February Global Outlook 

Tactical Asset Allocation

We build our TAA funds including bonds, equities, commercial property and other assets looking over a 12-month time horizon. Our decision-making sequence is first to consider the outlook for each asset class (e.g. government bonds), followed by views within that market (e.g. the US versus Europe, or European core economies against peripheral countries). As a broad-based multi-asset portfolio, we can use a number of levers to both take and mitigate risk. This may result in positions that differ from other internal portfolios, which do not have this range of levers and/or time horizon.

TAA Model Portfolio - as at 10 January 2019

TAA Model Allocation - As at 10 January 2019



Ken Dickson, Investment Director, FX Research

In this month’s Global Outlook, we explore the investment opportunities that are emerging in a number of markets. These come against a backdrop of weaker international trade, a loss of momentum in business activity and the significant market price adjustments at the end of 2018. The slowdowns in Germany and Italy were some of the biggest surprises for investors. We will therefore highlight a number of alternative European markets that we think look attractive.

In 2018, economies weakened and asset returns turned negative. Strategies with diversification qualities were also extremely hard to find. The House View foresees recovery in global growth later in 2019. We think policymakers will continue to adjust their monetary and fiscal stances to offset the growing cyclical risks. As a result, the ‘lower for longer’ environment looks set to continue as policy normalisation slows. Andrew Milligan, Head of Global Strategy, sets out our House View expectations for this year. We look to maintain a positive risk profile, as we believe the current business cycle will extend beyond its third post 2008 cycle phase of weakness.

The investment industry still uses traditional measures like GDP growth and inflation to develop its world views. However, in our opening Spotlight article, Jeremy Lawson, Chief Economist and Head of the ASI Research Institute, and his colleague Stephanie Kelly, Senior Political Economist, introduce a new measure of economic national progress. This thought-provoking article meets, head on, the growing criticism of narrow economic-based indicators of national health. Using extensive new research, they conclude that countries with both dynamic economies and high levels of environmental, social and governance factors deliver improved and sustainable returns.

While 2018 was unusual in terms of investment returns, the real estate market was positive. We expect this performance to continue into the near future. Craig Wright, Senior Research Analyst European Real Estate, reviews the fundamental drivers that have attracted substantial investor flows into the international logistics market over recent years. Our comprehensive survey of key players in the market highlights that further gains are likely. This will be due to the fast-growing online retail market combined with increasing complexity within supply chains. There are also significant differences across international markets and Craig pinpoints where investors are likely to travel to next.

We do not think the current loss of economic momentum will develop into a recession. With that in mind, Carolina Martinez, Senior Strategy Analyst in our Multi-Asset Investing team, reviews US and European earnings. She highlights the importance of using both qualitative and quantitative techniques within our Tactical Asset Allocation framework. This includes comparing our econometrically modelled results with the current market earnings data.

We are also seeing opportunities in European High Yield. In 2018, the market refinanced risk to a much more acute level than in previous years. Accordingly, Ben Pakenham, Deputy Head of European High Yield, notes that, while structural changes will limit the scale of longer-term returns, December’s markets led to exaggerated price moves. Ben is looking for a meaningful rally to develop throughout this year.


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Ken Dickson, Global Strategy

Chart Editor

Tzoulianna Leventi,

Investment Analyst, Multi-Asset Investing


Beyond growth: Incorporating
sustainability factors into
economic analysis

Chapter 1


Jeremy Lawson, Chief Economist and Head of ASI Research Institute

Stephanie Kelly, Senior Political Economist

We need to move beyond narrow, purely economic measures of national success. Our model integrates environmental, social and governance factors with growth analysis to better measure sustainable development.

A new indicator of national progress

Much of what passes for macroeconomic analysis is very narrow in its scope. Economic outlooks tend to focus on short-term growth dynamics in a small number of large economies like the US, Eurozone, China and Japan. These are also heavily tilted towards what is happening in the developed world.

Much of what passes for macroeconomic analysis is very narrow in its scope.

This leaves a lot of questions unanswered. Is growth strong compared with what one would expect? How are small countries that are flying under the radar performing? Is growth environmentally sustainable and inclusive? And is the quality of political institutions being undermined?

The most successful societies blend strong economies with healthy environments, inclusive social policies, representative political institutions and fair legal frameworks. To recognise this, we have built a new indicator of national progress for 135 countries. This combines a measure of economic strength with environmental, social and governance (ESG) factors aligned to the UN Sustainable Development Goals.

