INVESTMENT STRATEGY
OUTLOOK

The late-late cycle show

U.S. Federal Reserve tightening, trade wars, China uncertainty, Italy and Brexit imply 2018’s volatility should continue into 2019. The U.S. recession danger zone is 2020, which gives equity markets some upside. But late-cycle risks are rising.

 

We expect the following in 2019:

  • The Fed to follow its December rate rise with three to four additional hikes
  • U.S. 10-year Treasury yield at 3.0% by the end of 2019
  • An inversion of the U.S. yield curve that will create recession risks for 2020
  • U.S. gross domestic product (GDP) growth of 2.0% for 2019
  • Volatile equity markets that deliver mid-single-digit returns; better potential in Europe and Japan than the U.S.
  • U.S. dollar to have modest upside potential; Japanese yen to be the strongest major currency

Late cycle, but not end of cycle

2018 has been a challenging year in most asset classes as investors adjusted to trade wars, China growth uncertainties, unstable European politics and a succession of Fed rate hikes. These issues will continue into 2019, with the added complexity that GDP and profit growth is likely to be slower in the U.S., while inflation pressures will build.

The key issue is that the end of the cycle is getting closer. The current U.S. expansion will become the longest on record if it continues to July 2019, which seems likely.

The danger zone for a U.S. recession is 2020. The yield curve will probably invert during 2019 if, as we expect, the Fed raises interest rates another three to four times. The chart below shows that every recession in the past 50 years has been preceded by the 10-year U.S. Treasury yield falling below the two-year yield. An inverted curve is a powerful indicator because the bond market is signaling that the Fed will soon move to reduce interest rates.

Bear markets don’t normally start until around six months before a recession, so equity markets still have some potential upside. Monitoring recession risks will be critical, however, to avoid buying a dip that turns into a prolonged slide.

Making America great…until 2020

An important reason for the strength in the U.S. economy and corporate earnings in 2018 has been the Trump administration’s fiscal stimulus.

The chart below shows the U.S. unemployment rate and the government fiscal deficit as a share of GDP. High unemployment usually means a large deficit as the government stimulates the economy. The deficit is small when the unemployment rate is low. By adding fiscal stimulus when the unemployment rate is below 4%, the Trump administration is doing something that has never been done before. The International Monetary Fund (IMF) forecasts the fiscal deficit will reach 5.0% of GDP in 2019, which would be unusually large for an economy beyond full capacity.

The peak economic boost from the fiscal stimulus will be seen in late 2018 and early 2019, but the stimulus becomes a drag on the economy in 2020. The mid-term election results, with the Republican party losing control of the House of Representatives, likely means the Trump administration will be unable to push through more tax cuts.

A rotation away from the U.S.

The story of 2018 was U.S. growth leadership relative to other regions, in large part because of the Trump stimulus. This helped U.S. equities outperform other markets and the U.S. dollar to appreciate.

Japan and Europe disappointed in 2018. A succession of natural disasters (earthquake, typhoon and floods) caused Japan’s GDP growth to be negative in Q3, while we now know Europe’s economy was unsustainably strong at the end of 2017, making a slowdown likely. The problems in Italy, European bank exposure to Turkey, and Europe’s trade links to China meant it underperformed industry consensus forecasts. The most recent issue for Europe was the implementation of new emissions standards for motor vehicles. This caused a contraction in Q3 German GDP as manufacturing output plunged.

Both Japan and Europe should rebound from these temporary setbacks. For Japan, rising household incomes from jobs and wage growth, and strong business confidence mean above-trend growth is still a good bet. Regarding Europe, Italy and Brexit are ongoing headwinds for the region, but credit growth is picking up and financial conditions remain broadly supportive of growth.

Japan and Europe aren’t likely to grow faster than the U.S. in 2019, but we believe they have potential to outperform pessimistic expectations.

China’s stimulus won’t be that stimulating

China’s economy is on track for GDP growth of around 6.5% in 2018, its slowest since 1990. It faces headwinds from high indebtedness, slowing property construction, poor demographics and the trade war with the United States.

China responded to its last two downturns, in 2009 and 2015, with massive fiscal and credit stimulus. These efforts came at a price: China’s debt-to-GDP ratio rose from 140% in 2008 to over 250% at present, creating concerns about financial stability.

Stimulus is underway, but it is unlikely to be as large and effective as previously. It should, however, be enough to keep growth near 6% for 2019.

Asset class preferences

Our cycle, value and sentiment investment process results in an overall neutral view on global equities.

  • We have an underweight preference for U.S. equities, mostly driven by expensive valuation. The cycle is broadly neutral but is likely to be under downward pressure later in 2019. The sell-off in late 2018 has triggered some contrarian oversold signals, so there is scope for a tactical bounce.
  • We’re more positive on non-U.S. developed equities. Valuation in Japan and Europe is reasonable, and the cycle should be a modest tailwind given that we believe industry consensus expectations are too pessimistic.
  • We like the value offered by emerging markets equities, but the threat of trade wars, China slowing, and further U.S. dollar strength keeps us at a neutral allocation. A stronger contrarian signal that investors are turning negative on EM would be a reason to increase allocations.
  • High yield credit is expensive and losing cycle support, as is typical this late in the cycle, when profit growth slows and there are concerns about defaults.
  • For government bonds, we like the value offered by U.S. Treasuries. Our models give a fair-value yield of 2.7% for the U.S. 10-year bond. German, Japanese and U.K. bonds are very expensive, with yields well below fair value. The cycle is a headwind for all bond markets as inflation pressures build and central banks tighten further -- such as the Fed and Bank of England (BOE) -- or move away from extreme stimulus -- such as the European Central Bank (ECB) and Bank of Japan (BOJ.)
  • We like real assets. Real Estate Investment Trusts (REITs) are slightly cheap, while Global Listed Infrastructure (GLI) and Commodities are around fair value. Commodities typically benefit from late-cycle support as inflation pressures build. We expect GLI will benefit from its European focus as the region rebounds. Rising Treasury yields, however, are a headwind for REITs.
  • The yen is our preferred currency. It’s significantly undervalued, getting cycle support as the BOJ becomes less dovish, and it has contrarian sentiment support from extreme short positions in the market. The euro and British sterling appear undervalued as we move into 2019. The recovery in European economic indicators should support the euro. Sterling will be volatile around the Brexit negotiations but should rebound if a deal is agreed with Europe. It has more upside potential than the euro.

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