Stock markets sold off in the fourth quarter, capping a volatile year. The declines in equities were only part of the negative story. The proportion of asset classes that ended 2018 in the red was unprecedented as major global stock, bond, currency, commodities and even hedge fund averages lost money. This challenging situation was driven by two structural transitions: from quantitative easing to quantitative tightening, and from a globally synchronized to a multi-cycle growth dynamic. In 2019, we believe the global economy will reconnect and resume a more balanced posture as the Federal Reserve pauses rate hikes and allows the U.S. to ease into a “soft landing,” and China’s renewed stimulus supports recovery in the rest of the world. We still expect central banks to shrink their balance sheets and political risks to persist, but this restoration of sustainable global growth, together with simple mean reversion, would likely give us market outcomes that are more positive—and more diverse—than last year’s.
When the Asset Allocation Committee (“AAC” or “the Committee”) met this time last year, we were talking about 2018 being “a game of two halves.” We sensed that the prevailing environment, characterized by synchronized global growth, historically low financial market volatility and positive calendar-year returns for almost every asset class, could not last. In the event, volatility jumped in February, emerging markets endured a severe summer sell-off, and economic activity outside the U.S., especially in Europe, slowed earlier and more persistently than expected.
However, it was during the fourth quarter that self-doubt really took hold in the markets. Equities sold off again, credit markets went with them, oil slid into a bear market, U.S. Treasury yields retreated and almost inverted the curve, and the put-to-call option ratio hit bearish levels not seen since 2008. As the table below indicates, almost no form of long-term investment was compensated during 2018—a worse result even than in 2008.
Such a structural outcome in markets is likely to have structural origins. We think investors are struggling to navigate two transitions within the current business cycle: from quantitative easing to quantitative tightening, and from globally synchronized growth to a multi-cycle dynamic in which the U.S. has been pulling away from the rest of the world. As we entered the fourth quarter of 2018, the AAC acknowledged that we were at a “critical point” in the cycle.
Three eventful months later, do we share the market’s lack of confidence?
No, we do not. We have reaffirmed our bias toward global stocks, increasing our exposure to developed markets equities, as well as other markets with higher risk-adjusted return outlooks, such as emerging markets, segments of credit, and commodities. This reflects the twin pillars for our core outlook: we still expect QE to become QT, but especially after its rate hike in December, we expect the Federal Reserve to pause, facilitating a “soft landing” for the U.S. in 2019; and we believe that the market underestimates the ability of China to successfully stabilize its growth trajectory, and with it the rest of the world.
If we are right, the net result could be a re-synchronization of global growth at more sustainable levels, and some mean reversion in the pricing of financial markets.
A Soft Landing for the U.S.
The Committee members see little risk to the Fed’s balance sheet policy—or the European Central Bank’s (ECB), for that matter. Treasury yields are in check as increased supply is being met by robust real-money demand, and in the event of a growth disappointment there are rates-related levers to pull before QT is abandoned.
We do think the Fed will now pause for at least the first half of 2019, potentially introducing one or two more rate hikes later in the year. Wage inflation is ticking up, but not feeding into broader headline inflation. Lower oil prices are also helping to ease that pressure. The Fed has also made clear its willingness to tolerate slightly higher-than-target inflation.
At the end of 2018, markets abruptly shifted to pricing for a marked slowdown in the U.S. economy. We remain more confident in the central bank’s ability to prepare a soft landing.
Our forecast is for U.S. GDP growth to slow from around 3% in 2018 to 2.0 – 2.5% in 2019. That would represent a return to post-crisis trend growth, which is what the rest of the world experienced last year. It is therefore a more sustainable level of growth which, together with the Fed pause, could extend the cycle well into 2020. It suggests substantially lower earnings growth for U.S. equity investors as tax cuts fade and wages rise, but leaves an increased possibility of multiple expansion—especially after valuations fell to below their historical average towards the end of 2018.
China Could Stimulate the Rest of the World
Outside the U.S., economic activity started slowing a year ago; as a result, China, in particular, has adopted stimulus policies again. A lack of domestic demand and the background trade tensions with the U.S. could still prevent that stimulus from gaining traction, but our central scenario sees China’s slowdown stabilizing this year.
