Our view that “2018 could shape up to be a challenging year” proved prescient as most major asset classes failed to generate meaningful – or even positive – returns for much of the year. As so often happens, markets struggled to make headway in spite of an almost unanimous expectation of… wait for it… synchronized global growth. This year proved to be a great reminder that if something is widely recognized, it is probably already priced into asset values. Taking this into account will make forecasting for 2019 all the more difficult, as we discuss below.
Asynchronous slowdown – it doesn’t roll off the tongue as nicely as “synchronized global growth,” but it seems to be a fitting description of the oncoming macro environment. In recent months, we’ve covered the likely factors that can act as a drag on global growth. The linchpin is policy tightening from the Fed and other central banks that could bite into economic activity (as we already see evidence of in the US housing market). The list also includes growing trade tensions and supply chain interruption (see falling global auto sales), sluggish capital investment, a Brexit supply shock, and fiscal policy limitations that come with rising deficits.
On a brighter note, these headwinds should be less synchronized as regional economies are at different points in the cycle. The US has the most to lose as recent growth in the 3.5%–4.0% GDP range was supercharged by the $1.5 billion tax cut (Source: Committee for a Responsible Federal Budget). We expect US growth to decelerate next year, but to a still-respectable 2.0%–2.5%. In contrast, euro area growth already downshifted in Q1–Q3, establishing a lower bar for expectations – Brexit uncertainties notwithstanding. China presents the greatest macro wildcard as a credit and manufacturing slowdown is offset by a government with plenty of fiscal and monetary latitude.
Gauging Global Macro
In summary, we think the global economic backdrop for 2019 will be one of uneven deceleration driven by the US, which will mean-revert to something closer to longer-run potential GDP. We do not yet see a US or global recession for next year as consumption is supported by strong employment trends in many countries, but the possibility cannot be ruled out. Policy mistakes (from President Trump, China’s President Xi, Fed Chairman Jerome Powell, or British Prime Minister Theresa May) at this late stage of the cycle could exacerbate the slowdown to something more painful. We estimate the probability of a US or global recession next year at 30%. This is higher than most current estimates we see, but still represents less than a 1 in 3 chance.
We are always somewhat reticent about making forecasts, but acknowledge it comes with the territory. This year, however, the market environment makes it even more difficult. Three of our favorite touchstones – the trajectory of growth, market sentiment, and valuation – offer conflicting signals. On growth, the message is mixed because GDP in most regions is likely to decelerate but remain positive. So the direction (positive) supports risk assets but the rate of change (slowing) does not.
This leads to problem number two: What’s priced in? Arguably, falling stock prices and widening credit spreads1 in October and November have already begun to reflect many of our concerns for next year. The October/November correction stole much of our pessimistic thunder for 2019.
Finally, valuation is providing few clues because prices are no longer at extreme levels. Rising interest rates and slowing growth have put sovereign / high quality bonds closer to our estimates of fair value. Likewise, solid earnings growth, falling price-to-earnings ratios (P/Es),2 and widening credit spreads have taken stocks and corporate bonds from very expensive back to average or slightly above. Investors, already skittish, are unlikely to find much comfort or direction in these mixed signals.
Outlook for 2019
With the backdrop above, this is how we see 2019 playing out…
Central Banks – The deceleration of US growth and slowing inflation pressure will allow the Fed to raise rates only once in 2019 (assuming a previous hike in December 2018). The Fed will be persuaded not by growing market volatility but instead by the slowdown in rate-sensitive sectors – combined with a reluctance to meaningfully invert the yield curve, which would find long-term debt instruments at a lower yield than short-term debt instruments. In Europe, we believe European Central Bank (ECB) asset purchases will end, as expected. However, we do not believe the much-anticipated first hike will happen next year, as European manufacturing and export volumes remain sluggish and inflation fails to reach the ECB’s target.
