2019: Risks to the outlook
20 December 2018
2018 has been characterised by stable, positive growth, low inflation and slowly tightening monetary policy. So what might we see in 2019? Richard Larner, head of Research, Brooks Macdonald provides looks at the economic and market influences
At the start of 2018, we forecast that growth would remain positive across the world’s major regions throughout the year. We also expected inflation to remain under control, partly as a result of structural deflationary headwinds. This led us to anticipate that central banks would gradually withdraw some of the unprecedented policy support they have held in place since the global financial crisis.
The global growth backdrop remains supportive and inflation is under control
These hypotheses were largely proved correct. Growth remains positive around the world as we enter 2019, led by the US, where economic activity is being boosted by the effects of the government’s tax reforms.
Meanwhile, the Federal Open Market Committee (FOMC) has been successful in controlling US inflation, with core personal consumption expenditure inflation at the Federal Reserve’s (Fed) 2% mandate target level, the dollar’s strength and lower commodity prices are expected to weigh on price growth in the coming quarters.
The inflationary impact of rising wages is being absorbed by corporates via margin contraction and by stronger productivity growth helping increase overall output.
US growth may have peaked, but it should remain positive in 2019, even before any further fiscal stimulus
Nevertheless, questions remain over the sustainability of global growth.
The US economic cycle has matured further and there are tentative signs of cyclical headwinds developing in the economy’s housing sector, which generally provides a reliable leading indicator for the broader economy.
We are also cognisant that US unemployment has already reached low levels and that employment growth will eventually slow in time, removing one of the key supports of consumption growth.
For these reasons, we believe that US growth may have peaked in the middle of 2018, when the boost provided by the tax reforms was most potent and economic activity was being concentrated to avoid the effects of trade tariffs implemented later in the year.
Despite this, the strength of most leading indicators suggests that US economic growth will slow in the coming year, rather than begin to contract.
We also recognise the potential for the government to provide an additional boost to growth by implementing a large infrastructure investment programme; such a policy would be politically desirable for President Trump who will be reticent to let the economic cycle turn before the next Presidential election in 2020.
We expect China to succeed in stabilising its economy, dispelling fears of a ‘hard landing’
China, the world’s other key growth driver, has also shown signs of slowing in recent months.
This has weighed on sentiment towards Asia, the broader emerging market region and the commodity supply chains that support it.
However, much of the slowdown has been a result of China’s authorities tackling some of the structural problems facing the economy, most pertinently unsustainable credit growth and high pollution levels.
They still hold the financial firepower to support growth if it begins to decelerate too quickly and we believe they retain the will to do so.
Indeed, stimulus measures have already been enacted, including the loosening of certain lending and environmental restrictions, monetary policy stimuli and income tax cuts.
We are further encouraged by recent rhetoric from President Xi Jinping, which has suggested the government’s commitment to supporting growth and businesses’ development remains as strong as ever.
As such, we expect the government to succeed in managing the economy’s slowdown as it transitions from investment-led to consumption-driven growth and believe that fears of a more rapid and protracted slowdown are overdone.
Europe’s economy holds potential, but a number of political hurdles remain to be overcome
In Europe, there remains scope for cyclical expansion, with many economies still failing to make use of significant levels of spare capacity.
We are optimistic that the US’s 2018 growth acceleration will eventually have a positive effect in Europe and the world’s other major regions.
A stabilisation in China and other emerging markets would be also beneficial for Europe’s large export sector.
However, the region’s growth continues to be held back by a lack of reform and political issues. Chief of these are Brexit and Italy’s fiscal situation, each of which hold the potential to have significant adverse impacts on economic activity in 2019.
We acknowledge that the investment backdrop is becoming more challenging
While the global economic environment generally remains positive, it is important for investors to acknowledge changes that have occurred in the investment backdrop.
In aggregate, the world’s major central banks are shifting policy from quantitative easing towards quantitative tightening, with the Fed leading the way.
US policymakers have raised the Federal Funds Rate (upper bound) from 0.5% at the start of December 2016 to 2.25% at time of writing and the Fed is now, and is expected to continue, reducing the size of its balance sheet by the sizable monthly rate of $50bn.
The European Central Bank (ECB) is also moving slowly away from ultra accommodative policy now that its Governing Council has judged the threat of deflation to have decreased on the Continent. It will end its own monthly asset purchases at the start of 2019 and is expected to begin raising interest rates in the second half of next year.
However, policymakers will be wary of derailing their economies
Despite this, central bankers will remain mindful of the many economic risks still inherent within the global economy.
In the US, policymakers have highlighted the risks associated with tighter monetary policy, fading fiscal stimulus and slower overseas growth, while also suggesting that the path of monetary policy should become more data dependent now that the Federal Funds Rate is approaching the FOMC’s estimate of its long-run neutral level (around 3.0%).
