Macro: A Soft Landing
1. A Soft Landing for the U.S. and the Wider World
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.
2. A Recovery Beyond U.S. Shores
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.
3. Central Banks Press On with Balance Sheet Reduction
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.
4. Political and Policy Spotlight Falls on Europe
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 a lot of 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 European Central Bank make it likely that Europe will steal the political and policy spotlight in 2019.
Fixed Income: The Pause That Refreshes
5. The Fed Pauses for the First Half of 2019
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.
6. Credit Drivers Begin to Change (Again)
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.
Equities: Attractive Valuations Are Back
7. U.S. Equity Returns Will Be Determined Primarily by Multiple Expansion
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.
8. The Real Value Will Be ex-U.S., Especially in Emerging Markets
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.
Alternatives: Investors Will Renew Their Search for Something Different
9. Greater Appetite for Uncorrelated Strategies
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.
10. Less Appetite for Traditional Private Equity Buyout
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.
A Gentle Descent Back Into Balance
As 2018 drew to a close, the leaders of our investment platforms gathered to talk about the evolution of the investment environment over the past 12 months and the key themes they anticipate for 2019.
Erik Knutzen: It’s been said that mature part of the business and credit cycle is the hardest time to invest, and the volatility of 2018 highlighted the reasons. From here, market participants know that a late-cycle melt-up is always a possibility, but they are also starting to look over the horizon at recession risks, and the result tends to be heightened volatility and tighter asset correlations. We certainly saw that in 2018, really for the first time since the financial crisis. I think we would all anticipate similar dynamics in 2019, albeit with a low probability of seeing signs of recession over that period.
Brad Tank: In the fixed income team right now our main thesis is one of a “soft landing” for the U.S. and, by extension, global markets. We see U.S. GDP growth decelerating from 3.5% to 2.0 – 2.5%, and the Fed hitting the pause button for at least the first half of the year.
Joseph Amato: Should we be worried about a flat or inverted yield curve?
Tank: We don’t think so. Rates at the short end of the curve are certainly influenced by the Fed and the U.S. economy, but at the long end it’s all about global growth and inflation. A flat yield curve today is just the result of Fed rates being higher than rates in most of the rest of the world, which in turn is just a sign that these economies are at different points in the cycle.
Amato: In the U.S., it appears that we are closer to late-cycle than mid-cycle now. We see liquidity coming out of the system, and we can see the peak of the rate-hikes mountain through the mist. Global growth slowed through 2018, the U.S. is likely to slow in 2019. But as Brad says, it’s hard to generalize because we are at different stages of the cycle in different regions. Some of our research is starting to pick up on signs of recovery in non-U.S. growth. The data is not fully demonstrating that yet, but it’s part of our outlook for 2019, which is the main foundation for continuing with our overweights on emerging markets, both debt and equity, in our multi-asset class views. If we thought that global growth was going through a broad slowdown, then we wouldn’t maintain that sort of risk-asset exposure.
Anthony Tutrone: Does this include China? I think it has to, as what happens in China will determine much of the view on risk in Europe and the emerging world. All through 2018 what I was hearing about was weakening in China.
Knutzen: Right, and the two key risks I’ve found that our clients have been focused on are the risk of a Fed overshoot, which we should come back to later, and the risk of a hard landing in China.
Amato: Last year we anticipated that China’s structural reforms—President Xi’s pivot from pace of growth to quality of growth—could suppress short-term performance. That’s exactly what happened in the first half of the year, but since then the authorities are back in stimulus mode.
Knutzen: There are still big questions around China, both domestically and in terms of the trade tensions with the U.S. How strong and how effective will the stimulus be? Is there an effective transmission mechanism without pumping up bubbles in wealth management products and real estate? So far I think we have to give the benefit of the doubt: even as they seek to stimulate, they are not pumping up the old bubbles, there is still restriction of wealth management products, and still a desire to open domestic markets. Combine Brad’s “soft landing” in the U.S. with an effective stimulus in China and perhaps some easing in the trade tensions, and that could add up to a decent tailwind for re-convergence in non-U.S. growth and global risk assets.
Tank: There are risks out there that can conspire to produce a negative quarter or two—things like a total breakdown in talks between the U.S. and China, or growing political and policy risk in Europe—and while I don’t think negative growth will materialize in 2019, some of those drivers could make themselves evident. In terms of our views on non-U.S. markets, I think it’s important to recognize that the action on politics and policy in 2018 has been focused in the U.S., with the change in leadership at the Fed, tax cuts and the trade issue, and in emerging markets, especially Turkey, Argentina, Brazil and Mexico. There is no doubt that the Democrats getting back control of the House of Representatives could lead to a certain amount of mayhem if they launch a raft of investigations of the White House. But, overall, 2019 is likely to see the spotlight move more decisively over to Europe. Brexit is due at the end of March, Italy has to implement the budget it has agreed with the EU, a clash with the populist governments in the east is a possibility, the situation in Ukraine is worsening again, and we have the end of the Merkel era in Germany and the end of the Draghi era at the ECB. Who would have predicted, 18 months ago, when France was flying high on the Macron election, that we’d be seeing widespread civil disturbance and tear gas on the streets of Paris at the end of 2018?
Amato: The risks are real. Of course, the surprise could be that, as in 2012, Europe doesn’t implode, and an easing of tensions leads to economic and market recovery being realized. Overall, however, it supports the case for tilting toward emerging markets and Japan over Europe when looking for risk exposure outside the U.S. If you accept that recession probability is low in 2019, and if Europe gets through the year unscathed, you could stand to benefit through emerging markets without so much exposure to the potential downside risks.
Tutrone: How do lower oil prices relate to these views?