THE year 2018 kicked off with a bang on expectations that synchronised growth experienced in 2017 would continue. However, concerns over global growth grew and investors shifted to profit taking and a risk-off mode.
The US and China trade tensions quickly escalated after a few rounds of tariffs. Geo-political issues shrouded Europe and dampened the economic outlook. In addition, the Federal Reserve raised rates four times, tightening financial conditions. Towards the end of 2018, almost all of the asset classes were in negative territory. In fact, the returns across asset classes were virtually a mirror image of 2017's, when almost all asset classes increased in value.
We see a synchronised slowdown in global economic growth in the US, Europe, and Japan slowing. Importantly, these markets are forecasted to grow. Recession probabilities globally and in the US remain low but are rising. Overall, global economic growth will likely remain above 3 per cent. Emerging markets (EM) may experience expanded growth differentials relative to developed markets. For example, growth may accelerate in Brazil (from 1.3 per cent in 2018e to 3.0 per cent in 2019e) and in India (from 7.4 per cent in 2018e to 7.6 per cent in 2019e).
RISKS AND OPPORTUNITIES
- Federal Reserve interest rate policy
In October 2018, chairman of the Federal Reserve Jerome Powell stated that the Federal Funds rate was "a long way" from neutral. In November 2018, he commented that the Federal Funds rate would remain "just below" neutral. In December 2018, he said that the Federal Reserve balance sheet reduction was on "autopilot", and this unnerved investors.
In January 2019, Mr Powell became more data dependent and signalled a temporary pause on interest rates while the Federal Reserve evaluates the markets. At its recent meeting, the Federal Reserve indicated that it now sees risks as more balanced and has decided to move away from a tightening policy and will also observe the pace of the balance sheet reduction.
BNP Paribas Wealth Management expects one additional rate hike by the Federal Reserve in 2019. If interest rate rises due to economic growth and not an inflation surprise, the equity market should perform positively. However, the Fed is likely closer to the end of rate rises and for the first time in this cycle, short-term dollar yields are turning more attractive. Finally, real rates (interest rate after inflation) in the US are just barely positive. Normally, a recession is triggered when real rates are much higher, at or above the past recessions average of 3 per cent.
A vast majority of bear markets materialise when a recession looms. Recessions are then usually preceded by an inversion of the yield curve. If we observe the behaviour of financial markets over the past 50 years, we note that there is no hurry to exit the equity markets. Indeed, in the 12 months preceding an inversion of the yield curve, the S&P 500 index delivers an average return of 15 per cent.
Moreover, in the months following an inversion of the yield curve, stock markets continue to rise by more than 20 per cent on average. Hence, our view is that it is important not to exit the equity markets too soon after a yield curve inversion. Better still, this inversion has not fully occurred just yet.
- A potential hard landing in China
In 2018, a domestic slowdown partially due to much needed reforms, combined with trade tensions, impacted the Chinese economy. The Chinese government is now applying targeted fiscal and monetary policies to ease the slowdown. It acknowledged increasing downward pressure and the challenging external environment, but also emphasised the need to stabilise growth and promote reforms. It is expected that fiscal policy will be more proactive with larger-scale tax cuts and fee reductions, as well as a substantial increase in the issuance of special local government bonds. The Chinese government also highlighted key areas for additional infrastructure spending and opening up of the domestic markets as key focus of reforms. The pace of these reforms will be determined by the progress on trade negotiations. Finally, the yuan has been appreciating, unlike prior volatility episodes, and capital outflows remain contained.
- Trade tensions
Trade tensions are presently thawing and could lessen as the year progresses. This has been the second catalyst for markets year-to-date including the Federal Reserve pausing.
In 2019, the US economy shows signs of slowing. There is now more common interest for trade tensions not to worsen. Our base case is for no further escalation in tariffs, with either the US keeping existing tariffs or putting on hold additional tariffs.
China's response could be relatively muted and a trade deal or truce might be possible with conditions comprising the long-term issues of technology transfer and intellectual property, which will likely take years to resolve. Enforcement and monitoring on these issues will be key going forward.
Private and public overall financial balance is much healthier heading into 2019, compared to periods prior to other recessions. Corporate cash flow after capex remains in surplus. Furthermore, the US consumer savings rate is in surplus at 6.0 per cent this cycle, relative to 3.1 per cent in 2007 before the financial crisis. Consumers have been cautious, which could act to further extend the current cycle.
How should investors navigate this environment?
We believe in employing a barbell approach. This entails building portfolios with both defensive and secular growth ideas, the focus of which is to reduce exposure to volatility and to equip investment portfolios with quality defensive assets. We believe that higher quality shorter-dated bonds, better quality equities with dividend yield as well as gold, are all suitable instruments to act as a portfolio and recession hedge.
Multi-year opportunities exist in a number of longer-term secular themes. Even before US-China trade tensions emerged, manufacturers were moving their supply chains from China to lower-cost regions such as Southeast Asia, India, Eastern Europe, and Mexico. The trade dispute is a wake-up call for companies to grasp the importance of diversifying their production bases. In this context we have identified the sectors that will benefit from the shift and upgrade in supply chains, as well as their knock-on effects on local consumption markets in the medium to long term.
Our view is that emerging market currencies offer an attractive investment. We believe that the US dollar is set to change direction and depreciate in 2019 as the country comes close to the peak of its economic cycle. Meanwhile, the impact on the economy of tax reforms would also start softening.
Demographics are a powerful driver of market returns. These mega-trends include longer life spans and increased spending on healthcare, leisure, smart cities as well as impact investing. With the correction in technology stocks, areas such as Industry 4.0, cyber security, and mobility should not be forgotten, and technology related investments could instead be revisited. Ultimately, it is important to utilise volatility as our friend, and investors could gradually add to these themes when market opportunities present themselves.
- The writer is chief investment officer, Asia, BNP Paribas Wealth Management