Investment Outlook 01.2019
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Outlook 2019 – Ten Predictions
What happened in 2018?
For investors 2018 was a very demanding year that presented several tough challenges:
- US policy was erratic and unpredictable to a completely unprecedented degree. The US administration’s aggressive approach to trade policy exerted a particularly unsettling influence on investors.
- Both the US Federal Reserve and the European Central Bank made major changes to monetary policy and announced other such changes.
- There was a distinct slow-down in the pace of growth in Europe. In addition, political imponderables related to Brexit, the formation of a new government in Germany, Italian fiscal policy, and the protest rallies in France (“Gilets Jaunes”) all led to feelings of uncertainty among financial market participants.
- The crises in Turkey and Argentina triggered severe exchange losses in the emerging economies.
- The trade dispute between China and the USA and the slow-down in China’s economy resulted in corrections on the Chinese stock market and negative impacts on the whole complex of emerging economies.
The above-mentioned factors, especially the political uncertainties arising in 2018, caused a sharp increase in market volatility and produced atypical results in the global financial markets. For instance, some higher-risk categories of investment underwent very marked corrections despite overall economic development, which remained solid in Europe and was strong in the USA, and despite a background of continuing low inflation. Furthermore, almost all asset classes declined in value, with the exception of European government bonds and insurance-linked securities, both of which went up slightly. Therefore, the natural diversification effects failed to materialize, and the outcome was unusually high portfolio losses.
In addition, one result of the unforeseeable political influences was that asset prices were far less driven by fundamental factors than would normally be the case. Consequently, many active funds managers who rely on fundamental data were not able to do better than their benchmark indices.
For a detailed review of last year’s predictions we refer to the PDF document.
Outlook 2019 – Ten Predictions
Leading growth indicators weakened in 2018. The European PMI, for example, fell from 60.6 to 51.5 in 2018. The US ISM index, which remained at very strong levels for most of 2018, fell markedly in December to 54.3 from 58.8. China’s economy slowed in 2018, because of the effect of structural reforms and US trade restrictions.
While growth dynamic certainly slowed on a global basis and is much less synchronized than in 2017, most economists do not expect a US recession in 2019. There is, however, the risk that the German economy, plagued by falling export demand and problems in the auto sector, could dip into temporary contraction in 2019.
We see, however, potential for positive surprises in 2019. It is entirely possible that president Trump will come to an agreement with China on revised trade terms. In addition, we consider it quite likely that the Chinese government will decide on a more meaningful stimulus package to revive the Chinese economy during the first half of 2019.
Overall, we expect US real GDP growth of 2.3%, Euro area growth of 1.4%, Japanese growth of 0.9% and Chinese growth of 6.1%.
Inflation has remained surprisingly low. We saw some pick-up of headline inflation in the second half of 2018, but this was mostly driven by rising energy prices and reversed towards the end of the year, when oil prices collapsed. Core inflation remained very stable around 1.0% in the Eurozone and rose from about 1.7% to 2.2% in the US.
We do not see a risk of accelerating inflation in Europe, next year. However, US inflation should pick up somewhat, since wage growth recently rose above 3.0% (see figure 6). This wage pressure should eventually feed through to goods prices. We see a risk that US inflation could overshoot.
Overall, we expect US inflation around 2.5% and European inflation around 1.0%.
3. Central Banks
Most likely, the Fed will reduce the pace of monetary tightening in 2019, on the back of softer growth data. Since real interest rates remain at about zero – so monetary policy cannot be seen as outright restrictive – and US growth remains strong with accelerating inflation, we expect 2-3 rate hikes in 2019. This is clearly above market expectations. The futures markets prices only imply a 20% probability of one more rate hike in 2019.
The ECB stopped its asset purchase program in December 2018. However, it will reinvest maturing bonds to keep its balance sheet constant for the foreseeable future and possibly well past the first hike. In the past the ECB indicated that it would raise rates for the first time in 2019, but it sounded more dovish in its recent policy meeting, when president Draghi made ECB’s first rate hike data-dependent. We still believe there is a fair chance of a first hike this year, but this has become a close call.
Mario Draghi will depart at the end of October. His successor has not yet been determined. Mr. Erkki Liikanen, the former Bank of Finland governor, is currently the most likely candidate to succeed president Draghi.
Further Fed rate hikes in 2019 together with rising inflation and stronger debt issuance by the US treasury should drive US 10-year rates higher. We expect 10-year yields to rise towards 3.5% in 2019, and European yields to climb towards 0.75%.
We also expect US inflation expectations to rise from the surprisingly low current levels.
Despite last year’s spread widening, credits, including high-grade and high-yield bonds, do not offer value in our view. While we do not expect default rates to increase meaningfully in 2019, corporates increased leverage. We expect credit spreads to move sideways or to rise from current levels. As a result, we remain underweight credits.