Our work is a testament to the benefits of more open economies and societies. This is a message that risks being lost amidst the wave of political populism sweeping through the developed and, in some highprofile cases, developing world.

We have identified 46 countries that have performed better than one would have expected over the past five years in both economic and sustainable development terms. The vast majority of these ‘Social Capitalist’ countries are developing economies in Africa and Eastern Europe. These can be viewed as hunting grounds that will generate both global economic and sustainable development leadership over the next 20 years.

Much of what passes for macroeconomic analysis is very narrow in its scope.

Chart 1: Social Capitalism across the world

Strong gains in living standards concentrated in developing countries

When we shift our attention from large developed economies that have struggled in recent years, we find that strong growth in living standards has been the norm, not the exception. Indeed, the vast majority of developing countries converged on US and broader developed country living standards over the past decade.

This is a distinct improvement since the ‘80s and ‘90s. And, in many cases, this has been accompanied by impressive progress on sustainable development objectives. This reveals that the supposed trade-off between strong economies and strong societies is a false one.

It also highlights the benefits of globalisation at a time when support is dangerously low. Without globalisation, much of the poverty reduction in developing countries over the past 20 years would not have been possible. This is a good news story that deserves to be celebrated. Moreover, stronger absolute and relative growth creates the resources and helps build the political coalitions necessary to support the ESG goals that will make future growth more sustainable.

That said, there is still work to be done. For developing countries to sustain this strong growth performance over the next decade and beyond, further domestic economic and institutional reforms will be necessary, especially since the tailwind from globalisation is currently fading.

Although two of the most prominent developing economies – India and China – do not make the ‘Social Capitalist’ grade, both have been persistently economically dynamic. Moreover, recent developments suggest that their governments are placing more weight on broader measures of progress. If China is to become a ‘Social Capitalist’ it will need to improve the transparency and representativeness of its political and governance institutions. In India, the focus should be on environmental indicators and social equality.

Weak growth a threat to sustainability goals in developed economies

Conversely, the majority of developed economies – particularly in the Eurozone – have scored well on sustainability factors but failed to generate robust economic growth. The danger is that this persistently weak economic growth will amplify existing populist pressures and eventually undermine support for broader sustainability goals.

If developed countries’ commitment to open economies and societies weakens further, it will inevitably weigh on their own growth prospects. It would also damage the prospects for further catch-up growth in developing countries.

At a time of enormous productivity, demographic, social and environmental challenges, this would prove especially counterproductive. The task is therefore to identify country-specific political and policy solutions that can reconcile each of these objectives.

Exceptions to the pattern of weak economic performance and strong ESG credentials among the developed economies include Portugal, Ireland and Sweden, which have performed well across both dimensions.

Meanwhile, Japan stands out – contrary to general wisdom – as an economy that has been more economically dynamic than most, with the country’s shrinking population masking relatively healthy productivity performance. Abenomics has not been the failure it is sometime made out to be.

Chart 2: Top 20 ESG Index countries

Source: Research Institute, Aberdeen Standard Investments, (as of January 2019)

Environmental outcomes a weak point in ESG scores

Although most countries’ ESG scores have been on a rising trend over time, there is a lot of room for improvement. Most major countries are not doing enough to reduce greenhouse gas emissions and limit the damage from climate change, nor improve air quality.

The Paris Agreement is a starting point for addressing the enormous challenge of preventing further damaging increases in global temperatures. However, much more needs to be done, both at a national level and in terms of international coordination.

It is encouraging that Finland, France and the Netherlands have seen improvements in their air quality since 2011. By contrast, Norway, Denmark, Switzerland, Australia, Spain and Portugal have worsened during the period.

And while income and other inequalities between developed and developing countries have been shrinking, disparities within countries are high and have risen over recent decades. Social group equality and participation in civil society organisations were either the least improved or the worst indicators across our whole sample of major markets.

Against a backdrop of populist politics shaped in part by the discontents of globalisation, this degradation of equality and representation is striking and concerning. Addressing these factors will be important for gaining broad-based buy-in for growth-enhancing reforms. This is a challenge that policymakers are struggling to meet.

Dynamic economies throw off more investment opportunities

Our research can be used for a wide range of investing purposes. Strategic investors – whether in listed equities or private markets – who do not wish to take ESG factors into account, can draw on the growth dynamism component of the ‘Social Capitalist’ index to identify the countries where long-term returns may be highest.