This would likely improve business sentiment and activity in the developed economies outside the U.S., supported by lower energy costs. We anticipate only a gradual recovery in oil prices, as production from U.S. shale producers partly offsets OPEC supply cuts. While Q3 2018 data out of Japan and Germany was weak, this was largely due to a collapse in diesel auto sales in Germany, and a combination of catastrophic floods and preparations for the forthcoming consumption-tax hike in Japan, all of which are likely to fall out of next quarter’s data. In addition, both the Bank of Japan and the ECB look set to remain accommodative.
Political risk remains quite pronounced in Europe, and therefore, on balance, the Committee has a bias toward Japan and emerging markets in its positive view on non-U.S. regions, at least in the short term, while we await clarity on these risks. (See “Up for Debate: Where is political and policy risk most likely to blow up in 2019?”)
After the signficiant sell-off in the fourth quarter of 2018, the Committee has upgraded equities in the U.S., seeing outsized opportunities in developing countries.
A tilt in favor of emerging markets and commodities could be interpreted as a very confident, “risk-on” or “high-beta” view.
That is not really the case, however. While some Committee members felt that a positive view on cyclical and trade-oriented markets should imply a similarly favorable outlook for cyclical and value stocks in the U.S., overall, as in credit, the AAC believes that a preference for value over growth should be married with a focus on quality, which will become increasingly important.
Moreover, the AAC’s favorable view of stocks outside the U.S. and commodities says more about their potential for mean reversion—emerging markets sold off hard last summer and oil prices collapsed in the fourth quarter.
“Bottoming out is not a one-day event,” as one Committee member put it. “It might be counterintuitive, but I think it started in October, because that’s when emerging markets bounced. The outperformance of emerging market debt, currencies and equities through the volatility of the fourth quarter ought to build confidence.”
While the AAC expects pessimism to lift from markets and global growth to re-synchronize to some extent, the underlying reality of mature-cycle volatility and relatively tight correlations is likely here to stay. Persistent tail risks include political events, trade tensions, signs of disinflation, and the fact that anxiety can periodically spike simply because “slow growth” can sometimes feel like “no growth.” The Committee favors adding risk, but cautiously.
Helpfully, credit spreads have widened enough to make corporate bonds viable for the first time in a while. The broad U.S. high yield market is yielding more than 7%. As such, while the AAC still prefers global equities over global bonds and regards developed market government bond yields outside the U.S. as too low, we have upgraded our views across the credit sectors.
We still consider this opportunity to be particularly attractive at the short and intermediate end of the credit curve, and would describe it as favoring higher-quality issuers in high yield, alongside some of the more attractively priced investment grade names. A portfolio built in this way could reach a 5 – 6% yield profile, which would be attractive in a slowing-growth environment beset by event risk.
For the same reasons of high volatility and stock-bond correlation, the Committee remains favorable toward hedge funds. Many failed to capitalize on the conditions set up last year, often being wrong-footed by whipsawing in trades that had been strongly trending, such as value stocks versus momentum stocks, and certain parts of commodity futures curves. Nonetheless, we believe the fundamental background is still supportive. Private markets were downgraded to neutral to reflect the high valuations and overstretched leverage in many traditional buyout deals, but the Committee still sees opportunity available in the broader sector. (See “Up for Debate: Are private markets overstretched?”)
Back into Balance
The end of 2018 was almost a perfect mirror image of the end of 2017. A year of synchronized global growth gave way to a year of surprisingly persistent growth divergence. A year in which seemingly all financial assets went up gave way to a year in which an unprecedented number went down. A year of historically low market volatility gave way to a rollercoaster ride.
The fundamentals of mean reversion would suggest that 2019 is likely to pitch itself somewhere between these two extremes, even if the AAC’s fundamental economic and market views did not fully support the same thesis. As it stands, we anticipate a soft landing in the U.S. and a moderate recovery elsewhere, extending this record-breaking cycle through the end of the year, and supporting a positive, but still volatile environment for risk assets.