Macro: A Soft Landing
A Soft Landing for the U.S. and the Wider WorldVerdict: PARTIALLY CORRECT
Our soft-landing thesis remains intact, but we have been surprised by renewed U.S.-China trade tensions and the stubbornly strong dollar.
What we said: We anticipate that U.S. GDP growth will slow from 3.5% to around 2.0 – 2.5% in 2019, and some of the tail risks associated with the U.S.-China trade dispute will dissipate. We believe that U.S. wages will continue to rise, squeezing corporate earnings, but the inflationary effect will be partly offset by lower commodity prices. This would all help to dampen the past year’s dollar rally and moderate global liquidity conditions, and would support a re-convergence of the rest of the world’s growth rates with those of the U.S.
What we’ve seen: Consensus forecasts for 2019 growth are coming in at around 2.5%. Strong employment data through the opening months of the year have been accompanied by steady wage inflation, and this year’s U.S. earnings growth looks unlikely to exceed single digits. After a strong start to the year, crude oil declined by 16% in May. We have also seen slightly higher GDP growth in Europe and Japan than in the U.S. The path to a U.S.-China trade deal has proven rockier than anticipated, with a breakdown in talks remaining a key risk to an economic soft landing. Supported by the global “carry trade,” the dollar has been surprisingly resilient; but a more dovish Fed may contribute to depreciation by year-end.
A Recovery Beyond U.S. ShoresVerdict: PARTIALLY CORRECT
Our China call was a good one, but renewed U.S.-China trade tensions and the weakness of the recovery in Europe so far this year have been disappointing.
What we said: We expected the U.S. to diverge from the rest of the world in 2018, but were perhaps surprised at how early, how severe and how long-lasting that divergence has been. As the U.S.-China trade dispute cools and China’s fiscal stimulus takes hold, however, we believe the signs of recovery we already see in Japan, Europe and the emerging world will grow and enable some re-convergence, confirming our view that these economies are still mid-cycle relative to the late-cycle position of the U.S.
What we’ve seen: Our positive call on China has proven a good one so far this year. After some poor early data releases, we saw signs that stimulus measures were helping credit activity, as well as improvements in Purchasing Managers’ Indices. Elsewhere, our view has yet to be fully realized, in part because any recovery in Japan and Europe depends heavily on the stabilization of China and reduced trade tensions. In Europe, unemployment, GDP, services and consumer confidence have improved, though manufacturing has struggled. The potential for that weakness to affect consumer confidence is a substantial risk, and one to add to global trade tensions and Brexit.
Central Banks Press On With Balance Sheet ReductionVerdict: INCORRECT
While balance sheet policies remained unchanged as we went to press, the potential for change marked an emphatic dovish turn to central bank messaging.
What we said: The Federal Reserve will proceed more cautiously with interest rates than anticipated, but we do not expect any change to central banks’ approaches to balance sheet management, which means liquidity conditions overall will become tighter. At the European Central Bank, we anticipate balance sheet policy will also proceed as expected, with rates on hold until after the summer.
What we’ve seen: The Federal Reserve’s messaging has become more dovish even as the markets have doubled down on that dovishness. If anything, the Fed chairman has gone further than we anticipated by refusing to push back unambiguously against the 2019 rate cuts that have been priced into futures markets. Similarly, the ECB has confirmed that rates will likely be on hold until after the summer and potentially well into 2020. Both the ECB and Fed have hinted at changes to balance sheet policy.
Political and Policy Spotlight Falls on EuropeVerdict: PARTIALLY CORRECT
The major European risks remain live, particularly Brexit and the question of Italy’s fiscal stance, but we have been surprised by the worsening trade tensions between the U.S. and China.
What we said: Last year saw important elections in the emerging world and the U.S., and a worsening of the trade dispute between the U.S. and China. Trade, China’s growth trajectory in general and the potential for noise out of Washington now that the Democratic Party has control of the House of Representatives still pose risks. Nonetheless, the confluence of Brexit, the Italian budget, the populist turn in the east, a weak government in Spain, and the end of the Merkel era in Germany and the Draghi era at the ECB make it likely that Europe will steal the political and policy spotlight in 2019.
What we’ve seen: The sudden deterioration of the trade negotiations with China in May kept eyes focused on the U.S. Meanwhile, the U.K. and European Union avoided a chaotic hard Brexit and populist parties failed to break through in either the Spanish or European Parliament elections. That said, Brexit tensions have been postponed, not cancelled, while one key populist, Italy’s Deputy Prime Minister Matteo Salvini, emerged emboldened from his budget tussle with the European Commission, pushing up Italian bond yields.
Fixed Income: The Pause That Refreshes
The Fed Pauses for the First Half of 2019Verdict: CORRECT
The Fed has not hiked rates; if anything, the lack of inflationary pressures has led to an even more dovish stance than we expected.
What we said: The Fed is likely on hold for at least the first half of the year. The temptation to combat signs of inflation in the pipeline remains strong. However, if the U.S. experiences a soft landing and moderate risk-asset market returns in 2019, it will be in no small part because the Fed resisted the impulse to overshoot with tightening.
What we’ve seen: When we articulated this view, it was not a given that the federal funds rate would be the same in June as it was in January. Despite a strong showing from risk assets, it is, as of this writing. If anything, gloomy pricing in government bond markets, disappointing economic data and very subdued inflation have led to a much more dovish stance from the Fed.
