Expect a tougher climb
- Global (and U.S.) growth will slow but shouldn’t turn negative in 2019
- We expect most asset classes to see slightly better performance next year
- We think investors should stay invested and keep putting money to work
- Investment selectivity will be crucial in 2019
- Reforms, weaker currencies, cheaper valuations and controlled inflation, give indication that select emerging markets with should have year of robust growth.
- 2018 in review— Let’s not do that again
2018 in review— Let’s not do that again
Despite solid global economic growth, 2018 turned out to be the most challenging year for investors in a decade. The U.S., the world’s largest economy, expanded at its fastest pace of this cycle. Sales and profits climbed for global corporations, while central banks kept interest rates at well-below-normal rates. Yet, as we near the end of 2018, few major asset classes have outperformed cash. What happened?
This much is true: U.S. economic growth surpassed our expectations coming into the year. The Tax Cuts and Jobs Act, passed late in 2017, sent economists and Wall Street analysts scrambling to estimate its effects. We now know that U.S. consumer spending and private investment surged—at least temporarily— as tax rates fell. U.S. corporate profits rose by over 25% in the second and third quarters. But as Exhibit 1 shows, in contrast to 2017, positive economic surprises (i.e., economic performance relative to expectations) were essentially limited to the U.S. Results in the rest of the world were disappointing
We feel this disappointment wasn’t due to any single factor, but rather to a confluence of moderate headwinds. Higher global tariffs and uncertainty about more on the way restricted country market access and drove up costs. Rising U.S. interest rates and a stronger U.S. dollar stressed the global financial system, and China’s economic policy in particular, by encouraging capital flight. It’s no wonder investors began to focus on the crosscurrents and fading tailwinds that we anticipated would hit in 2019 a bit ahead of schedule. And, as investment managers, it’s time we did the same.
What’s in store for investors in 2019?
Lets start with what we expect to see in 2019: a recession in a major economy. But—there’s always a “but”—economic growth is set to slow in both the U.S. and China while failing to bounce back convincingly in the eurozone, Japan or United Kingdom (Exhibit 2). This slower growth tips the balance of risks toward the negative. An unusual amount of uncertainty remains on key questions like the direction of corporate credit spreads and the U.S. dollar, but we are more confident that market returns will improve only moderately from their lackluster 2018 showing. Despite this— or, rather, because of it—our focus is on finding opportunities to buy and own high quality assets without becoming too defensive in their approach. They’re walking a fine line, to be sure.
Fading tailwinds, stiffer headwinds.
Global growth received a boost in 2018 when the U.S. opted for a late-cycle fiscal expansion, borrowing nearly $1 trillion to fund tax cuts and federal spending, these measures added more than 0.5% to U.S. gross domestic product (GDP) growth and helped lift S&P 500 sales and profits. But most of the positive effects of this stimulus have already begun to wear off and will vanish almost entirely by 2020. In their place we’ll find tighter financial conditions (Exhibit 3) thanks to rising interest rates, wider corporate bond spreads, falling equity market valuations and, yes, new and rising taxes on international trade.
Where might the world turn in 2019 to replace the boost it’s just received from the U.S.? China’s government has attempted a large monetary and fiscal stimulus to help support its economy amid attempts to de-risk its financial system. We should be seeing the effects of that effort more in 2019, which could produce upside surprises to growth in Asia. In addition, we’re looking for signs of economic strength in the emerging markets. Stimulus packages and reforms coupled with weaker currencies and cheaper valuations, give indication that select emerging markets with controlled inflation should have year of robust growth. We like to single out especially India.
“Slower” doesn’t mean “negative”
Expectations are not particularly high for growth in developed markets outside the U.S. in 2019— and that may actually be a good thing. With less room to disappoint, the eurozone and Japan are positioned to deliver above-trend growth while keeping monetary policy exceptionally accommodative—historically a friendly operating backdrop for companies and the investors who own their stocks. These markets may also benefit from a pause—if not a reversal—in the trend of the strongly rising U.S. dollar. While a strong dollar provides a temporary advantage to international firms selling into the U.S., it also raises the cost for borrowers with dollar liabilities and drives investment flows away from many places that need them.
Of course, the fate of the dollar may rest primarily in the hands of the Federal Reserve. The Fed has been slowly but steadily raising short-term interest rates for three years and seems primed to hike at least twice more in 2019. In the Fed’s view, the currently low unemployment rate could generate higher inflation, which demands tighter policy. With rates rising in the U.S. but flat or down in most of the rest of the world, the dollar has been far and away the best-performing currency. We think it is now well above its fair value and could remain so unless and until the Fed shows signs of slowing or other central banks become less accommodative. Keep in mind that even if the Fed stops raising rates, its ongoing balance sheet shrinkage will effectively continue the tightening process.
