little risk of recession.

But don’t be too optimistic, warns Sébastien Lavoie, chief economist with Laurentian Bank Securities Inc. in Montreal. “Investors can take some comfort that the worst may be behind us. But don’t be super-positive,” Lavoie says. “[The economic situation] is a little sunshine in a rather cloudy sky.”

There was a sharp reminder of the unpredictability of geopolitics on Jan. 3, when the U.S. assassinated Iranian general Qassim Suleimani. Iran swore it would retaliate and the U.S. made further threats. As Investment Executive went to press, financial markets were holding steady. But this situation is potentially explosive.

Lavoie says this could be the pattern this year. Given all the risks out there, he says, “If it isn’t a tense situation in one part of the world, it will likely be tense somewhere else. It’s just a question of what will be on the front burner, making [2020] a ‘muddle through’ year.”

The U.S./China trade deal was scheduled to be signed on Jan. 15, but there’s nothing in that agreement to stop the U.S. from raising tariffs on Chinese goods again, says Beata Caranci, senior vice president and chief economist with Toronto-Dominion Bank in Toronto.

Lavoie calls the deal “a truce that could be called off at any point.” Furthermore, as both he and Caranci point out, this is only phase one and doesn’t address the key complaints of the U.S. concerning China’s technology transfers and subsidies.

On the plus side, economic fundamentals are relatively good. Lower U.S. interest rates have pretty much eliminated the risk of recession in the near term, even though there is a global downturn in manufacturing. That’s less of an issue in the U.S. and other industrialized countries than it is in emerging economies because services are a much bigger part of more mature economies. In the U.S., for example, manufacturing accounts for only about 12% of GDP.

Overall, global economic growth is expected to tick upward to about 3.3% from 3.0% in 2019, but still below the 3.6% in 2014-18 and way below the 5.1% in 2003-07. But only the U.S. is in good shape. Much of the slowing is because of China, which has been hurt by the trade war and, like most industrialized countries, has an aging population. Europe is fragile. Japan is using large amounts of fiscal stimulus to keep afloat. Other emerging economies are struggling with the strong U.S. dollar (US$), in which much of their debt is denominated. Canada’s consumers are overleveraged and the housing market is overheated.

The U.S. Federal Reserve Board cut its overnight rate to 1.75% from 2.5% in three steps between July 31 and Oct. 30, 2019. When combined with debt-light American consumers and a far from overheated housing market, those cuts should lead to healthy retail sales, resulting in a 2% or so increase in real GDP.

The economic forecasts don’t include stronger business spending. Companies have the cash, but have held back on investing because of the uncertainty about the U.S./China trade war. That’s dissipated somewhat and the U.S./Mexico/Canada trade agreement has been signed, so companies could start adding to their capacity.

With inflation expected to remain low, interest rates are likely to stay around current levels this year, then gradually rise. Caranci, for example, expects the Fed rate to stay at 1.75% until around mid-2021.

Financial markets anticipate further gains in equities this year, although nothing like the 27.6% increase in the S&P 500 composite index last year. That surge was mainly recovery from the deep 20% plunge in the fourth quarter of 2018. This year, U.S. equities are beginning from a high base and are dependent on earnings growth to push stock prices higher.

Market expectations are for a 9% increase in U.S. corporate earnings, but that may be optimistic, says Jurrien Timmer, director of global macro with FMR LLC (a.k.a. Fidelity Investments). He notes that some of the anticipated earnings gains are already priced in and there’s little scope for increased price/earnings ratios as the average ratio for the S&P 500 is already relatively high at around 18, up from 13.7 a year ago.

Charles Burbeck, an independent global equities investor in London, agrees with Lavoie. Burbeck believes U.S. companies’ earnings overall could rise by 4%-5%, with one percentage point of that coming from some decline in the US$. Lavoie is expecting a “low single-digit” gain for the S&P 500.

Economic growth comes from two factors: increasing numbers of workers and increasing output per worker (a.k.a. productivity). But China’s one-child policy, in effect from 1979-2015, means there are now more people retiring than entering the labour force in that country. A similar trend is occurring in most of the industrialized world as baby boomers retire.

Labour force numbers are dropping in Japan and Europe as well. Japan is coping with massive fiscal stimulus, but Europe is very fragile and is teetering on the edge of recession. Germany, usually the engine of Europe’s economic growth, has been hurt badly by the global manufacturing recession and its economy has contracted three times in the past six quarters, says Craig Alexander, partner and chief economist with Deloitte Canada in Toronto.

China’s economic growth has slipped below 6% from 6.9% in 2014-18 and 11.7% in 2003-07. There are brighter prospects in other emerging economies, many of which have younger populations, but those prospects are dependent on global growth and vulnerable to rises in the US$, in which much of their debt is denominated. Thus, while many analysts recommend overweighting emerging markets, which have low valuations, don’t overdo it.

One of the key questions is whether the US$ will weaken somewhat. That would be welcomed by the U.S. because it would make U.S. exports more competitive. The potential stumbling block to that scenario is the greenback’s status as the world’s reserve currency. Whenever global risks are high, money flows into US$ for safety reasons.

While the biggest risk is renewed escalation of the U.S./China trade war, there’s also the possibility of a U.S./European Union (EU) trade war, which U.S. President Donald Trump has been threatening.

From a global perspective, a downturn in Europe probably would not push the rest of the world into recession. But such a downturn would negatively impact the many countries that export to the region, including the U.S., which buys and sells more from/to the EU than with China. But the issues are less difficult to overcome.

“With Europe, it’s a question of fair trade,” says François Bourdon, global chief investment officer with Fiera Capital Inc. in Montreal. Getting to that point is a matter of negotiating a level playing field in terms of tariffs and subsidies and doesn’t involve major changes in the way either region operates.

With China, the U.S. is dealing with what Bourdon calls “state capitalism,” in which the government makes up the rules – and wages are much lower than in the U.S.

Other risks include North Korea, which is increasing its nuclear weapons program; social unrest in many regions, including Hong Kong, Venezuela and Argentina; and a messy Brexit.

U.K. Prime Minister Boris Johnson’s win in that country’s December election means the U.K. is scheduled to leave the EU on Jan. 31. But that leaves the urgent need for both parties to negotiate an agreement that allows for continued smooth trade between the two regions – a deal Johnson wants done by the end of 2020. If that proves impossible, both regions will be hurt and the odds of a recession in Europe increase.

Alexander notes that the rise in populism and nationalism, which tend to be anti-immigration, anti-international co-operation and anti-trade, is behind much of the current tensions. Trump’s “America first” slogan sums this up, but the phenomenon is widespread and is not going away. And in the U.S., Trump may well win the November election despite impeachment proceedings.

There’s also risk of inflation rising, in Bourdon’s view. He believes U.S. wage increases could rise to 4% and push inflation up to about 3% by this summer or autumn and force the Fed to raise interest rates again.

Energy commodity prices can be a major inflation factor. As 2019 ended, there didn’t appear to be a big risk of oil prices surging. However, Lavoie says, the U.S./Iran tensions are a “simple reminder that the oil risk premium is alive and a risk to the global outlook.”