Four countries serve as useful examples here. Between 2007 and 2017, per capita GDP as a ratio to that of the US increased from 37 to 48% in Poland, 15 to 25% in China, 14 to 21% in Indonesia and 7 to 12% in India. If their average per capita growth rates were to be sustained over the next decade, those ratios would reach 67%, 44%, 31% and 20% respectively. That would, in turn, imply rapid growth in corporate earnings, both in aggregate and for many individual companies.

This analysis is only a starting point. Investors would need to assess whether the factors that contributed to earlier rapid growth were likely to persist. And even if they were, valuations at the aggregate and individual stock level would be critical for determining the opportunity set, especially on shorter time horizons.

‘Social Capitalist’ economies may generate more sustainable returns

When growth dynamism is combined with ESG performance, the results may be even more powerful. The best way to think about our ESG index – in raw or development-adjusted form – is that it tells us something important about a country’s health and the long-term sustainability of its development model.

A country enjoying rapid growth at the expense of environmental outcomes may face more pressing resource constraints. It may also be more vulnerable to climate change. Similarly, countries in which rapid growth coincides with deterioration in social outcomes may find it more difficult to sustain the political and policy consensus necessary to maintain that growth into the future. Meanwhile, countries with weak political institutions may be more vulnerable to violent and economically damaging regime changes.

In that sense, our ESG analysis can act as a screen for investors who need to identify risks as well as opportunities. Our Emerging Market Debt team incorporates this principle into its funds. The team uses its own ESG scoring to better determine whether sovereign credit spreads compensate investors for countries’ underlying vulnerabilities. Moreover, by focusing on where ESG factors are changing the most, the team is in a better position to determine whether the market is efficiently pricing future risk-adjusted returns.

A vehicle for expressing ethical preferences

Of course, not all investors are motivated by the outlook for pure, risk-adjusted returns. Some may simply want to ensure that their money is invested in a way that is consistent with their own ethical principles. The ESG component of our index is ideal for this purpose. For example, it is possible to build an Exchange Traded Fund (ETF) that uses either our raw aggregate ESG scores or aggregate development-adjusted ESG scores to determine whether, and by how much, to deviate from the benchmark. Our ESG index can also be easily broken into its sub components for those investors only wanting to focus on environmental, social or political factors.


Our model of growth and ESG dynamism sheds lights on which countries are making the most progress on joint economic and sustainability criteria. Many of these countries – particularly in Africa and Eastern Europe – fly underneath the radar in traditional macroeconomic analysis.

In the future, we intend to extend our work in a number of ways. We will identify best-practice ESG-related policies and institutions that can be feasibly imitated elsewhere. This will begin later this year with the environment. We will explore the extent to which our ESG index and its components contain ‘causal’ information about countries’ long-term growth prospects, as well as how growth dynamics influence ESG choices. This will include a more thorough investigation of the link between growth dynamics, ESG factors and asset returns. We are also working with product specialists to determine if we can develop new funds that draw on our research.


Does 2019 rhyme with 2016
and 2012?

Chapter 2


Andrew Milligan, Head of Global Strategy

Political strains are rattling markets, and economic activity is likely to get worse before it gets better. But as long as policy easing ensures recession is avoided, there will be useful entry points to put cash to work.

Focusing on fundamentals

The year 2018 stands out as a most unusual year for investors, setting the scene for some difficult decisions at the start of 2019. The decline in US share prices in December 2018 was the worst December since the 1930s. Overall, 2018 saw the third-largest calendar year decline in the S&P 500 multiple. Only 2000 and 2008 experienced larger deratings. Problems were not limited to the US. Indeed, the majority of financial assets in most countries recorded negative returns, meaning the normal rules of diversification failed to work. Despite a year of average global economic growth, and strong corporate earnings, a wide array of economic, financial and political issues caused a major revaluation of a range of markets.

The key tension for markets in 2019 remains the state of US relations with China

Surveys of fund managers showed relatively high levels of cash and distinctly low levels of optimism at the end of 2018. This is understandable, partly on economic grounds but especially in light of a wide array of political risks. These certainly make country level analysis more complicated. They also raise some fundamental questions about the future of this investment cycle. A litany of individual issues, such as Democrats vs the White House, Saudi Arabia vs Iran, populism in Europe, Russia and the Ukraine, and events in the Koreas, all require careful analysis. The strength of political institutions in the US and other advanced industrial economies is being tested. However, the key tension for markets in 2019 remains the state of US relations with China. At the very least, a ceasefire on tariff talks would encourage investors to put cash to work. More worrying is growing evidence of strategic rivalry between the two largest global economies. This has major implications for supply chains, regulation of key sectors and cross-border capital flows, to name just a few issues.

