- Our Investment Outlook 2019Our Investment Outlook 2019
Our Investment Outlook 2019 provides a roadmap to navigating the months ahead. For equities, we provide an overview of all sectors. We believe that technology will remain a strong driver. For fixed income, we examine the relatively rare phenomenon of a US yield curve inversion (when US short-term interest rates exceed long-term interest rates). And we discuss how to establish a successful currency strategy comprising carry, value and safe-haven currencies.
From the point of view of macroeconomics, several factors may well prolong the economic cycle and speak against an imminent global slowdown. Productivity gains and benign inflation will be key for central banks’ monetary responses and hence financial markets.
Last but not least, our special focus section is devoted to what has excited us most in the last two years: our longterm Supertrends, five investment themes that offer superior return prospects. Furthermore, we showcase education as part of our efforts in sustainable and impact investing, a market that has been seeing rapid growth as investors increasingly seek to combine financial returns with a social and environmental impact.
We wish you a successful year ahead!
- Interview with Michael Strobaek
- Interview with Nannette Hechler-Fayd’herbe
2018: The year when trade shifted
& global security
is a fairly stable USD.
- Keeping inflation under controlGrowth momentum in advanced economies seems strong enough to extend the cycle into 2019 and beyond. The more important question for markets is whether inflation will remain as benign as it has been. If inflation rises significantly more than markets (and we) currently expect, the US Federal Reserve (Fed) will be seen as being behind the curve. Bond yields would further increase significantly, while equities and other risk assets would likely decline substantially. Barring an unlikely surge in productivity, wage growth will be the key driver of inflation.
- US dollar stabilityGyrations of the USD tend to destabilize the world economy and financial markets. USD strength, as seen in H1 2018, can put severe strain on economies that require cheap dollar funding. Significant USD weakness puts pressure on export champions such as Germany and Japan. It also raises the specter of inflation as commodity prices tend to rise sharply in response to a weak USD. The best of all worlds is a fairly stable USD. With Fed tightening well advanced, and the European Central Bank as well as the Bank of Japan gradually catching up, chances are good that the USD will indeed be stable.
- China’s resilienceUS trade policy is putting considerable strain on China. Moreover, after the USA recently renegotiated trade agreements with Mexico, Canada and South Korea, and amid de-escalating trade tensions with Europe, the US trade stance towards China could harden further. China’s patience is thus likely to be additionally tested. If its policy makers proceed cautiously, as in 2018, risks of instability should be limited and the expansion can be extended. Aggressive currency policy, credit easing or foreign policy, would be destabilizing, however.
- Calmer European politicsEurozone growth is expected to remain above potential in 2019, thanks in part to still loose monetary conditions. We expect political stresses to calm down to some extent. The exit of Britain from the European Union (EU), slated for 29 March 2019, should not do much harm to either side if handled wisely. In Germany, the ongoing political realignment is unlikely to cause instability, as the influence of the extreme parties remains limited. Meanwhile, we believe that Italy and the EU will ultimately find a compromise over the country’s budget deficit while reaffirming Italy’s euro membership.
- Emerging markets rebalancingEmerging markets (EM) entered the financial crisis with fairly healthy balance sheets. After 2008, cheap USD funds seduced EM, especially corporations, to substantially boost their foreign currency borrowing. Yet with the costs of USD liquidity rising in 2018 as a result of a more hawkish Fed, stresses emerged and some EM currencies suffered severe setbacks. At the end of 2018, there were indications that internal and external balance was being restored, in part with the support of the International Monetary Fund. If that process continues in 2019, EM can recover and global investors would benefit.
- Tech and healthcare innovationsTechnology stocks have been the dominant driver of global equity markets in the past decade. The MSCI World IT sector has outperformed the overall market by approximately 200% since March 2009. Social media, online shopping and ever more elaborate hand-held devices have taken the world by storm. An important question for investors is whether growth in this sector will remain this strong, with the emergence of new areas of focus such as virtual reality and artificial intelligence. A second key sector that is likely to influence the fate of equity markets is healthcare, with investors keeping an eye on gene therapy and other innovative treatments.
