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2019 Outlook: Managing an atypical late cycle

Global views and trends

Colin HARTE
 

Neutral on equities and underweight fixed income

Looking ahead to 2019

Investors face robust, but weaker global growth in 2019. The US economy has strong momentum: full-year growth is likely to be firm at around 2.6%, but weaker than the impressive 3% seen late in 2018. The eurozone should continue to expand at above its potential growth rate. As for China, we expect the slowdown to remain controlled thanks to policy measures that aim to support the economy without resorting to another rapid build-up of debt (Exhibit 1).

Overall, we see the US faring better than its chief counterparts, resulting in asynchronous growth. The main challenge will be maintaining the economic expansion as both fiscal and monetary policy become less supportive and as growth in the rest of the world slows.

Exhibit 1: We expect robust, but slower GDP growth rates in our central case

Exhibit-1-gdp-growth

Source: Bloomberg and BNP Paribas Asset Management, as at 21/11/2018

We see the balance of risks for growth and markets in 2019 as skewed to the downside. Investors face the risk of the US economy overheating amid low spare capacity, persistent growth challenges in Europe and further trade tensions between the US and China.

The risks of quantitative tightening

While the aggressive and unconventional monetary policies of recent years led to distortions such as persistently low asset price volatility, high risk-adjusted returns and historically tight equity and fixed income risk premia, these look set to unwind as central banks trim balance sheets and raise interest rates. ‘Quantitative tightening’ is gathering momentum. Central bank policies are being normalised, even if inflation rises modestly. Only a significant downturn would change their course. The Federal Reserve is leading this trend: US interest rates are now approaching ‘neutral’ levels.

As interest rates continue to rise and the effects of quantitative tightening become more visible, and with valuations in many markets looking more stretched, investors should brace for higher volatility and lower buy-and-hold returns. Investors should get used to the idea that government bonds will not necessarily protect portfolios against equity downturns.

Geopolitical tectonic shifts

We believe that the Sino-US tensions are likely to be escalating and de-escalating over time and need monitoring. Should they lead to renewed market stress and pressure on trade volumes, it is global growth, and emerging market growth in particular, that could suffer.

In Europe, the dispute between Italy and Brussels needs to be monitored closely, too. The main risk is that Italian sovereign debt suffers to the point where investor concerns over debt sustainability or anti-euro political rhetoric revive talk of a eurozone break-up. This would damage the region’s growth prospects and risky asset valuations, including the euro.

A flexible asset allocation

In light of our central scenario, we prefer to be neutral on equities and underweight fixed income. We expect upside to equity markets in early 2019, but we are more cautious further out as tighter monetary policy and fading US fiscal stimulus could be a headwind.

In fixed-income markets, we prefer to express our underweight in eurozone government bonds as we see scope for a greater upward correction in yields than in the US. This is due to the stark valuation difference (Exhibit 2) as well as the fact that the ECB’s QE distorted the European bond market much more than the Fed’s QE did in the US. As such, we see greater risks in European fixed income as the ECB begins to normalise policy.

Exhibit 2: German yields have decoupled from US yields

Exhibit-2-german-yields

Source: Bloomberg and BNP Paribas Asset Management, as at 21/11/2018

We would underweight high-yield credit at this stage of the cycle, especially in the US, since spreads are tight currently and the asset class is vulnerable to quantitative tightening and slower growth.

More volatility can equate to opportunities, so we have become more tactical and reactive. Since markets may see material reversals, we are ready to turn more defensive if needed. We are closely watching our in-house technical indicators and market dynamics analysis to identify potential moves that may not be visible in the macroeconomic fundamentals.

As we explained above, some of the current risks are political in nature and are rooted in de-globalisation forces that are unlikely to disappear soon. Instead of trying to anticipate events, our scenario forecasts give us a distribution of market outcomes in risk environments, enabling us to take positions that could improve portfolio performance should an alternative scenario materialise or be discounted by investors.

This is an abbreviated version of 2019 OUTLOOK: MANAGING AN ATYPICAL LATE CYCLE.

For the full version, click here >

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