Chart 1: S&P 500 de-rated sharply during 2018

Source: Refinitiv Datastream, (as of January, 2019)

Good news and bad news

The good news is there is still a scarcity of major imbalances in the world economy. However, the International Monetary Fund and Bank for International Settlements warn about a series of issues to monitor: debt levels in some emerging markets, in many US corporates, in large parts of the Chinese economy, in a range of European banks and in sovereign debt issuers. Against this backdrop, the issues we are monitoring are the overall state of financial conditions, and whether a late-cycle inflation surge might appear. So far neither seems a problem.

However, it is right for investors to worry about a degree of fragility in the world economy, which is experiencing its third major slowdown since 2009. Strong economic data in the US contrasts with deceleration in China and stagnation in Europe and into year end, caused by a trade and manufacturing sector collapse. Even in the US, slowdown fears have grown. The New York Fed’s recession probability model has risen to 23%, the highest pre-recession value since July 2006. Our own models point to something slightly higher (35-45% on a 12-month time horizon). In this environment, policy errors would be damaging, hence the worries in December about a Fed on auto-pilot or the surge in US-China trade tensions. The latest business surveys, the report from Apple, and the signals from many companies about supply-chain disruption all suggest that activity measures will get worse before they get better. In particular, leading indicators point to a contraction in global trade into spring 2019.

The most likely scenario this year, a synchronised economic slowdown in the US, China and the EU, is less than rosy. Although the US economy remains on solid footing, it is taking a step down towards trend growth, partly as fiscal stimulus eases and partly as global trade growth slows. We do not expect the US to enter a recession in 2019, and one in 2020 would require a major policy error. Therefore, 2021 is still the first likely year for a recession. Europe, Japan and the UK are growing in unspectacular manner; slow credit growth is a key feature in each. The slowdown in European activity in late 2018 largely reflects the impact of weaker global trade. Hence, in many respects, the swing factor this year is still China.

Chart 2: Financial Conditions ease after December FOMC

Source: Bloomberg, Financial Conditions Indeces, (as of January, 2019)

We are reassured that policymakers are quickly responding to the economic and market signals. The Federal Reserve has moved to a more dovish mode, and the Chinese government have made a series of positive monetary, fiscal and regulatory announcements. Meanwhile, French, German, Italian and UK governments are all on course to ease fiscal policy this year. In addition, low oil prices will support consumer incomes, while the depreciation in the US dollar and lower real yields are easing financial conditions, for example for emerging market (EM) economies. Looking ahead, though, investors will need to assess the speed and efficacy of these measures. For example, will cuts to Chinese reserve requirement or fiscal expansion offset the extensive deleveraging cycle in place? And will they feed more into the domestic economy than overseas activity? Questions are being asked about the ECB – will it end quantitative easing but reassure markets via the refinancing of targeted longer-term refinancing operations? Should it even consider raising interest rates when core inflation is so low?

Confidence and valuations

Consumer, business and investor confidence will play a part too. The fourth quarter of 2018 saw the largest inflows into moneymarket funds since 2008, while investment sentiment is the worst in several years, suggesting potential upside for stocks. Of course, a vicious circle could develop whereby individuals hold onto cash rather than spending or investing. In these circumstances, our measures of technical sentiment matter significantly. Our findings are moderately upbeat that the equity rally seen in January can continue in a moderate manner. Mini-bear markets in equities, as seen in Q4 2018, can easily occur without a full -blown economic recession occurring. Importantly, we have seen increased signs of ‘risk-on’ capitulation among institutional investors. Could this mean we have seen the worst of marginal selling pressure and could ‘risk-assets’ respond more enthusiastically to any good news compared to bad?

A vital question for investors is what is priced into the equity markets? The S&P 500 PEG ratio has fallen back around 35% from its peak in this cycle. It is now trading just above its 2011 lows. Valuations are supported by high free cash-flow yields in many cases. Our analysis suggests that equities are already pricing in as sharp a slowdown in sales and profits as occurred in 2011-12 or 2015-16.

The profits outlook is key. Our forecasts suggest that in 2019 we could see midsingle digit earnings growth in both developed markets and emerging markets. This would come on the back of moderate top-line revenues, lower commodity prices, flat yield curves, but continued cost control as productivity offsets slowly rising wages. In the immediate future, S&P 500 earnings per share have been downgraded sharply, with a near 20% de-rating. This is a signal that the market is priced for earnings declines this year. The outlook statements made in the spring corporate earnings season have been somewhat mixed but sufficiently positive about 2019 prospects to reassure investors.

