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We are neutral risk as we enter 2019 with the global economy slowing, U.S. monetary policy tightening and trade tensions introducing further risks to a slowing China. We don't expect a recession to unfold over the next year, but the current rise in volatility reflects the increasing risks to that outlook. In this lower return environment, we like the return prospects for U.S. high yield bonds, which may benefit from a relatively strong current yield and strong equity market fundamentals. We expect this to reduce downside risk but also offer potential upside market participation.
Risk asset is a term broadly used to describe any financial security or instrument that is not a risk-free asset — that is, a high quality government bond. Risk assets would therefore include equities, commodities, property and all areas of fixed income apart from high quality sovereign bonds, such as Treasuries.
We entered 2018 with a significant overweight to risk assets such as U.S. equities, developed ex-U.S. equities and emerging market equities, but we steadily pared that back during the year as risks increased around growth and monetary policy. We moved to neutral risk before the Federal Reserve got to its "neutral" rate of interest, as our concerns built around the U.S. Federal Reserve (Fed) over-tightening. Our "first to neutral" approach also captures our view of risk taking today — as the outlook for 2019 is hazy, we have gone first to neutral as we assess our next move. Policy intentions from the Fed, along with the outlook for global growth, will be the key drivers of the move: increasing or decreasing recommended risk. Geopolitical risk will remain front-and-center in 2019, from Brexit to trade to a new head of the European Central Bank (ECB) in late 2019. While growth is slowing and will likely continue into the first half of 2019, the prospects for some improvement in Europe and China remain. Steady-but-unspectacular growth, alongside tame inflation, should not force the hands of central bankers into premature tightening. We believe this risk is greatest in the U.S., where the economic expansion has had the strongest momentum.
As part of our 2019 Outlook, we review our investing trends and how those trends are developing.
Mild Growth Myopia has driven our overall outlook. Just as we did not get too excited about the temporary acceleration in U.S. growth over the past two quarters — we are not overly concerned with the recent growth slowdown. We believe investors should head into 2019 looking for opportunities to reassert a positive stance.
The continued Stuckflation environment has also enabled our opportunistic approach. Continued low inflation gives central banks an excuse to either take their foot off the brake (in the U.S.) or continue easy money policies (in Europe and Japan). We believe earning positive investment returns is easier when not having to "fight the Fed" (or other central banks).
That said, it has taken the Fed in particular longer than we expected to appreciate the benign inflationary environment. And, up until recently, there were real concerns that the Fed would fail our Pass/Fail Monetarism theme. However more recent dovish comments from Fed Chairman Jerome Powell and Fed Vice Chairman Richard Clarida suggest that the Fed may squeak by with a passing grade after all (though risks remain).
Technology Slowzone has certainly slowed the pace of U.S. equity returns, as the tech sector — the main driver of equity returns throughout 2017 and into 2018 — turned into a drag the past few months. Meanwhile, Global (Re) Positioning System and Executive Power Drive were fairly benign views on protectionism and populism, and recent developments suggest both are playing out as expected.
Growth may be falling but low inflation, robust confidence and cheap oil should stabilize the global economy.
The synchronicity of global growth in 2017 gave way to wider variability in 2018, as U.S. growth outpaced expectations and growth in Europe and Asia slowed. Boosted by tax cuts and deregulation, U.S. growth hit a 4% pace mid-year before beginning to slow as the fourth quarter approached. Europe and Japan were both hurt by temporary factors in the third quarter, including emissions-related challenges for the German auto manufacturers and earthquake and typhoon disruptions for the Japanese economy. The slowdown in China, visible more through the scope of stimulus measures than official statistics, has been exacerbated by trade-related tensions and should generate continued policy response in 2019.
The "core" PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.
We don't see current conditions pointing to a significant fall in growth, resulting in recession, in the developed world. U.S. growth will clearly slow in 2019, as the positive boost from tax cuts fade and the tighter labor market constrains growth to a range of 2.0%-2.5%. We look for Eurozone growth to stabilize between 1.5% and 2.0%, as the positive impact of low interest rates, robust confidence, cheap oil and continued credit growth offset the negative impact of political upheaval and a slowdown in global growth. Japan's growth should be modest, but positive, supported by domestic consumption. We expect Chinese growth to continue slowing in the first half of the year. As long as trade frictions do not significantly ramp up from here, we expect Chinese growth to reaccelerate in the second half of the year.