- Different growth tracksDifferent growth tracksThe impact of US fiscal stimulus will likely peak in the course of 2019, but growth should remain above trend on the back of robust corporate capital expenditure, hiring and wage growth. In China, however, we are likely to see growth slow toward 6%. US tariffs, sluggish manufacturing investment and slowing consumption growth are likely to act as constraints. In Europe and Japan, still lax monetary conditions should help maintain moderate growth momentum. But in a number of emerging markets, growth looks set to remain subpar as policymakers focus on inflation and currency control.
- Inflation on the moveInflation on the moveNotwithstanding higher capital spending, capacity constraints are likely to tighten further in most advanced economies. Given declining unemployment and intensifying labor shortages, wage growth should continue to pick up. Despite a moderate recovery of productivity growth, core inflation is thus likely to gradually move higher, with commodity prices an upside risk. Central banks will continue to respond in varying degrees, depending on domestic and external constraints.
- Eye on emerging marketsEye on emerging marketsHow high is the risk of renewed economic and financial instability? In many advanced economies, not least the USA, the unsustainable trajectory of government debt is the major longer-term risk. However, barring instability in Italy, a crisis seems unlikely because balance sheets of households and banks have improved since 2008, while corporate balance sheets have only modestly deteriorated. In China, high debt levels should slow growth rather than spark a crisis. Stress is more likely to resurface in financially fragile emerging markets.
- Fiscal stimulus reducedFiscal stimulus reducedOur base case for 2019 sees a moderate slowdown in global GDP growth relative to 2018, chiefly due to fading policy stimulus in the USA and policy tightening in EM ex-China. While certain aspects of the US tax reform should continue to enhance household cash flows and remain supportive for companies, the impact of US fiscal stimulus is set to diminish. Across other advanced economies, we expect fiscal policy to be largely neutral apart from minor stimulus in Japan, and possibly the Eurozone. In contrast, many EM governments will likely be forced to tighten fiscal policy.
- Companies keep investingCompanies keep investingBarring a significant worsening of the global trade conflicts – or other triggers of greater uncertainty – we expect corporate capital expenditure (capex) to continue to expand in 2019. The need to adapt supply chains in response to tariffs may itself trigger some investment spending. Corporate investment is key to extending the cycle as government stimulus fades.
- China in a holding patternChina in a holding patternChina’s strong foreign asset position and low inflation give its policymakers more leeway in their actions than in many EM. At the same time, given the high debt levels of state-owned companies and local governments, Chinese policymakers are likely to refrain from returning to aggressive credit stimulus. Instead, they are likely to do “just enough” to prevent US tariffs from significantly depressing growth.
- Upside and downside risksUpside and downside risksOf course, there are both downside risks and upside risks to our base case. On the downside, country-specific issues such as Italy’s fiscal situation might weaken Europe’s growth outlook. A sharper-than-expected slowdown in China would most affect other Asian economies, but would also impact Europe.
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- More money in workers’ pocketsMore money in workers’ pocketsAccording to our base case, core inflation will rise modestly in the USA, Eurozone and several other developed economies in 2019 as capacity constraints tighten. By late 2019, unemployment rates in the USA and Europe will likely approach 20-year lows.
- Beware the inflation “jokers”Beware the inflation “jokers”Wage inflation does not translate directly into price inflation. Other costs, including interest expenses and input costs (especially for raw materials such as oil) are key drivers of headline inflation. The significant increases in oil prices in 2007 and 2008 as well as in 2011 were the main reason why headline inflation rose at the time. If our global growth scenario holds, the price of oil and other cyclical commodities could rise further in 2019. Interest costs are also likely to creep up.
- Emerging markets take a different pathEmerging markets take a different pathIn emerging markets (EM) inflation may take a different path than in advanced economies. After 2011, inflation in EM diverged from the advanced economies as growth remained robust in the former and weakened in the latter following the Eurozone crisis. Inflation in EM then declined on the heels of lower oil prices and weakening growth in China.
- Interest rates to riseInterest rates to riseThe base case of continued economic growth and moderately rising inflation suggests that monetary policy will tighten in most advanced and some emerging economies in 2019. At the time of writing, the futures market implied that the Fed funds rate would end up below 3% by the end of 2019. This would imply one to two further rate hikes in 2019, after a likely hike in December 2018, taking the real Fed funds rate to about 1%, broadly in line with our forecast.