Our core expectation is that US monetary policy will tighten only gradually, which should ensure that any market impact will be muted in the absence of a protracted growth slowdown.
However, we are wary that there is no reliable precedent as to what will occur as the Fed removes liquidity by reducing the size of its balance sheet, particularly if overseas banks begin to do the same; it is possible that this will continue to put upward pressure on yields and the US dollar.
As such, the threat of tighter US monetary policy remainsa key risk for asset markets.
We expect policy to remain most supportive outside the US, where economies are showing fewer signs of overheating
Outside the US, we expect policy to remain accommodative.
In the eurozone, ECB President Mario Draghi has committed to keeping interest rates at their current levels until at least the summer of 2019 to support the bloc’s economic recovery.
Likewise, Japanese monetary policy is expected to remain expansionary, with Shinzō Abe’s ‘Abenomics’ reform programme expected to remain in place now that he is likely to stay on as Prime Minister until 2021.
The UK provides a more uncertain situation because of Brexit
The path of UK monetary policy will depend on the strength of the economy, which will be heavily influenced by Brexit developments.
We see scope for further rate rises in 2019 in the event of a favourable outcome in the Brexit process, be this a Withdrawal Agreement being passed or a second referendum leading to ‘no Brexit’. Conversely, we see scope for rate cuts and more quantitative easing in the event of a no-deal scenario playing out, albeit it will be difficult for the Bank of England to loosen monetary policy further if sterling is under pressure, as a result of the adverse implications for consumption (via higher inflation and lower real wage growth).
The US’s economic leadership will be under threat as the rest of the world plays catch up
One of the themes of 2018 was the outperformance of the US economy over the rest of the world.
In 2019, we expect this dynamic to reverse as US growth decelerates and growth outside the US improves. If this occurs, it could undermine the dollar. In turn, this could mitigate some of the stress that the US currency’s strength caused in 2018 and raise sentiment towards some of the affected areas; we would expect the emerging markets, and particular Far East equities, to be among the greatest beneficiaries.
The threat of protectionism may reduce in 2019
Another development that could raise sentiment outside of the US and undermine the strength of the dollar would be a de-escalation of trade protectionism.
Indeed, there are tentative signs that such a shift is beginning to occur, with the US and China having agreed a trade war ceasefire following President Trump’s meeting with Premier Xi Jinping at the G20 summit in early December. However, China’s appetite for greater geopolitical influence remains strong and this will continue to put it at loggerheads with the US in the coming years.
It is also clear that policies aimed at containing China’s advancement enjoy bipartisan support in the US and we cannot rule out further escalation of the risks associated with protectionism in the future.
Nevertheless, we believe the recent ceasefire is symptomatic of both presidents needing to boost their domestic political capital and our central expectation is that it is unlikely there will be a re-escalation of US trade protectionism against China before the next presidential election in 2020.
Overall, we do not yet believe there has been a systemic deterioration in the investment backdrop
It is clear that tighter US monetary policy is a key risk facing asset markets, with the early-October bout of market weakness catalysed by Fed Chair Jerome Powell’s comments that US interest rates were a ‘long way from neutral’. However, the Fed backed away from this more hawkish-than-expected stance in the final months of the year, as inflation expectations were tempered and cyclical growth headwinds appeared in some areas of the US economy. As such, we do not believe that expectations of tighter US monetary policy are likely to derail markets in the near term, but we recognise that market volatility is likely to remain elevated as the global monetary policy backdrop shifts further from quantitative easing towards quantitative tightening.
Corporate earnings should continue to find support from the positive global growth backdrop
A key factor supporting our constructive view on asset markets is that we expect the global growth outlook to stabilise or possibly strengthen in the first half of 2019. This should help businesses continue to achieve the strong financial performance that has been the key support to equity markets in 2018.
We also see scope for further market upside if some of the risks that have weighed on markets in 2018 are seen to be diminishing, as appears to be the case with trade protectionism.
Our asset allocation reflects these views
Given our macroeconomic view, the sector-specific headwinds facing bond markets and relative asset-class valuations, we retain our preference for equities over fixed income.
Within equities, we continue to prefer growth assets, particularly those linked to our favoured technology and healthcare themes, over value.
We expect fixed income markets to be weighed by slowly tightening global monetary policy. Furthermore, the treasury market faces the headwind of rising US government debt issuance in the second half of 2019 and this could have negative ramifications for bond markets globally.
However, within fixed income we are most cautious on credit markets. There has been a significant increase in corporate leverage over the last few years, particularly among smaller-capitalisation companies, as businesses have sought to take advantage of the low interest rate environment to take on debt.
Meanwhile, there has been a simultaneous deterioration in the quality of bond issuance throughout credit markets. Both of these factors add risk to the sector, in which valuations are already high.
Given the many risks to the outlook, we continue to endorse a balanced approach to portfolio construction incorporating alternative income-producing assets, such as structured investments, to increase portfolio diversification.
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