There were two major market corrections in 2018, and similar levels of volatility would be expected for 2019. One factor is politics. Examples include the extent of the rise of populist parties in May’s European elections, the outcome of Brexit, and US-China-Korea relations. Secondly, if the Fed continues to normalise its balance sheet, we could see further de-risking as excess liquidity is mopped up – no buyer of last resort. 2019 is also a year when M&A should appear if political uncertainty dies down. Firms in the US and Japan in particular are flush with cash. Therefore, whether for defensive or offensive purposes, an upturn in M&A activity would make sense.

Investment strategy for 2019

After the weakness in equity markets in December, January was quite the reverse. The S&P500 Index showed its best January performance since 1989. Fund flows into emerging market assets have clearly picked up. Where next? What matters in coming weeks and months is not so much a deterioration in economic or corporate data but rather how far it deteriorates relative to current negative expectations. If, as we expect, global economies avoid recession in 2019, companies deliver positive profits growth, and US interest rates clearly peak, as the Fed recently hinted, there is likely to be a strong risk rally into the spring. This would remove the recent demand for portfolio insurance, in the form of money-market funds, equity put options, gold, Treasuries and bunds or the yen and Swiss franc.

Our funds are positioned moderately prorisk. We are overweight global equities, led by emerging markets and Japan on valuation grounds, as well as the US given a solid profit outlook. We still see opportunities in European real estate due to a favourable supply/demand balance. Equity investors should be sensitive to the strength of balance sheets, and credit spreads, the maturity profile and debt roll-over needs of corporates. There is competition from higher US interest rates and indeed US Treasuries, for US based investors. But in many other parts of the world the need for income or yield remains intact. Hence, our portfolios contain emerging market bonds and high-yield European debt. We are wary of expensive sovereign debt, notably Japan and Germany. We are also cautious of markets where balance sheet pressures could appear, hence our concerns about high-yield US bonds against the backdrop of low oil prices with limited upside. We see the US dollar as much more of a two-way market, with a balance of positive and negative drivers.

Our investment approach identifies a number of triggers to amend such a portfolio in 2019. On a more positive tack, these would include lower risks of a policy mistake, indeed more signs that the Fed and other central banks are not just on hold, as recently hinted at, but pulling back from aggressive policy stances and pushing out their monetary policy normalisation programmes. Any US interest rate increases in the second half of 2019 would preferably reflect strong economic growth, rather than strong inflation. The direction of the US dollar was of considerable importance in 2018 in transmitting financial stress across the world. A moderately lower US currency this year would reflect more interest among US investors in buying relatively cheaper overseas assets. A flat yield curve can continue for some time in the later stages of an investment cycle. However, a prolonged yield curve inversion would be a warning sign. Profit margins need to be well behaved rather than experiencing late-cycle pressures. Although there is the potential for the start-of-the-year rally to develop further, as tail risks are priced out, this is very different from saying that a new bull market has begun. Fundamental, strategic tensions are unlikely to go away. There are also few signs yet of policy easing on the size of previous episodes. Our view of a world of low returns, requiring more dynamic investing, remains in place.

The key tension for markets in 2019 remains the state of US relations with China

Will European logistics property
keep on trucking?

Chapter 3


Craig Wright, Senior Real Estate Research Analyst, Europe

In response to the strength of the logistics market, we surveyed executives at international logistics occupiers to examine the key market fundamentals. We believe that momentum is likely to be sustained, but with an increasing level of complexity.

Investors have been accumulating logistics assets, and for good reason

Logistics has become one of the hottest global property assets. Investors poured €121 billion into global logistics markets in 2018, with over €35 billion going into European logistics property. This represents an increase of 33% compared to the long–term average figure for the region. Domestic and international real estate investors have boosted logistics allocations due to strong occupier demand, higher income yields than other commercial sectors, diversification benefits and the expectation of capital value growth.

There remains substantial opportunities for investors to participate in the growth of the logistics sector.

Trade, manufacturing and consumption have all been growing steadily over the last five years, increasing the need for the movement of goods. Over this period, Eurozone industrial production has increased by roughly 12%, and total export volumes are up by 26%, while household consumption has increased by 9%. Eurozone capacity utilisation rates increased from 77% to 83.5% in December 2018. Perhaps it’s not a surprise then, that 76% of our logistics survey responses reported growth in their businesses in 2018, with the majority describing that growth as “substantial”.

