2018 was another eventful year for markets around the world, but what lies in store for the next 12 months for investors? Andrew Milligan, Head of Global Strategy, outlines Aberdeen Standard Investments’ 2019 global markets outlook. Here are five key takeaways.
Growth positive, but slowing
A mixture of monetary tightening by the US and China, trade tariffs and the effect of political uncertainty on business confidence has acted as a brake on the global economy. It’s the third deceleration of this post-2008 economic cycle, following the European Union monetary problems of 2012 and the collapse in oil prices and subsequent profits recession of 2015-16.
But a slowdown in growth is a world away from an actual recession. When we look at the global economy, we see that imbalances such as current account positions and debt levels are manageable for most countries. Technical indicators, such as the flat rather than the inverted US yield curve and the level of spread between corporate and government bond yields, appear to be at sustainable levels. Healthy cash flows also underline strength in company balance sheets.
One of our key assumptions is that core inflation will remain under control. Even if there are upward pressures on wages in countries such as Germany, Japan, South Korea and parts of the US, technological developments and the types of jobs being created in today’s “gig economy” should temper wage growth. Against this backdrop, the US Federal Reserve doesn’t need to raise rates more aggressively.
We expect the Bank of Japan to remain influential in supporting the global economy as the one major central bank that will continue to add liquidity next year. That’s important because if it withdrew its yield curve control and allowed Japanese bond yield to rise materially, that would have a knock-on effect globally. As it is, we expect the world economy to stabilise next year, backed by stimulus in China and fiscal easing in Europe.
We don’t anticipate a global recession until 2020 or possibly 2021 as the effects of US fiscal stimulus starts to fade.
The key questions for 2019 are: will the US Fed pause in its rate-hiking cycle – we think it will – and how successful will stimulus from the People’s Bank of China be in invigorating domestic, regional and global growth.
Volatility here to stay
The road ahead is littered with potential hazards for investors, from monetary tightening to trade disputes and political unrest. We anticipate further stock market corrections next year, just as in 2018.
Markets have already priced in further rate rises by the US Federal Reserve. Fiscal stimulus has ensured the US growth cycle is out of sync with the rest of the world. This has led to a divergence in monetary policies, with the Fed tightening as other central banks remain in easing mode or on hold.
As US conditions have tightened, the US dollar has appreciated, putting some developed and emerging markets under pressure. Economies with serious imbalances will continue to be exposed. We think global capital flows will be a more important driver of the US dollar than interest rate differentials in 2019, barring an inflation shock.
We do anticipate further US trade tariffs, on China and other countries, creating a headwind to global economic growth and causing another rotation among consumer, industrial and material stocks.
We also expect populism to be a factor periodically affecting cross-border capital flows next year. The benefits of structural reform and globalisation have not been shared equally, leading to political discord that disrupts markets.
Some countries appear attractive by comparison. Japan, for example, is a relative oasis of political calm, with the BOJ set to maintain easy monetary policy and the government likely to provide additional fiscal support.
A lot of bad news has already been priced in and we think markets will be able to recover from sell-offs. However, in these circumstances it’s important to adopt an active management approach and we will continue to search for diversifiers to help safeguard our portfolios from volatility.
Although our approach remains pro-risk, it is important to emphasise we have added some safe haven assets and inflation protection, as there are risks to our predicted shape of the global economic cycle.
Politics and geopolitics a swing factor
Investors require a deep understanding of politics and geopolitics to take a forward-looking view on financial markets. After all, Government policies are key drivers of economies, and economies drive markets over the long term.
The major risks that could foment uncertainty next year surround US foreign policy, particularly the broad US-China relationship, and the stand-off between Italy and the EU. The latter has particular implications for the Eurozone.
While we expect further US trade tariffs, with China and perhaps on autos, we don’t anticipate a full-blown trade war. If trade tensions pick up, they would provide a jolt to the world economy. To put things into perspective, US-China trade looks set to be worth about $600 billion, versus $17 trillion for trade worldwide.
Following the US mid-term election results, we think the likelihood of full-blown trade wars is less likely. Hence we see this problem as manageable.
It is broader US-China politics that offer the starkest warning signals. Evidently the US increasingly views China as a strategic competitor. The recent speech delivered by US Vice-President Mike Pence offered some telling insights into the potential policy approach of the US administration.
If that speech signposts a major deterioration in US-China relations – not just in trade, but in security, and the transfer of technology and intellectual property – then the political and economic climate would be transformed and investors would need to take cover. But as long as US-China discussions remain centred on trade, we think financial markets can cope.
Profits offset politics
While politics and geopolitics will remain important drivers next year, we continue to focus on company profits and the fundamentals that drive financial markets.
The main reason we are overweight risk assets in spite of volatile markets is corporate cash flows. We saw 25% year-on-year growth in US profits in the third quarter of 2018. By and large companies have been able to push through productivity growth.
Even if profit margins have started to come under pressure in some sectors, unless there is a major policy error or an inflation shock, we still expect to see healthy single-digit profit growth globally next year. That can revive business confidence and offset worries about politics.
The backdrop remains one of low rates and bond yields. The prospect of attractive dividend yields and share buybacks point investors towards equities rather than bonds. If profit growth does come through, we expect a recovery in risk assets as long as US-China relations remain stable.
Emerging market valuations look attractive provided we don’t see a major appreciation in the US dollar. Investors are already long dollar assets. If inflation remains restrained as we expect, the dollar should stabilise and possibly fall back if the Fed pauses next year.
Triggers to release company value that we will look to capitalise on include a stimulus package in China that points to an increase in activity, a relaxation in trade tensions, successful fiscal easing across Europe and signals that the US Fed is pausing its hiking cycle.
All these would be positive for developed and emerging markets.
China takes centre stage
There is a catalogue of key decisions facing Chinese authorities next year with implications for regional and global growth. How they deal with the nation’s debt overhang and the rebalancing of its economy are acid tests.
But Chinese policymakers operate within a largely closed capital account system, with mechanisms to continue transferring debt burdens between the corporate, financial and public sectors.
Even if China’s economic growth is slowing, authorities are pulling on fiscal, monetary and regulatory levers to safeguard stability. They have introduced a number of measures, including selectively re-opening credit taps. As an investor, we would like to see further stimuli to spur an acceleration in growth next year.
Cordial US-China relations will continue to be fundamental to the global status quo. If they nose-dive, that could send the global economy into reverse and decimate asset valuations.
We think the US will add further trade tariffs next year. But China’s economy relies far more on domestic consumption and services than exports now. Trade is not as significant a factor as it was.
Another key consideration will be China’s policy towards its currency. It doesn’t matter if the RMB goes through 7 to the dollar, it will be the speed of this advance that will matter. Whether authorities manage RMB depreciation or allow the currency to move down more rapidly will be a market trigger for investors to look out for.
We want to see continued reform of state-owned enterprises and internationalisation of the RMB to allow more cross-border capital flows. That would project confidence about China’s ability to manage its transition issues.
If presidents Xi and Trump reach an understanding and investors start to see the world as an attractive place to invest, we could see global investors move out of US securities into cheap developed and emerging market assets, in a repeat of 2017.
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