Article by John O'Sullivan

PAUL SAMUELSON was the rare sort of economist who understood that a well-crafted joke can have a greater impact than pages of complex maths. One of his famous quips was that declines in the stockmarket have predicted nine of the last five recessions. The joke dates from the mid-1960s. But it may well turn out to have particular relevance for financial markets in 2020.



Samuelson was one of the architects of the efficient-market hypothesis, which holds that stock prices, like oil prices and currencies, cannot be predicted. That is largely because such prices already have forecasts about events in politics and economics embedded in them. To predict the markets is to make forecasts about forecasts. If it were easy, we would all be rich.

Even so, it is wrong to think that all such attempts are futile. Useful things can still be said about how the markets might behave in 2020. To start with, we have a handle on the immediate outlook for the economy. Leading indicators of the world economy point to a continued slowdown. Forecasts for GDP growth are being revised down. And fears of a recession in America are growing. As such worries take firmer hold, share prices are likely to suffer for a while—perhaps quite badly. Yet there is reason to believe that recession fears will recede later in the year. The big surprise in 2020 may well be how quickly the mood in markets starts to recover.

Today’s investor anxiety is clearly evident in the thirst for rich-world government bonds, the safest of assets. In Germany and Switzerland, interest rates are negative not just on overnight deposits but also on bonds that mature in the distant future. Yields on ten-year bonds have dipped below short-term interest rates. In the past, this has been a reliable signal that a recession is coming. A survey conducted by Bank of America finds that two-fifths of fund managers expect one in the next year. The same proportion thinks the trade war between America and China will never be resolved. Surveys of business confidence are similarly gloomy.
 

So the big question for markets in 2020 is whether there is something on the horizon that can spur a little optimism. Don’t expect much good news in the early part of the year; signs that the slump in business sentiment is starting to infect the confidence of consumers are more likely. As recession fears build to a peak, stock prices will come under greater pressure. Long-term bond yields will fall further in America and plunge deeper into negative territory in Europe.

Yet misery is rarely eternal. There are forces at work to counter it. One is monetary policy. Sceptics are right to point out that with interest rates already so low, central banks are short of ammunition with which to fire up the economy. But interest-rate cuts in America and China, and bond purchases by the European Central Bank, will at least keep credit flowing smoothly to businesses and consumers. That will put a floor under stock prices.

It will probably take more than that to lift overall spirits in financial markets. But it would be unwise to bet against such a revival by the end of 2020. If government-bond yields fall further, politicians will wake up to the logic of economic stimulus by fiscal means—tax cuts and spending increases, funded by borrowing. Such policies fell out of fashion because their implementation is often ill-timed: it takes an age for politicians to agree on anything. But as recession fears grow, the pressure on them will build. As investors start to price in aggressive fiscal stimulus, stock prices will revive and bond yields will start to rise. As Samuelson noted a half-century ago, the markets sometimes predict disasters that don’t happen; 2020 could be one of those years.