Interest Rates – For the first time in years, we are not calling for higher nominal yields in the US out the curve. While rates could certainly bump a bit higher in the near term, to say 3.10%–3.25%, we expect the US 10-year Treasury to finish 2019 below 3% as growth decelerates and headline inflation softens. How much below 3%? For now, we don’t see growth slowing enough to push the UST-10 below 2.5%. In Europe, we expect core sovereign yields (Germany, France) to be range-bound. Rates in Europe already reflect slower growth, while halting asset purchases will add to net supply, supporting yield levels.
Given this math, we think high-quality sovereign bonds will earn their yield plus some modest price appreciation in certain markets. For what it’s worth, neither the Bloomberg Barclays US Aggregate Bond Index3 nor the Global Aggregate Bond Index4 has ever had back-to-back negative calendar-year returns. Both are in the red through November 2018. As the result of two more Fed hikes at the short end and somewhat lower rates further out the maturity spectrum, we expect the US yield curve to go completely flat or invert slightly. This process will bring more calls of recession for 2020.
Equities – We expect returns across equities to be mixed. For the S&P 500®,5 2019 earnings growth estimates are already being trimmed from 11% to the 8% range. With moderating global activity, it may come in closer to 5%–7% as revenue growth and profit margins are likely to be under some pressure. However, with the Fed turning more dovish, inflation in check (we believe), and only modestly elevated valuations, we see little reason for price multiples to contract meaningfully. The combination of mid-single-digit earnings growth with stable P/Es should yield a result similar to this year – positive but sub-par returns.
The math for European equities is similar, but we maintain our preference for European stocks, as their lower valuations imply less downside if the global economy falters more than we expect. Simply put, we have no idea whether US or European stocks will outperform, but we like the risk/return trade-off in Europe better.
For investors with a strong stomach, we favor emerging market stocks as the headwinds from Fed tightening and US dollar strength are likely to wane. In addition, the carnage in EM stocks already reflects our macro concerns for next year. Overall, we believe equity volatility levels will be similar to what we experienced in 2018. Markets are likely to remain on edge as investors (over)react to a slower-growth, less certain macro environment.
Credit – We do not subscribe to the idea that a credit bubble is likely to burst anytime soon. There are no impending “maturity walls” as companies have used all-time low rates to term out their debt. Moreover, we are only expecting a slowdown in growth, not a downturn that would impair credit fundamentals and precipitate a deeper credit crisis. However, we expect corporate issues to struggle (some spread widening) on perceptions of deteriorating credit quality.
Within investment grade corporate bonds, we believe yields will rise only modestly. Widening spreads may offset falling base treasury rates. This should result in lackluster positive returns after adjusting for the duration impact on prices. As investors become more worried about the trajectory of growth, high yield spreads may come under more pressure. While their return forecasts may be similar, the downside risk is greater for high yield issues. For attractive yields, our preference in credit remains with senior bank loans. With short rates likely to rise only modestly, we put little weight on the floating nature of their coupons. Instead investors should focus on their defensive features: a more senior position in the capital structure and higher recovery rates.
Risks – The two greatest threats to our current outlook are recession and inflation. In simple terms, we are expecting risk assets to weather a modest economic slowdown with some speed bumps. However, if the deceleration slides towards recession, the fallout could be far more severe than we are currently projecting. We also believe inflation to be under control for now. If this proves incorrect and inflation rises more vigorously, the Fed will find it harder to pull back, nominal rates will rise (not fall), and consumers will feel the pinch.
Portfolio Positioning – We maintain the view we’ve held throughout 2018: There may be a bit more room for risk assets to run higher, but a slowing global economy argues for caution. Greed isn’t likely to be rewarded this late in the cycle, so investors should seek lower-risk ways to construct their allocations.
1 Risk spread is the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk.
2 The price-to-earnings ratio, or P/E, is the price an investor is paying for $1 of a company's earnings or profit.
3 The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the U.S.-dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, mortgage-backed securities, asset-backed securities, and collateralized mortgage-backed securities sectors.
4 Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.
5 S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
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