The long-awaited pickup in inflation finally started to appear in 2018, but only in the headline figures — and for different reasons than many economists expected. While unemployment rates across the developed world have steadily fallen since 2013, the resulting increase in wages has been fairly tempered. Instead, the near doubling in oil prices from June 2017 to October 2018 has worked its way into the inflation numbers. With oil subsequently falling by 30% over the ensuing months, this pressure is set to somewhat subside. The negative impact on U.S. growth from falling oil prices should be more muted than in 2016, as energy sector capital expenditures have decreased from over 1.3% of gross domestic product back then to roughly 0.8% today.
An overriding influence on the inflation outlook remains with our Stuckflation theme, where the impact of technology in increasing supply has capped overall pricing power. In fact, U.S. core inflation seems "stuck" below 2%, while Europe and Japan are "stuck" at 1% and 0.4%, respectively. Wages in the U.S. may creep up in 2019, but strong pricing power remains elusive and we do not expect core inflation to sustain above the Fed's 2% target. We expect European inflation to be constrained by limited upside growth risk, as is also the case in Japan.
We believe fiscal policy is more important as monetary stimulus fades.
Actions and messaging from the Federal Reserve could move markets.
After being a central driver of market action since the global financial crisis, monetary policy has moved somewhat to the sideline. Among the developed world's major central banks, the Fed is the most likely to move markets in 2019. This may start in late 2018, as the Fed faces a key policy challenge at its December 19 meeting to set the tone for the coming year. As of this writing, the meeting had not yet occurred, but we argue that the Fed should pause. Still, an acceptable outcome would be a 0.25% policy rate hike accompanied by dovish forward guidance. Our outlook for slowing growth, and constrained inflation, should limit the Fed to just one hike in 2019 — which is roughly in line with market expectations.
The ECB announced it will end quantitative easing by year-end 2018, but we expect the ECB to avoid any interest rate hikes in 2019 by keeping the policy rate at -0.40%. We expect little change out of the Bank of Japan, as modest growth and core inflation below 1% will likely encourage steady policy. Finally, the People's Bank of China will remain part of the toolbox Chinese policy makers can access should they need to ease further in the first half of 2019 to support growth.
Fiscal policy has historically been easiest at the start of economic cycles and tightens as the cycle matures. Like many things this cycle, it hasn't followed the usual script. After being a headwind to growth from 2010-2015, fiscal policy has been roughly neutral globally from 2016-2018 when the tide started to shift. The U.S. started the trend among developed economies with the significant boost from tax reform in 2018, which is estimated to have boosted growth by around 0.5%. The contribution should be similar in 2019, which is constructive but should not lead to acceleration in growth.
We expect Europe to see a boost from fiscal policy in 2019 after a modest drag in 2018, including contribution from the controversial jump in the projected deficit in Italy. The recent U-turn by French President Emmanuel Macron, from considering a petrol tax to proposing tax cuts, is a reflection of the trend toward looser fiscal policy in reaction to voter unrest. China is also forecasted to swing from a fiscal headwind of 0.4% in 2018, as it sought to rein in credit creation, to a fiscal tailwind of 0.6% in 2019 as it seeks to offset slowing growth and the risk of trade friction. As shown in Exhibit 5, Japan is the only major economy forecasted to see an improvement in the fiscal deficit, which history suggests is likely wishful thinking.
Dovish central banks may help avoid the dreaded inverted yield curve.
Yield Curve is constructed by plotting a session's final yields for various maturities including 1-month, 3-month, 6-month, 1-year, 2-year, 3-year, 5-year, 7-year, 10-year, 20-year and 30-year maturities. A flat yield curve would show similar interest rates between the various maturities.
The Treasury yield curve continued to flatten in 2018. At the end of 2013, the difference between the 10-year and 2-year yields was more than 2.6%. Today, that difference is just barely 0.1% — with some parts of the yield curve (the section between the 2-year and 5-year yields, for instance) inverted. This is what we strongly believe the Fed should avoid (see our Pass/Fail Monetarism theme). We are looking for signs of a more dovish Fed in 2019.
We believe other major central banks, specifically the ECB and Bank of Japan (BoJ), will retain their dovish approach in 2019, putting even more pressure on the Fed to do so. Market expectations for the yield curve one year from now can be found in the chart. Currently, these expectations suggest just one additional Fed rate hike in 2019 (in addition to one this December). We believe that is the absolute most the Fed should hike. Regarding how many times the Fed will hike, the communication surrounding the decision at the upcoming Fed meeting (December 19) will be key.
A more dovish Fed, combined with muted global growth and a lack of inflation, will continue to keep long-term rates mostly range bound. As such, portfolios remain positioned with a neutral-to-long duration, relative to their benchmarks.
Fundamentals should back high yield bonds for a potentially strong 2019 recovery.