Online retail increases the demand base, but also the supply chain complexity

Investors have seen the potential growth in demand from online retail and the implied additional logistics required to fulfil a new type of distribution. Almost all of the logistics executives in our survey believe “changing consumer habits” are a risk to their businesses. Online retail sales in the EU grew by 14% last year, an accelerating trend in most countries. UK consumers buy roughly 34% of their consumer durables online (November 2018), and while this share is lower in the rest of Europe, the gap is narrowing.

With the changing drivers of logistics demand, there is an inevitable increase in supply chain complexity. The growth in online retail sales has a direct relationship with “last mile” parcel delivery volumes. At forecast rates of growth, the revenues from parcel deliveries from businesses to consumers (B2C) will have grown by 170% in the decade to 2020. By 2021, we expect Germany to handle 4.2 billion parcels a year, double the volume delivered in 2009. This implies a significant increase in the demand for logistics facilities close to larger conurbations. Total logistics take up in Europe exceeded 10 million square metres in 2017 – a new record according to the independent consultant Property Market Analysis (PMA), with ecommerce adding an extra 20% to traditional demand.

Chart 1: Structurally higher demand from online retail expansion

Source: Aberdeen Standard Investments, (as of January, 2019)

Amazon has developed facilities ever closer to the end consumer. In its third phase of expansion in the US between 2014 and 2016, the company managed to more than double the average number of people living within 10 miles of an Amazon facility – to 1.1 million. This more than double the number following its previous phase of development. Our survey corroborates the importance of understanding how location requirements are changing, with over 50% of respondents expecting location to become more important to logistics tenants. Furthermore, 76% believe that “on-demand warehousing” will grow in importance as occupiers adapt to demand fluctuations in urban locations.

The paradox is that while distribution requirements are becoming more heavily reliant on proximity to the end customer, the availability of land for the provision of logistics operations in urban areas is ever more limited. Urbanisation, competition from alternative uses and changing legislation are all making it harder for companies to find suitable locations. Taking Frankfurt for example, in the past 20 years the population grew by 11%, while the number of hectares zoned for industrial and warehousing fell by 11%. Similar trends are emerging in many European cities as political pressure to provide more housing is rising.

A two-speed story for rental growth

In London, a perfect storm of structurally higher demand and structurally lower supply has driven logistics rents up by a staggering 40% over five years. Given greater land supply on the continent, the rental tensions are weaker and we do not anticipate similar growth in European markets, particularly for “big-box” units. Still there are pockets of real rental growth emerging in urban fringe locations where demand far exceeds supply.

Critically, from an income perspective, risk to cash flows is also a key driver. Stronger occupier fundamentals reinforce the durability of income from the sector. Vacancy rates and void periods should remain low while solid trading performance should ensure turnover of tenants is minimal. Encouragingly, only half the respondents to our survey suggest “softening customer demand” is a risk to their business.

A positive outlook

Institutional investors are clearly increasing their allocation to sectors with strong structural tailwinds. The findings in our survey clearly support the positive view the market holds for logistics in Europe. While this is creating pricing pressures for prime assets in some submarkets, there remains substantial opportunities for investors to participate in the growth of the sector.

There are some risks to returns from a potential economic slowdown, through headwinds in the German car manufacturing industry and from the trade war between the US and China. In the UK, a no-deal Brexit is an additional risk to the free movement of goods and to consumer demand. However, strong positive messages from the tenants in our survey, in addition to the structural changes to the way we shop, should continue to support the different logistics segments and the continued expectation of healthy performance from the sector. For now at least, logistics assets will keep on trucking.

There remains substantial opportunities for investors to participate in the growth of the logistics sector.

Earnings prospects for the US
and Europe within a mid-cycle

Chapter 4


Carolina Martinez, Global Strategy

Hold your nerve. We expect earnings to decelerate this year in line with an expected slowdown scenario.

We use qualitative analysis and quantitative techniques to develop our tactical market views

In any year, there are uncertainties for economies and markets. Therefore, the investment process within our tactical model portfolio follows a disciplined approach to incorporate the changing and forwardlooking nature of markets. This framework identifies, assesses and calibrates the key drivers of asset performance, enabling us to form our asset allocation views. We see four key categories of factors driving these views. These are asset valuations, monetary conditions and policy, behavioral factors including risk appetite and positioning and, finally, macro profits. This last factor looks to identify how the underlying performance of economies, combined with changing inflation dynamics, interacts with corporate profits and cash generation. More specifically, our proprietary econometric models for equity earnings follow a topdown approach. This provides statistical analysis of the relationships between local and global economic activity, labour market dynamics, commodity prices, exchange rates, interest rates and credit spreads with changes in earnings performance. In this article, we investigate how our modelling compares with the actual earnings history in Europe and the US. We also set our expectations for the coming year.