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- US households in better shapeUS households in better shapeThe chart presents a “spider web” for a relatively broad range of US economic and financial indicators that allow for a differentiated risk assessment.
- Eurozone juggles high debt, low growthEurozone juggles high debt, low growthIn the Eurozone, the key vulnerabilities – i.e. the fiscal balance and member countries’ external balance – have improved substantially compared to 2007. The key issue for the Eurozone is high government debt, especially in Italy, coupled with low economic growth.
- Emerging markets: The strong outnumber the fragileEmerging markets: The strong outnumber the fragileThe fragilities in EM as a group are fairly limited, in our view. However, the reliance on foreign savings was significant in selected countries, notably Argentina, Turkey and South Africa, and should have been seen as a warning sign. Yet the external imbalances are less serious in other key countries such as Brazil, Mexico or Indonesia. Compared to the 1990s, the situation has in fact improved dramatically.
- China curbs appetite for debtChina curbs appetite for debtChina is in a special fiscal situation: central government debt is not very high, but debt of state-owned enterprises and local governments has increased sharply since the financial crisis. Household sector debt is also elevated compared to household incomes. As most of China’s debt is denominated in domestic currency and debts of strategic sectors are backed by the central government, we see the risk of a financial crisis as quite limited.
- Crisis risks are still rareCrisis risks are still rareIn conclusion, we believe that the potential for financial instability is lower in most countries and sectors than before the 2008 financial crisis. The exceptions are select EM where the corporate sector is more vulnerable due to fairly high levels of foreign currency debt. In the case of China and the USA, where corporate debt is also high, the exposure is largely in domestic currency and thus less risky. In the Eurozone we note a significant improvement in the financial stability metrics, but continued political risks.
Regions in focus
The ties that bind: Regional performance in an interconnected world
- Anticipating asset trendsAnticipating asset trendsUS financial markets entered a late stage of the economic cycle in 2018, characterized by rising interest rates combined with a flattening yield curve. Our base case for 2019 foresees only a moderate further increase in US yields. This suggests that US fixed income investors should prepare to lengthen duration. In core bond markets outside the USA where yields are far lower, duration should remain short. In credit, the risk-return trade-off looks better for high yield than for investment grade bonds. Equities should continue to outperform on the back of robust earnings growth. Emerging market (EM) assets, which came under pressure due to tighter US monetary conditions, should regain ground as long as the risk of US rate hikes and USD strength abates.
- Pockets of growth in certain sectorsPockets of growth in certain sectorsDespite some wobbles, technology stocks continued to outperform in 2018. We expect economic growth to normalize in 2019. But in line with late cycle patterns, growth stocks should generally continue to outperform. This should include the healthcare sector, especially if companies achieve breakthroughs in areas such as gene therapy. Some cyclical sectors like capex-oriented industrials should be buoyed as well. In Europe, depressed financial stocks should benefit from rising yields, while in the USA, the flattening yield curve will likely weigh on the sector. Real estate stocks may also remain under pressure due to rising interest rates.
- Where to for currencies?Where to for currencies?In 2018, the USD made moderate gains against the other major currencies, but appreciated significantly against a number of EM currencies. Going into 2019, we have a neutral view on EUR/USD. While the yield gap continues to support the USD, the start of monetary policy tightening outside the USA is likely to work against the currency. Valuation continues to speak in favor of the GBP as well as a number of EM currencies, some of which are also supported by a greater carry advantage. Among safe havens, we favor the undervalued JPY over the more expensive CHF.
- Why the US cycle matters mostWhy the US cycle matters mostThe US economic cycle still matters most for global financial markets. While the US economy now represents slightly more than 20% of the world economy (and less than 15% adjusted for differences in purchasing power), the US equity market still constitutes 54% of the global equity market (MSCI AC World). And while the US high grade bond market, at 41%, represents a smaller share of the global bond market, US bond yields are a key driver of global asset markets, as the USD remains the largely undisputed global reserve currency.
- Brighter outlook for emerging market bondsBrighter outlook for emerging market bondsAs for the non-USD bond segment, emerging markets (EM) are likely to be most affected by US interest rate developments. Indeed, 2018 provided a stark reminder that tighter USD liquidity can put severe strain on EM assets. Yet if our base case materializes and pressure on the Fed to tighten policy eases, EM hard currency bonds should outperform. Insofar as a less aggressive Fed reduces pressure on EM currencies, EM local currency bonds should also do well.