Fixed-income returns were hit by higher interest rates and wider credit spreads throughout most of 2018, leading to flat-to-slightly-negative returns year-to-date. Interestingly, high yield outperformed investment grade debt given a higher starting point yield, which has cushioned against higher interest rates. However, investment grade returns are catching up with high yield given the recent fall in both interest rates and equity markets (to which high yield returns are exposed).
We expect fairly constructive returns from both investment grade and high yield debt in 2019, as interest rates remain range bound (with inflation stuck) and credit spreads tighten (as investors realize a slowing global economy does not mean a global recession). In fact, investment grade fixed income and high yield represent the only two asset classes to which we have an overweight position heading into 2019.
We're neutral, but a lot rides on the Fed, trade and Brexit.
Equity markets remain largely tethered to the news flow on trade and the Fed, amid slowing global growth. A pause by the Fed on December 19 — driven by tighter financial conditions, slowing global growth and Stuckflation — would be met with positive global equity performance. Conversely, a Fed that fails to credibly adjust its message could lead to further equity weakness, especially in emerging markets. We're sticking with our underweight to emerging market equities, and a neutral risk position more broadly, until we get more clarity.
European equities should benefit from earnings growth of 5%-10% in 2019, and enter the year with attractive valuations. Clarity on the path for Brexit will be necessary for the stocks to become more attractive. The potential of a delay to the October 2019 Value Added Tax (VAT) increase would be a positive for Japanese equities, where growth is slow but stable and valuations are slightly cheap. Finally, emerging market equities will need reduced uncertainty around the Fed, trade and Chinese growth to improve their outlook.
Global real estate may be attractive given our constructive outlook on high yield and credit.
Real assets underperformed the broader global equity market in 2018. Higher interest rates through the first nine months of the year represented a drag to interest-rate sensitive global real estate and listed infrastructure. Meanwhile, the fall in oil prices dragged down natural resource returns over the past few months. The latter served as a good reminder of the humility needed in this business. For example: Many investors saw $75/barrel oil as just a stop along the road to $100; instead, oil fell to nearly $50. It also served as an example of our Stuckflation theme — the ability for supply to constantly meet demand.
As with global equities, the Fed's December 19 meeting will set the tone for real assets in 2019. Should the Fed indicate a pause in its rate hike campaign, and inflation remains stuck, global real estate and listed infrastructure could show strong outperformance. Global real estate could be an especially attractive asset class given our constructive outlook for high yield and global real estate's high exposure to credit risk. Natural resources could also benefit from a new-look Fed, as any move toward more dovishness would likely weigh on the dollar and support dollar-based commodity prices. We sit neutral across all real assets while we wait.
The fundamentals point to continued global growth in 2019, but the way forward holds increased uncertainty.
Equity markets don't directly track economic developments, as 2018 clearly demonstrated. Despite relatively strong global growth and corporate profits, investors instead have focused on the adverse risks to those trends continuing into 2019.
U.S. corporate activity, between share buybacks and dividends, has provided a 5% return as corporations bought back over $750 billion in shares over the last year — an increase of 40% from 2017. The funding of those buybacks has shifted from roughly two-thirds cash in 2017 to more than 85% in 2018 because of higher interest rates and cash repatriation.
Fund flows have continued to favor fixed income over equities, with $171 billion flowing into investment grade bonds over the last year while $96 billion entered the equity markets. As a reminder, fund flows into equities at the end of the last two market cycles (1999 and 2007) were much higher than those into fixed income. The vibrant animal spirits that typically emerge at market peaks remain in hibernation.
Business cycles have tended to end when the economy overheats and monetary policy becomes significantly restrictive. The current economic cycle is distinguished by its length, but not its magnitude.
We haven't seen the surge in commodity prices typical at the end of cycles, and a broad index of commodity prices is actually down 6% so far this year. Cycle peaks have also usually seen average hourly earnings increasing in the neighborhood of 4%, and we have just recently cracked the 3% level.
These factors favor the economic expansion continuing through 2019, with monetary policy being the primary risk case. The other is the potential of disappointing growth from China exacerbated by the impact of increasing tariffs. While logic says that neither side will benefit from a full-blown trade war, predicting the way forward is fraught with uncertainty as the dispute is as much about geopolitical leadership as it is current trade deficits.
As we look into 2019, we are very risk aware as we are overweight the lowest-risk risk asset (high yield bonds) and underweight the highest-risk risk asset (emerging market equities). We also remain comfortable with significant bond allocations as we forecast the potential for attractive risk adjusted returns for fixed income in 2019.
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