Recent positive news on the trade war, the Fed pausing rate hikes and Chinese stimulus offers opportunity for re-rating.

Repercussions of a mid-cycle slowdown on earnings

For 2019, we recognise the growing risk of recessionary forces. However, our central scenario remains focused on a slowdown. Although this cycle is already unusually long, we note that business cycles do not tend to die of old age. Recessions usually result from deep imbalances and policy errors. We do not currently see imbalances in the private sector. Nor do we expect an error in policy-induced tightening of financial conditions, which usually determines a deeper economic malaise. Our view implies a gradual slowdown in US and global activity. However, we also see policy measures adjusting to cushion the impact of this; allowing for stable economic data later in the year. This scenario also implies softer commodity prices and widening credit spreads, as companies face less accommodative conditions and a decline in consumer demand. We model this scenario with industrial production both globally and in the US gradually slowing from current levels. Credit spreads have already widened during the first month of the year. We expect this to continue in an orderly fashion during the year, up to 200 basis points relative to the 10-year Treasury yield.

Chart 1: Mid-cycle slowdown pushes earnings growth towards zero

Source: Aberdeen Standard Investments, (as of January, 2019)

Strong 2018 US equity earnings, spurred by tax cuts, are likely to fade

Our model for the S&P500 aims to explain earnings performance by a set of macro forces. We find that local and global growth are the main drivers of stock listed earnings. Particularly during last year, the outperformance of the US relative to the rest of the world supported corporate performance. Changes in credit spreads, especially investment grade, are also a key factor, when a widening in spreads holds a negative relationship with earnings. Our model points to underlying organic growth of 12% year-on-year (y/y) in December 2018. This is below the actual earnings figure of 20% y/y. These results suggest that the additional growth of around 8% or $28 was a result of the sugar rush of the fiscal impulse; an element that is not in this year’s projections.

More interestingly, disregarding a recession, we project a gradual deceleration in earnings from an annual growth of 21% to a soft 2% by the end of this year. This outlook for the US does not surprise us and is in line with previous episodes of decelerating economic activity. The history of US equity earnings has many episodes of fast deceleration that were a consequence of the progression in the business cycle.

Robust earnings growth in Europe due to synchronised global growth

In Europe, earnings growth closed 2018 at 8.6% y/y. While our top-down framework suggests organic growth of only 4%, we believe the difference is explained by the lagged effect of previous robust global growth and weaker activity in Europe. Furthermore, our model points to global growth and the euro as the main drivers of earnings performance. Local activity conditions are not found to be statistically significant. This is a reflection of the international exposure of European companies, particularly their connection to emerging markets (EM).

Our projected scenario for next year incorporates a deceleration in global activity with a weakening euro. This results in waning prospects for earnings next year. We expect an annual earnings contraction of 1% by December 2019. One possible upside risk for the outlook for European earnings is the likelihood of expansionary fiscal policies and a strong EM rebound. With President Macron’s announcements in France after the ’gilets jaunes’ demonstrations and the Italian budget negotiations, aggressive fiscal easing in Europe could spur domestic demand and move earnings above our projections. However, as mentioned, local conditions seem less relevant. A strong rebound in EM, led by Chinese demand, has the most potential to boost corporate performance.

Market pricing has already adjusted for the weaker outlook

In conclusion, our macro outlook of a slowdown in the global economic cycle had moderated the prospects for US and European equity earnings growth. At the same time, this was in the price by the end of last year. Multiples dropped by 26% in the US and 22% in Europe. Recent positive news on the trade-war rhetoric, the Fed pausing rate hikes and Chinese stimulus has provided some price relief and there is opportunity for re-rating. Our tactical portfolios have consequently adjusted accordingly. However, these developments have not been strong enough to materially change our expected economic scenario and its implied earnings projections for this year.

Recent positive news on the trade war, the Fed pausing rate hikes and Chinese stimulus offers opportunity for re-rating.

Opportunities appear after the
sharp deterioration in market

Chapter 5


Ben Pakenham, Investment Director

Our fundamental approach highlights the opportunities in a market that has overpriced risk in thin markets amidst deteriorating sentiment.

