A fork in
Corporate and economic fundamentals support risk taking in 2019, as long as key policy errors are avoided - and preferably policy decisions support a recovery in economic momentum.
Positive and negative drivers
Occasionally financial markets face a fork in the road. Today, certain drivers, such as valuations and investor positioning, suggest an overweight position in risk assets. Other factors, such as US monetary policy tightening or the growing debt burdens on many countries and companies, suggest that portfolios should become neutral, or even defensive in scope. The balancing factor will be policy decisions, and perhaps even policy errors.
Political uncertainty can quickly feed into investor uncertainty
In this article we present our global outlook for markets in 2019. This combines top-down and bottom-up analysis, from our Research Institute, the Global Strategy team and asset class experts. Our portfolios had a moderate level of risk at the start of the year, and therefore we searched for opportunities to buy oversold assets after the October correction. However, we have become more concerned about fragilities exposed as this investment cycle matures. Unless the tensions between the US and China die down, and indeed China and Europe implement more successful stimulus to revive growth into 2019, then during the course of the year our portfolios will need to be prepared for significant pressure on corporate profits growth in 2020.
Slower economic activity – but no recession
Global economic growth was strong and uniform in 2017, with acceleration across all major blocs. But 2018 has been very different with a divergence between US economic strength, weakening activity in China and stumbling performances in the Eurozone and Japan. Interest rate sensitive areas such as residential property or auto sales, highly indebted countries like Argentina and Turkey, and companies such as General Electric, have come under pressure.
Global industrial production is on course to grow only 1% per annum in Q4 2018, led by Europe, Japan and Asia. It is important to put some of the recent weakness into context. The European economy has suffered from poor auto sales affected by one-off regulatory changes, while Japan was affected by a series of natural disasters. We would expect sales and production to recover into the spring as consumer spending remains supported by lower unemployment and higher wages. On the other hand, the extent of the slowdown in the Chinese economy in 2018 is important to highlight. Trade tariffs are only a minor explanation, with policy induced deleveraging within the shadow banking system being playing a more significant part. The relative weakness of money supply growth in October demonstrates just one of the technical problems that the government has in regard to steering credit towards desirable areas.
2019 is also set to be a divergent year as the US remains supported by fiscal stimulus. Yet the world economy as a whole appears to be stabilising due to slower growth, hampered by political uncertainty affecting business investment, and tariffs bearing down on global trade.
2020 is forecast to be a complicated year. The US economy is set to slow sharply in response to a smaller fiscal stimulus, meaning the financing pressures of a US budget deficit rising to over $1tn a year become more evident. Recession risks are as high as 35% over the next 24 months, though we are not predicting the US economy will fall into recession.
Policy decisions matter
Markets are intensely sensitive to US decisions on monetary policy, rippling through into the US dollar, dollar liquidity and global monetary conditions. This is as well as trade policy, especially vis-a-vis China. We expect the Fed to pause in 2019, with only three moves this year. The key assumption behind this forecast is that underlying inflation remains contained. While wage pressures exist, technological factors and productivity gains restraining unit labour costs are more significant.
The flatter, anchored Phillips curve suggests central banks in most economies have more room to manoeuvre. Indeed, we suggest an obvious pause in Fed policy would be a major signal to investors. Already some Fed governors are concerned about the second round effects from the rising tariffs burden. We forecast another round of US-China tariffs in January 2019 and also on the auto sector, especially between the US and Europe. However, such moves should be put into perspective – for example, tariffs on $800bn of US-China trade compare with total global trade of $17tn. Another key assumption after the recent Xi-Trump meeting at the G20 summit is that the two countries have agreed to continue discussions on trade, even if longer term concerns remain.
Despite the attention placed on US policy decision making, three areas should provide positive tailwinds. The first is a range of Chinese actions – monetary, fiscal, and regulatory - to stimulate its economy, especially key sectors such as consumption, autos and property. The style of China’s response is important. This year US interest rates have risen to 2%, and are on course for 3%, while Chinese 2-year yields have fallen from 3.6% to 2.8%, undermining support for the RMB (see chart 1). Looking ahead, it matters less whether RMB/$ breaks through 7 than its speed when it does so and how well managed this is by the People’s Bank of China.
Chart 1: Mind the rates gapSource: Refinitiv Datastream, Aberdeen Standard Investments (as of 27 November, 2018)
The second area of support is the swing towards an easier fiscal policy being experienced in Europe - exemplified in Italy, France and the UK. The third is the sharp fall back in oil prices in Q4 2018. We see the recent fall in oil prices as much more a factor of rising supply rather than falling demand. Even if OPEC manages to stabilise prices with production cuts, the sector still faces considerably higher supply in late 2019 when new pipelines allow a wave of shale oil to be exported from the US.
