2019 outlook - Executive summary
Macroeconomic Outlook 2019: as QE ends, will the global cycle turn?
- We expect the US will enter a cyclical slowdown in 2019 while the Fed will end its hiking cycle at 3%-3.25%
- The Eurozone is already slowing down and we see European politics skewing risks to the downside. The European Central Bank will likely be prudent and leave interest rates on hold until at least September
- We have a less positive view on risk assets and are looking to move equities back to a neutral position over the course of 2019
- We expect that bund yields will remain range-bound between 0.2% and 0.7% in 2019 and see value in US treasuries above 3.25%
The last lap of the cycle
The US looks set to post growth of 2.9% for 2018 – its best since 2006. Some of this momentum, underpinned by a spectacular, pro-cyclical fiscal expansion, should continue for some time yet. However headwinds, including fiscal fade, restrictive trade policies and most importantly in our view, tighter financial conditions, are gathering. This should lead to a classic cyclical slowdown to 2.3% in 2019. For 2020, the current consensus forecast and the FOMC’s suggest a soft landing but in our view sharp slowdowns are historically more common. Indeed, economies faced with deceleration, typically develop a vicious circle of falling confidence, reduced spending and investment, as well as a sharp unwind in inventories. While we acknowledge that anticipating the exact timing of recessions is very difficult, our 2020 forecast sees US growth below potential, at 1.4%.
We therefore expect the US Fed to end its hiking cycle by the close of 2019 at 3%-3.25%, after a well-anticipated hike in December and three more next year. In late 2020, we would expect the Fed to reverse gears and enter a phase of easing.
European lacklustre resilience and political stand-offs
Lagging by about two years in this cyclical expansion – largely because of policy mistakes – the Eurozone is unfortunately already slowing down. A year ago, business surveys were suggesting there would be an acceleration in activity but after an incredibly disappointing 2018, Eurozone growth now looks likely to settle at 1.9%, vs. 2.5% in 2017. Looking further ahead, we anticipate that the bloc’s growth will drop further to 1.4% in 2019, and then to 1.2% in 2020. While consumption and construction should hold relatively steady, corporate investment should ease in the wake of falling business confidence (with company credit demand at its lowest since early 2014) and declining profitability. Most importantly, net trade should weigh on growth with slowing external demand, chiefly from the US and China, as well as lower competitiveness and fairly robust imports.
This lacklustre resilience should prove enough for the ECB to bring the deposit rate to 0% by spring 2020. Even with inflation at a non-negligible distance from the objective, we expect this move to be presented as a normalisation rather than a tightening, arguing that the side effects of negative interest rate policy are progressively offsetting its benefits. We also expect T-LTRO in the H1 2019.
If anything, and despite an already greyish outlook, we see European politics skewing risks to the downside. First, the Italian budget saga is still unfolding and there is the potential risk of financial contagion taking hold. As we expected, the EC has suggested the opening of an Excessive Deficit Procedure. And, if our macroeconomic assessment is correct, the softening of growth will see public debt return to a rising trend. Second, while UK Prime Minister Theresa May finalised a Withdrawal Agreement with the European Commission on 14 November, Brexiters, the Northern-Irish Democratic Unionist Party and Labour have expressed their opposition and there is a high risk of the UK Parliament rejecting the deal in December. UK political uncertainty remains visibly high and we are mindful that a “no deal” Brexit in March is very possible. Finally, while the US administration has narrowed its protectionist attacks towards China, tariffs being imposed on the EU’s car sector remain a 2019 possibility.
China walking a tightrope, diverging regional and intra-regional trends in emerging markets
2018 has also witnessed the shifting effect of the US-China trade conflict from a market shock to a growth shock. Our base case is for the tariff rate to rise from 10% to 25% next year, covering $250bn of Chinese goods. This protectionist escalation is the key driver of the economic slowdown we expect for China in 2019 (6.1% from -.6% this year). The trade impact will be partially offset by a “cautious” policy easing by Beijing, focusing on fiscal supports for households and private-sector businesses.
Given the structural shifts in the external environment, we expect Chinese policymakers to “walk the talk” with structural reforms, strengthening intellectual property protection, liberalising financial markets, opening up the capital account and reforming the corporate sector. These transformations (which we forecast will see the first annual current account deficit in China since 1993) will be beneficial in the long run and may also help in 2019 to appease the tension with the US.