The resulting increase in the supply of high quality bonds—aided and abetted by a booming federal deficit—could push up longer-term interest rates and corporate borrowing costs.
A broader base for growth should help cushion against a global recession—technically defined as negative GDP growth for two consecutive quarters— despite a deceleration in both the U.S. and China. In our view, there is little chance the U.S. will go into recession before late 2020 given continued strength in consumer and business activity confidence, especially the strong labor market. We would expect to see a material degradation in these and other leading indicators at least a year before the economy begins to contract (Exhibit 4). And while it’s not hard to find areas of risk that could eventually contribute to a recession, we don’t see the types of massive macroeconomic imbalances that helped turn the past two recessions into genuine market crises.
Why do we care so much whether growth merely slows from its current pace or turns negative? Recessions, or so-called “hard landings,” have historically been associated with 20%+ drops in equity markets, falling interest rates and sharply higher unemployment. Decelerations, also referred to as “soft landings,” have not.
Most investable assets are now available at lower prices.
It’s hard to put a happy face on the swoon in global risk assets that occurred during the fourth quarter of 2018. As of this publication, few major asset classes have bested cash this year—never a welcome development for an investor (let alone an investment manager). If this cloud does have a silver lining, it’s that financial markets are already pricing in a moderate global slowdown heading into 2019. So while its far from jubilant in this outlook, we generally expect better returns in markets next year.
One reason for this is that most publicly traded assets offer higher yields today than they did a year ago (Exhibit 5). Interest rates have risen, and credit spreads have widened. In addition, global equity valuations have fallen, in some cases substantially. And while there are important exceptions, like wheat and natural gas, most commodity prices will end 2018 lower than where they began. In short, during a year in which economic fundamentals generally improved, market prices remained flat or fell. This creates value.
"We think increased selectivity within asset classes, with a focus on quality and valuation, will yield the best results."
What if we’re wrong?
We remain cautiously optimistic outlook for 2019. At the same time, we also took time to discuss a critical question for our clients: What if we are wrong, especially on the downside? What would that look like in the real world and what would that mean for our clients? Most likely, we’d see a flatter yield curve, driven by sharply higher short-term rates (the Fed’s response to perceived overheating, perhaps) or sharply lower long-term rates, typically a product of recession risk. In this scenario, credit spreads would widen, earnings and stock valuations would be lower, and the direction of the U.S. dollar would be uncertain.
Our downside scenario also includes an unanticipated escalation of event risk in two key areas: Brexit and trade. The U.K. seems determined to leave the European Union (EU) in March, but the precise nature of its departure is still a huge source of uncertainty for global investors, particularly throughout Europe. A “crashing out” scenario— one in which the U.K. exits without a deal in place to manage the transition and tips itself into recession or, worse, stagflation—is not our base case, but it remains a serious risk until Parliament agrees to a plan.
Tariffs also seem destined to plague markets for at least another year. The steady escalation in the tit-for-tat between the U.S. and China, resulting in higher bilateral taxes on a broader basket of imported goods, has produced no clear winner but plenty of losers: U.S. producers facing higher costs and Chinese consumers and businesses losing access to U.S. farm and energy output. The negotiations at this point appear to hinge more on politics than economics, which means the resolution of this dispute is beyond our current ability to forecast. But should new U.S. tariffs spread beyond measures that have already been announced or threatened, the damage to the U.S. economy and investor sentiment could be severe.
Virtually the only refuge for investors seeking positive returns during a period of acute event risk or recession is long-duration, high quality bonds. On the equity side, while few stocks could eke out positive returns in a bear market, defensive sectors like consumer staples and health care would likely beat technology and financials. Moreover, established commercial real estate and defensive real assets like farmland could help provide at least a partial shield against the forces of the public markets.
Conclusion: seeking quality at a fair price in a slowing world.
When the dust clears, the global economy in 2019 may not behave all that differently than it did in 2018, but we are hopeful for better investment returns across most public and private asset classes. The world is slowing, but only gradually. Furthermore, we believe a global recession and bear market are still at least a few years away, leaving room for portfolios with risk assets to benefit.
In today’s uncertain market, the desire to minimize risk is often a key determinant of investment decisions. If you have clients at a certain stage in life, such as retirement, or who simply don’t want or need to take risks in their strategy, you may think you should opt for what were traditionally considered ‘low-risk’ asset classes like cash or fixed interest in an effort to protect capital.
However, with current low interest rates and low economic growth, investing in these asset classes may severely limit the ability to grow your clients’ assets and meet their investment objectives. Worse, it may actually expose them to the unintended risks that a lack of diversification often brings.
For those seeking a smoother investment journey, we have developed an investment philosophy rooted in the fundamental belief that risk and returns are always related, within our actively managed global multi-asset risk-graded strategies.