The Q4 sell-off in combination with continuously rising corporate earnings led to a clear decline in forward price-earnings ratios, suggesting that equities are no longer expensive, measured against historic averages. US growth remains probably above trend. European growth softened but remains positive.
However, we continue to see heightened political risks. The biggest risk is certainly an extended escalating trade war. This would dampen global trade and growth and would be an increasing drag on corporate earnings, as exemplified by recent profit warnings regarding Apple.
In our base-case scenario, we expect positive returns from equity markets, with the US continuing to outperform. However, the variability of possible outcomes has increased in our view. While in a late cycle, equity markets tend to perform very well and can deliver double-digit returns, last year reminds us that the sentiment can turn sour very quickly, because investors fear that the party could be over rather sooner than later.
7. Emerging markets
After the hefty correction of emerging-markets bonds and equities in 2018, we see many value opportunities. A more meaningful China stimulus package and a further increase of oil prices would serve as further catalysts for positive returns.
However, a stronger rebound of the USD and rising US yields may provide further headwind for emerging markets. Overall, we are currently constructive and expect moderately positive returns.
We are moderately positive on oil prices for 2019, since some supply disruptions, e.g., in Venezuela and Iran, and a disciplined OPEC will support oil prices. However, oil prices are capped. US oil producers usually increase production when oil prices rise above USD/bl 50-55. This level represents average production costs of US shale oil producers.
The outlook for industrial metals is bleak, since supply looks healthy and global demand will not rise much as global growth rolls over.
We continue to be skeptical about the outlook for gold prices, since real rates are likely to rise in 2019. Gold’s recent rebound may run out of steam sometime soon.
REITS are exposed to rising interest rates. However, REITS are often undervalued against the intrinsic value of their property portfolios. Therefore, selective REITS can be seen as a good value play. As long as house prices do not collapse, REITS should also trade more stable than the brought market when equity markets correct.
Absolute-return strategies had a disappointing year as markets were driven by politics rather than fundamentals. In addition, some trend-following strategies suffered from frequent and sudden reversals. Furthermore, certain risk factors, like value and small caps, underperformed significantly.
If markets were to behave more normally, i.e., pay more attention to fundamentals, absolute-return strategies should find many ways to perform well, especially since volatility and dispersion have increased.
The USD is well supported in our view. The US yield advantage vis-à-vis the EUR is very high historically, and the US growth outlook is much brighter compared to Europe’s. These factors should continue to support the USD and keep downside pressure on the EUR-USD exchange rate. If the ECB, for example, in the second half of 2019, became more hawkish and indicated a first rate-hike, the sentiment would most likely shift in favor of the EUR. This is especially so since the US is running large twin deficits (budget and current account deficits), which are a net negative for the USD.
If the ECB turned more hawkish, we would expect the CHF to weaken more meaningfully.
Outlook for 2019 / new strategic asset allocation
We are facing an investment year, which will continue to be challenging. The global economy will lose some of its momentum. Nevertheless, we do not assume that any of the leading economic regions will fall into recession in the next 12 to 18 months. The political environment will remain demanding and unpredictable. Moreover, we are in a late-cycle economic phase and a period of monetary policy normalization. In this sort of environment, heightened volatility on the financial markets is to be expected. Such phases, however, definitely hold out prospects of good stock market returns.
As at the end of every year, we reviewed our strategic asset allocation in December, and we decided to adopt a somewhat more defensive investment strategy. The reason for doing so was to be in line with the market environment described above. The following outlines our balanced strategy.
- The proportion of government bonds was increased from 2.5% to 8.0%.
- The proportion of high-yield bonds was reduced from 5.0% to 4.0%.
- The proportion of convertible bonds was likewise reduced from 5.0% to 4.0%.
- The overall proportion of shares remained unchanged, but the proportion of US equities was increased from 13% to 20%. The other regions, namely Europe, Asia und emerging markets, were subject to individual reductions. This shift brings our share exposure closer to the market capitalization of the world’s equity markets. Furthermore, the US equity market shows a more interesting mix of sectors than the European equity market in the medium term, with a higher proportion of technology stocks and a lower proportion of financial securities. In addition, the US equity market is rather more defensive than the share markets in Europe and the emerging economies.
- The proportion of absolute-return strategies was reduced from 12.5% to 10.0%.
Current tactical positioning
We still see upside potential for bond yields, and thus stay underweight in government bonds. However, since government bonds are the best portfolio hedge against a return of a risk-off environment, we recently reduced our underweight.
Credits, in our view, are priced to perfection, which warrants a cautious stance and an underweight position for corporate and high-yield bonds.
Regarding equities we currently see balanced downside and upside risks. We see upside for equities due to a sharp fall of equity valuations in late 2018 and a still positive economic outlook with moderate inflation. Downside risks relate to politics and especially an escalating trade war. As a result, we stay neutral on equities.
We currently run an overweight in energy, since we see potential for a further recovery of oil and energy prices after the dramatic slump in Q4 2018.