Credit Drivers Begin to Change (Again)Verdict: PARTIALLY CORRECT
Markets have yet to demand a more cautious stance from corporate borrowers through price signals, but we do see finance officers anticipating that pressure.
What we said: Last year, we anticipated that continued low default rates would lead to credit spreads being impacted less by fundamentals and more by technical developments, and that was the case until October and November of 2018. At that point we saw the market become more discerning with respect to both sectors and individual issuer creditworthiness, and we expect that to be a key theme throughout 2019 as U.S. growth slows. We see particular opportunity in medium-quality credits in the short and intermediate parts of the curve.
What we’ve seen: While there have been few obvious signs of fundamental credit deterioration or differentiation in spreads, we are beginning to see issuers address the market in ways that indicate sensitivity to lender fatigue. For example, a number of large BBB-rated companies responded to challenging operating results with aggressive actions for the benefit of bondholders, including dividend cuts and asset sales. In addition, the recent increase in net new high yield bond issuance (including more secured securities) and decline in net new leveraged loans appear to reflect a decision by some companies to avoid the reputational taint of reduced investor protections in the leveraged loan space.
Equities: Attractive Valuations Are Back
U.S. Equity Returns Will Be Determined Primarily
Year-to-date equity returns have been strong despite only modest earnings growth.
What we said: If U.S. equities in 2018 were about strong earnings growth balanced by shrinking valuation multiples, we envision 2019 flipping that around. As the cycle continues to mature, the range of possibilities widens, but the base case is for top lines to be under pressure from slowing U.S. growth while margins are squeezed a little by wage inflation, offset by some multiple expansion from what is now a modest base.
What we’ve seen: By midyear, the forward price-to-earnings multiple of the S&P 500 Index was 16.8, up from just 14.3 at the start of the year. Over that time, the index total return was more than 18%. Earnings growth and dividends account for around three percentage points of that gain, with the rest coming from multiple expansion. It remains to be seen whether the equity market can sustain some of its momentum through the second half of the year, but the consensus for 2019 earnings growth remains stuck in single digits.
The Real Value Will Be ex-U.S., Especially
Emerging markets lagged U.S. equities through the first half of the year, although the picture improves when onshore China A shares are considered.
What we said: Late-cycle dynamics with moderate multiples could help the U.S. perform better than expected, but even lower multiples and mid-cycle dynamics in Japan, China and the emerging world arguably make them a better source of value. Given our views on heightened political and policy risk in Europe, we think emerging markets provide the most attractive opportunity if you are not forecasting a major global slowdown for 2019.
What we’ve seen: We remain convinced that the rest of the world offers more attractive value than the U.S.: At midyear, the S&P 500’s forward price-to-earnings ratio of 16.8 compared with 14 for the MSCI Europe Index and 13 for the MSCI Emerging Markets Index. Investors have not responded to that opportunity so far, however. Since the start of the year, the S&P 500 was up more than 18%, the MSCI All Country World ex-U.S. Index was up 13%, MSCI Europe was up 17% and MSCI Emerging Markets was up 10% in local currency and close to 11% in dollars. Meanwhile, the onshore A-share China Securities Index 300, whose stocks are not fully represented in the MSCI Emerging Markets Index, was up 28.5% year-to-date by mid-June.
Alternatives: Investors Will Renew Their Search for Something Different
Greater Appetite for Uncorrelated StrategiesVerdict: INCORRECT
Many investors are interested in managing risk and seeking different returns, but alternative funds have not yet benefited.
What we said: Should the market volatility and tighter cross-asset class correlations that characterized 2018 persist into 2019, achieving genuine portfolio diversification with traditional assets will become increasingly difficult. While many hedge fund strategies—though not all—gave back early gains late in 2018 as they got caught by crowded trades, we do not see this dampening appetite for uncorrelated and absolute return strategies, given these portfolio management challenges.
What we’ve seen: According to Morningstar, U.S. alternative funds experienced negative flows in the first quarter of this year, with no strategy group seeing a net inflow. Non-U.S. alternative funds also saw first-quarter outflows after five years of net inflows. This trend reflects the strong performance of risk assets after the volatility of 2018: The HFRI Fund Weighted Composite Index of hedge fund strategies was up over 7% by June 30 and the HFRI Equity Hedge Index was up 9.5%—an improvement on 2018 but not so impressive next to high double-digits from the S&P 500.
As seen in May, however, markets generally do not go up in a straight line. Moving deeper into this economic cycle, we think it makes sense to prepare for more bouts of volatility and high stock/bond correlations, including considering exposure to uncorrelated strategies.
Less Appetite for Traditional Private Equity BuyoutVerdict: CORRECT
The search for less-crowded opportunities in private markets is gathering momentum—we drop a point for arguably overstating the potential move away from traditional buyout.
What we said: Valuations and leverage in private equity buyout are now such that multiple expansion seems almost impossible. We expect investors to increasingly seek something different in their private asset strategies, such as the economic advantages that come from co-investments, niches such as royalty streams, and private debt managers that can position for the opportunity in stressed leveraged credit markets.
What we’ve seen: Recent flows data suggest that commitments to traditional buyout funds will be lower this year than last year, while flows into niche and non-traditional strategies and asset classes in private markets are increasing. That does not mean that investors are no longer interested in buyout, but in discussions with clients we hear a readiness to accept lower returns potential for lower risk by moving into other strategies.