The final player in this scenario is Japan. Peak quantitative easing has shifted to quantitative tightening within 18 months, and therefore further liquidity injections affecting the global economy are dependent on Bank of Japan (BoJ) policy. Although inflation trends do not support a major change in BoJ policy, any surprises could have major implications for the structure of global fixed income.
Profits, Balance Sheets and Valuations
Against this background, we still expect 5-10% global profits growth in 2019. Profit margins are coming under pressure from a mix of factors such as rising labour costs and interest costs, with currency and energy costs as swing factors for individual sectors. Strong profits growth in the US has enabled sizeable share buy backs, on course for $1tn, mirrored to a lesser extent in Europe and Japan. These are adding close to 1% to the traditional dividend yield. The importance of share buy backs also appears in market volatility. February and October’s corrections took place at a time when share buy backs were curtailed by the US earnings season. As well as profits growth, the state of company balance sheets also needs examining. Here the situation is more worrying. The low level of corporate bond spreads reflects reasonable corporate fundamentals, but there are warning signs in higher yielding areas.
Historical analysis shows that it is normal for the S&P500 Price Equity (PE) ratio to decline 10-20% as the Fed tightens. On top of this, investors face a wide array of complex political issues, helping to explain why cash balances are above average as well as why the dollar has been well supported in 2018. However, cross-border capital flows also show that valuations remain an important driver for investors. A positive example is the steady, if modest, inflow into emerging market bonds and equities seen last autumn as investors searched for attractive assets. The PE ratio of many Asian indices has fallen to 9-10x.
But the bubble in some technology stocks has started to puncture. Investors have been reminded of the dangers of stretched valuations by the serious underperformance of technology hardware stocks. This is due to a mix of regulatory worries and the slowdown in the smartphone cycle (Chart 2).
Chart 2: Broad based deratingSource: Refinitiv Datastream, Aberdeen Standard Investments (as of October, 2018)
A balanced portfolio
2018 was an unusual year for portfolio outcomes. The extent of the derating in global equity was significant for a non-recessionary episode. As Chart 3 shows, 2018 was the first year since 1992 where none of the 12 global assets performed better than US inflation. Standard diversification is problematic as correlations between global equity and bond market indices change, both simultaneously stumbling this year. In these circumstances a dynamic approach to portfolio construction is necessary. Our funds bought into emerging market and US equity assets after the October correction. As well as this, a balanced approach is also required. As political risk premia rises, diversification becomes more important. Therefore, our portfolios include higher yielding developed market Australian and US government bonds.
Chart 3: What happened to real returns?*2 year US Treasuries, 10 year US Treasuries, US Investment Grade Corporate Bonds, US High Yield Corporate Bonds, Global High Yield Corporate Bonds, US aggregate bonds, S&P 500, Russell 2000, US REITS, MSCI Japan, MSCI Emerging Markets, Commodities
Source: Bloomberg, Morgan Stanley (as of 22 November, 2018)
Two other potential diversifiers include US Treasury Inflation-Protected Securities (TIPS) and Japanese yen, providing some protection during those periods where inflation concerns or safe haven fears dominate. Having been largely positioned overweight the US dollar against major currencies, we have reduced this component and are using the Euro to fund emerging market (EM) positions. Turning to income, still important in an environment of historically low interest rates outside of the US, we remain neutral to underweight of investment grade and some high yield credit. However we have been adding to EM debt and European high yield. Spreads have become more attractive as the underlying rate structure has backed up.
Overall, we forecast slower economic growth in 2019, but no recession in the US before 2020, especially if the US administration can encourage more business investment to help activity before the 2020 Presidential election. Valuations and profits growth are attractive for equity assets, but investor uncertainty is understandable. Key triggers include: a noticeable Fed pause, European policy easing, and the style and extent of China’s stimulus.
While political risk premia is expected to remain high markets can cope with individual country issues. Much more dangerous would be a major breakdown in US-China relations or renewed scepticism about the state of the European Union due to Italy’s budget problems. These three large economic blocs comprise almost 60% of global GDP, and the majority of marginal growth in the world economy.
After the decline in experienced by global equities in 2018, we do expect to see a better performance in 2019. But it would be unsurprising if the market volatility continues, for example in the form of a further 10% correction during the course of the year.
Markets are intensely sensitive to US decisions on monetary policy