A Transition Year?
In late November we produced our 2019 Outlook for the global economy and capital markets. Over the years, this has become a more difficult exercise, and not just because markets and geopolitics are increasingly complex and uncertain. The real reason it's become a chore lies in our market DNA. We think tactical calls are often tough to get right and we eschew market timing, so our views tend to evolve more slowly. (Read in your best Homer Simpson voice: "Boring!") To illustrate, we remain cautious but not bearish as we move into 2019 – a view we've held for some time.

However, while our big picture thoughts haven't moved much, a closer look reveals some important changes, highlighting that we expect 2019 to be a year of transition for investors.

Winds of Change
Here are five areas where our economic and capital views are shifting relative to the past few years:

1. Growth – For most of the post-Global Financial Crisis recovery and expansion, growth has been positive but slow. By and large, our call each of the last few years was for growth to be solid with a modest upward trajectory – nothing spectacular, but movement seemed to be accelerating in the right direction. In retrospect, 2018 probably was the apex of this growth in the US, turbo-charged by the tax cut and the massively expansionary Bipartisan Budget Act. Likewise, growth in the euro area, as measured by real GDP and other activity metrics, appears to have peaked in Q4 2017. The same could be argued for Japan.

Chart: US Growth Peaking, Europe & Japan Past Peak?
Source: Bloomberg, Natixis Investment Strategies Group, Q4:2015–Q4:2019 (quarterly). Bloomberg consensus estimates for Q4:2018–Q4:2019.

As we noted in last month's outlook, we see this slowdown as an inevitable deceleration from above-potential and unsustainable growth to more natural long-run levels. It does not, as yet, imply that a recession is imminent. It does, however, play a key role in the other major changes we see on the horizon.

2. Interest Rates – Like most observers, we have been anticipating higher US Treasury yields for some time. However, the cyclical rise in rates failed to materialize in 2014, 2015, and through most of 2016 – until the November election of President Trump. A strengthening economy coupled with Trump's expansionary policies finally goosed rates higher in 2017–18, but we think that may be it for a while.

Chart: US 10-Year Treasury: Inflation & Real Yield
Source: Bloomberg, Natixis Investment Strategies Group, December 2015 – November 2018 (monthly).

Having reached what we believe is the interim peak in global growth in early 2018, we think rates are more likely to move lower or be somewhat range-bound. The key drivers of this view include decelerating global growth putting downward pressure on real rates and lower oil prices reducing inflation expectations. While we don't think rates will plunge, for the first time in many years we don't see a big risk to bonds from a jump in yields. As a result, we're increasingly less concerned about term structure risk. Stated more simply, we aren't afraid of a little duration risk and we don't hate the return profile of high-quality bonds anymore.

One caveat however: this is mostly a US Treasury story. In Europe, bonds face greater pressure as the near-zero interest rate policy (ZIRP) has kept core European bond yields artificially suppressed for longer – so they have more distance to cover on the way to normalization. While we don't see growth or inflation driving bond yields higher in Europe, the cessation of new asset purchases by the ECB means rougher seas for fixed income investors in the Eurozone.

3. US Dollar – Commensurate with stronger US growth, rising interest rate differentials, and more aggressive central bank policy, we have generally been bullish on the greenback for most of the last five years. This proved prescient in four of those years with 2017 the only exception.

Today, with US growth slowing from a higher peak and the Federal Reserve sounding more dovish, US dollar gains seem less assured. As with our view on US yields, we don't see the dollar plunging. More likely, it will remain range-bound while markets watch and wait to see who backpedals faster – Powell or Draghi. So what's the big change? For the first time in five years, we aren't outright bullish on the USD.

4. The US Fed – Since the inception of the "Dot Plot," it has become common to monitor the divergence between the Fed's predicted rate path and the market's forecasted path as gleaned from Fed Fund futures. Going back as far as 2015, the market, as priced by Fed Fund futures, has routinely had less faith in the Fed's ability to actually raise rates, projecting a slower, shallower path for hikes. Until now, the Fed has won this battle, raising rates methodically over the past three years, undeterred by market volatility, geopolitical storms, and more recently, presidential disapproval.

Today, however, we believe this has changed. There was still a meaningful gap between market expectations – for less than two hikes next year – versus the Fed's Dot Plot of three hikes. However, in conjunction with last week's hike, the Fed has begun walking those projections down a bit. This is a significant shift because for the past three years the market has had to catch up to the Fed's view. In 2019, we think the Fed will have to down shift closer to the market's view.

5. Volatility – For several years now, extraordinary monetary policy combined with strong earnings growth has artificially suppressed equity volatility, with 2017 one of the most tranquil years in history. In this environment of historically low volatility, our annual outlooks have consistently called for a knee-jerk mean reversion toward higher volatility levels.

However, as we move into 2019, we believe the volatility spikes of January–February and October–December 2018 have set a higher bar – a bar that largely reflects a more appropriate base level of market uncertainty moving forward. In addition to a higher threshold, we suspect the market will begin suffering some geopolitical risk fatigue. While investors have been thrown off balance by trade, tariffs, and tweets, we believe these events are starting to lose their shock value.

Even so, there is still plenty of room for higher volatility, especially if the economy falters more than we expect or if the Fed over tightens. But for the first time in several years, we aren't predicting a dramatic rise in volatility levels moving forward. That's the good news. The bad news? Current levels of volatility can still shake investor confidence.

For investors, these changes, along with the recent market sell off, offer a good opportunity to review their portfolio positioning moving into the new year.
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