- Equities still offer potentialEquities still offer potentialIn a late cycle phase, equities typically continue to outperform most asset classes. Thus, equities should still be favored unless valuations become too stretched or a contraction takes shape. That being said, the performance of different sectors may diverge substantially depending on their sensitivity to interest rates. As for investment styles, momentum stocks tend to do well late in the cycle. This should benefit large leading sectors such as IT, one of our preferred sectors at the time of writing.
- Chinese demand should support commoditiesChinese demand should support commoditiesMost commodities, except for precious metals, tend to be highly cyclical assets. In most cases, they continue to do reasonably well in late cycle periods. But a significant rise in interest rates and a stronger USD tend to slow the ascent of commodity prices. Given our fairly moderate scenario for interest rates and the USD, this factor should not play a dominant role in 2019. As long as China’s all-important demand for commodities holds up, cyclical commodities should remain supported.
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- Consumer: E-commerce is the new normalConsumer: E-commerce is the new normalThe consumer sector should benefit in our base scenario of continued robust growth and tight labor markets, though China and the trade dispute are key risks. In China, big ticket items such as autos are likely to remain under pressure, while structural growth trends, such as the expanding middle class, should support luxury goods including cosmetics and high-end alcoholic beverages.
- Financials: Structural challenges remainFinancials: Structural challenges remainGrowing demand for loans in most advanced economies should prove beneficial for financial stocks. In Europe, a further steepening of the yield curve in anticipation of the European Central Bank’s rate hikes should also be beneficial, while further curve flattening in the USA could act as a drag. However, national regulations, weak balance sheets and inadequate provisioning are slowing the much needed consolidation of the European banking sector.
- Industrials: Set for late cycle growthIndustrials: Set for late cycle growthValuations of the industrials sector are at a cycle high, but growth in EPS and revenues should benefit if economic growth remains robust, as we expect. The capital goods subsector should be lifted by the recovery in the mining, oil and gas and industrial construction industries. The sector should also benefit from innovation in the automotive sector and further investment in robotics across industries.
- Materials: Shifting production and product trendsMaterials: Shifting production and product trendsIn steel, we expect production to keep improving on the back of strong demand. Environmental concerns in China should boost demand for higher-quality iron ore to reduce pollution. As China takes capacity out of the market and shifts to higher-quality iron ore, the global supply for steel should remain balanced in 2019. In the chemicals sector, China is shifting from coal to gas as a raw material input.
- Utilities: The evolution towards greener and cleanerUtilities: The evolution towards greener and cleanerRising interest rates could put further pressure on the valuations of regulated utility companies, especially in Europe. Regulated utilities also have to digest new tariffs for regulated returns in Spain and the UK. In addition, investors will focus on the ongoing shift towards renewables in electricity generation portfolios as costs are falling to competitive levels. Thermal power producers are benefiting from nuclear power plant closures in Germany and Belgium as well as expected coal plant closures across several countries.
- Political twists in the roadPolitical twists in the roadIn 2018, political events also impacted certain currencies. The escalating trade tensions between the USA and China depressed the RMB, while the close economic links of Japan and China may have prevented the attractively valued JPY from appreciating. In Europe, worries over Italian fiscal policy temporarily boosted the CHF, while the GBP swung back and forth with every twist in the road leading to Brexit. Looking to 2019, we do not think that the US-China trade conflict will be resolved quickly. As a result, the RMB may remain under pressure. Insofar as the Chinese authorities continue to ease monetary policy, this trend is set to persist. Yet we believe that China will proceed cautiously to avoid triggering investor uncertainty and capital outflows.
- EM currencies look more attractiveEM currencies look more attractiveThe developments of the past year appear to have produced a situation in which value and carry overlap for a number of currencies. Investors may thus be able to generate excess returns after a disappointing 2018. Among the advanced economy currencies, the GBP, NOK and SEK looked clearly attractive based on our valuation screen as we went to press. Among EM currencies, the TRY and MXN seemed attractive. The NZD and CHF appeared expensive, while the only EM currency that looked expensive was the THB.
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