Meanwhile, emerging markets have been suffering from the tightening of global financing conditions (dollar appreciation and rising UST yields), exacerbated by heavy capital outflows. Still, economic growth proved rather resilient. And whilst the US trade war rhetoric, currency shocks, and further tightening should all limit EM expansion in 2019, we expect domestic demand to remain relatively resilient, alleviating some of the pressures coming from weaker trade volumes. In particular, pent-up demand in large EMs such as Brazil and India should see stable EM GDP growth at 4.6%, as in 2018. This overall resilience would however mask diverging regional and intra-regional trends, with Argentina and Turkey in recession vs. Brazil substantially accelerating.
Asset Allocation: Shifting down a gear
2018 has been a frustrating year for investors. Despite a fair economic backdrop and strong earnings’ growth in most parts of the world, global markets delivered poor performance. At the time of writing, all major liquid asset classes had posted negative year-to-date total returns. An explanation we had put forward for such performance in our 2018 Outlook was that the tide of quantitative easing had begun to reverse, which would put downward pressure on asset prices and upward pressure on correlations. And, since the second half of 2018, the stock of assets owned by central banks globally has fallen, and this has initiated an unwind which could take several years.
If this view proves correct, 2019 could be just as challenging as 2018, which is why we are shifting the risk in our asset allocation down a gear. We have a less positive view on risk assets and are looking to move equities back to a neutral position over the course of 2019. Presently we are also maintaining an underweight position in credit, while keeping cash and government bonds at neutral.
As a result of the ECB’s cautious stance, inflation continuing to disappoint (stable breakeven) and the heightened political risk in Italy, bund yields should remain range-bound between 0.2% and 0.7%. The Italian situation has deteriorated and we expect Italian 10-year bond yields to grind higher and settle above 4%. In the US, we see value in treasuries above 3.25%, especially as a diversifier in the case of a more pronounced macroeconomic slowdown. Credit spreads are likely to remain under pressure in 2019 due to a host of macro headwinds and a less advantageous technical backdrop. In particular, we are concerned about the record share of BBB-rated credits, within the IG sector, which raises the spectre of downgrade risk into HY.
Turning to equities, our base case of decelerating economic activity is expected to dampen top line growth and profit margins are enduring growing pressures. We expect earnings per share growth to deliver close to 7% for global equities. Nevertheless, reduced excess liquidity, rising US short-term rates and possibly higher equity-risk premiums, driven by heightened volatility and weaker investor sentiment, all suggest limited scope for a multiple expansion.
That meant that we would see the moment when the expansion of the balance sheet of the main central banks across the world would peak and reverse.
With those two macroeconomic features in mind, we expected back then rising interest rates and low returns overall.
And indeed, as expected, 2018 ended up being a year of frustration for global investors.
Even though the macroeconomic backdrop was fairly good, and earnings growth surprised on the upside in the main countries, global liquid asset classes posted negative returns year-to-date overall.
Looking into 2019, we see headwinds gathering and we forecast an economic slowdown in the US, in China and in the Eurozone.
In the US, we see headwinds such as the fiscal fade, the first impact of protectionism and most importantly the tightening of financial conditions leading to a classic cyclical slowdown.
We therefore forecast US GDP growth to go down to 2.3% in 2019 and 1.4% in 2020.
The Eurozone, which lagged this economic expansion, is already showing signs of slowdown.
After a very disappointing 2018, we see further slowdown to 1.4% in 2019 and 1.2% in 2020.
While consumption and construction could hold relatively steady, corporate investment should ease and net trade would weigh on growth with slowing external demand, lower competitiveness and fairly robust imports.
With a global economic slowdown and further monetary tightening, 2019 looks set to be as challenging for investors as 2018.
We therefore have a less positive view of risk assets and will look, over the course of 2019, to downgrade equities back to neutral.
In the fixed income space, we expect German Bund yields to remain range-bound because of the cautiousness of the European Central Bank, the disappointing inflation and a heightened Italian political risk.
We see value in the US Treasury yields above 3.25%, especially as a risk diversifier in case of a macroeconomic sharper slowdown.
And finally, credit spreads are likely to remain under pressure because of macroeconomic headwinds and a less technical environment.
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