Refinancing risk returned to the European High Yield market at the end of 2018

In 2018, The Bank of America and Merrill Lynch (BAML) Euro high yield index posted the first negative annual return since 2011, and the worst return since 2008, falling 3.6%. The annual return reflected weakness from the final quarter of the year, which represented the poorest quarterly return in more than seven years. In a change from recent years, the sell-off was more traditional with lower credit quality substantially underperforming higher credit quality. Previously, duration was the key reason for bond under-performance as refinancing risk, even for the lowest quality credits, fell sharply during the period of unprecedented central bank balance sheet expansion. This theme reversed as many companies with shorter maturity debt profiles repriced for a perceived increase in refinancing risk.

A number of the risks that have concerned markets throughout 2018 have started to recede.

There was also a general deterioration in key drivers

Over the past year there were many reasons for the deterioration in market sentiment, justifying the widening of spreads., Globally, central bank behaviour is shifting from being a tailwind to a headwind questioning unsustainably high valuation levels. There was also a notable drop-off in company earnings in the second half of the year, particularly in the more cyclical sectors. Retail and basic industrials (commodities, chemicals, and construction) declined 8.4% and 8% respectively and the auto sector fell nearly 5% in the fourth quarter alone as Chinese demand weakened materially.

While the effects of US trade protectionism contributed to this emerging theme, growth concerns have not been limited to the far east as political tensions in Italy, Britain, France and industrial cooling in Germany have caused many to re-calibrate their expectations for the region. In the US, the fiscal boost aided economic growth but the market rightly expects some of this growth outperformance to unwind and the partial government shutdown added to immediate market concerns. With the US Federal Reserve (Fed) regularly hiking interest rates and perceived to be in autopilot mode for a reduction in balance sheet, risk appetite in markets collapsed. The inversion of the Treasury curve at the short end only served to highlight to the market that there was a non-negligible risk that the US could head towards recession in 2020.

Despite macroeconomic and structural change, thin markets led to an over-reaction in prices.

Going forward, we expect that market liquidity will be structurally thinner and volatility higher. Therefore, high yield investors will look for compensation through higher spreads. In the US and Europe the market has reached the lowest level of default rates.. However, the market became too bearish at the end of last year as liquidity exacerbated moves to the downside.

Over the course of last year, the average bond price in the European high yield market fell from around 105 to 95. According to JP Morgan, in the fourth quarter alone spreads spiked from around +400 to close to +600. This implies a worsening default experience than we predict.

There was also a general deterioration in key drivers

Looking ahead, a number of the risks that have concerned markets throughout 2018 have started to recede. The Fed has engineered a more flexible, data-dependent policy phase which implies a pause, or at least a slower path, in the rate cycle until the economic picture becomes clearer. Inflationary pressures are likely to ease with the recent fall in the oil price. This benefits consumers globally, as well as many European companies that have input costs derived from oil. Wage inflation is finally picking up, which could counter some of the recent economic weakness if this results in higher spending.

Global political risk is also easing. There have been positive developments in the US-China trade negotiations, as they appear to be slowly moving towards some form of an agreement. Our team is looking for a deal between the UK and the European Union (EU). We think the probability of Britain remaining in the EU is growing, and note that the Italian coalition has already stepped back materially from their initial deficit proposal.

Chart 1: Positive expectations following the Euro High Yield Bonds weakness during 2018

Source: Deutsche Bank, Aberdeen Standard Investments, (as of January 2019)

Companies within the European high yield sector companies are largely in good shape. Refinancing needs are limited, as evidenced by the €15bn of bonds coming due in 2019. This compares with gross issuance of €65bn last year and €101bn in 2017. Debt levels, as a proportion of earnings, remain subdued relative to late cycle metrics. The ability to service debt, due to low yields, has never been stronger. In 2018 approximately 100 bonds fell by more than ten points in the European market, and another 30 fell by more than 20 points. Defaults may rise, but we expect a modest deterioration in this risk. Therefore, the active investor has a greater opportunity within a more dispersed market.

While considering all the discussed risks, and speculating how they might change over the year ahead, we see opportunities in valuations after recent market weakness. Although the market was ripe for a re-pricing in 2018, we do not believe that the scale of the move that developed was justified by the underlying fundamentals.

Sentiment remains weak, which presents opportunity to add risk. In the short-term, a meaningful rally is possible. However, structural changes limit the outlook over the longer term.

A number of the risks that have concerned markets throughout 2018 have started to recede.
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