In brief

Significant US economic outperformance is unlikely to persist through 2019 as the sugar rush of the fiscal stimulus wanes. Growth in the major developed economies looks set to reconverge over the course of 2019 to a more lacklustre pace by recent standards, thanks in large part to Washington’s more hostile approach to trade. Companies globally are deferring investment and becoming more hesitant about hiring.

Corporate earnings growth should also converge towards a slower, yet still positive rate of growth. Equity investors may wish to seek more regionally diversified portfolios and to reduce risk by focusing on quality, larger cap stocks in historically defensive sectors.

The US Federal Reserve (Fed) may become more data dependent and rates are unlikely to rise much beyond the middle of the year. More sluggish growth may hinder the European Central Bank’s (ECB’s) attempts to normalise policy. Global monetary conditions will remain relatively loose, providing some solace for investors who had been concerned about the Fed hitting the brake.

UK investors face the greatest conundrum. A resolution to the current Brexit impasse will be good for the economy, but is likely to challenge Gilts and internationally focused UK stocks in 2019.

Navigating a market cycle is a bit like flying a plane. The dangerous bit—the part you really need to get right—is the take-off and landing. Investors need to have a closer eye on the controls and not be distracted by the usual turbulence as we pass down through the clouds.

A MOMENT OF RETROSPECTION

What exactly went wrong in 2018? Markets started the year full of optimism. The US economy delivered stellar performance, buoyed by tax cuts, which caused a surge in both growth and corporate earnings. The unemployment rate hit an almost 50-year low. The upward drift in inflation was gradual, so there weren’t many surprises from the Fed, which hiked rates by 25 basis points per quarter. Global quantitative easing wound down, beginning a reversal of the great search for yield. This challenged fixed income across the board, but not dramatically so (see On the Minds of Investors – Should we worry about quantitative tightening?1).

What proved considerably more disruptive in 2018 was US foreign policy. Undeterred by the threat of higher costs for US consumers and businesses, Washington ramped up trade tensions. It seems that there is considerable political appetite among the US electorate, and as a result both Republicans and Democrats, to reconsider US trading relationships, with China very much at the eye of the storm.

This trade aggression hit the Chinese economy at a point when growth was already slowing rapidly in response to tighter policy from Beijing. The emerging markets have thus endured the double whammy of slowing growth in China and rising borrowing costs as a result of higher US interest rates. Emerging market equities and debt took a significant hit in 2018.

Europe has been caught in the crossfire. Although early tensions between the US and EU over auto tariffs have dissipated for now, European demand has been battered by a downturn in global trade.

Returns “Trumped” by geopolitics

EXHIBIT 1: ASSET CLASS RETURNS

% total return year to date in EUR

Source: FactSet, Barclays, Bloomberg, BofA/Merrill Lynch, FTSE, MSCI, TOPIX, Thomson Reuters Datastream, Standard & Poor's, J.P. Morgan Securities, US Federal Reserve, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 30 November 2018.

Strong growth in the US economy did not therefore trickle elsewhere as it has tended to in the past. The US economy, equity market, and dollar have been the relative bright spots in an otherwise dismal year (see Exhibit 1).

THE US FISCAL SUGAR RUSH WILL FADE

We don’t believe significant US economic outperformance will persist through the course of 2019. The fiscal stimulus that provided an intense sugar rush in 2018 is expected to fade in the coming quarters, and overall US GDP growth is expected to moderate to less than 2% by the end of 2019 (see Exhibit 2).

The sugar rush of fiscal stimulus will fade in 2019

EXHIBIT 2: CONTRIBUTION OF FISCAL SPENDING TO US REAL GDP GROWTH

% points contribution to real GDP (quarter on quarter, seasonally adjusted annualised rate)

Source: Congressional Budget Office, J.P. Morgan Asset Management Multi-Asset Solutions, J.P. Morgan Asset Management. J.P. Morgan Asset Management Multi-Asset Solutions estimates as of 30 November 2018.

The tax cuts could have generated more lasting effects through increased business investment. But, in the face of geopolitical uncertainty, firms are now deferring investment. The effect has been most stark in Europe and Asia, but there is increasing evidence that capital expenditure intentions are fading within the US itself (see Exhibit 3). This is particularly disappointing because what the global economy desperately needs is stronger investment to revive potential growth, lift productivity and real wages, and in turn ease many of the political challenges.

The trade war is denting corporate enthusiasm for investment

EXHIBIT 3: US AND EUROPE FUTURE CAPITAL EXPENDITURE INTENTIONS

Index level, capex intentions over the next 6 months

Source: Dallas Fed, IFO, Kansas City Fed, New York Fed, Philadelphia Fed, Richmond Fed, Thomson Reuters Datastream, J.P. Morgan Asset Management. US capex intentions is an average index level of the five aforementioned fed districts equally weighted, displayed using a three-month moving average. Data as of 30 November 2018.

One potential solace for markets may come from the Fed. The recent decline in the oil price, alongside the strength of the US dollar in 2018, is likely to mean headline inflation remains close to the 2% target. We expect the Fed funds rate to edge closer to 3% by midyear, but believe the Fed will demonstrate that it is considerably more hesitant and data dependent in the coming months.

CHINESE AUTHORITIES ARE BACK ON THE ACCELERATOR

While fiscal stimulus in the US is fading, Beijing’s policymakers have put their feet firmly back on the accelerator to see off the impact of slowing exports. Local government bond issuance is now ramping up in a bid to fund domestic infrastructure projects (see Exhibit 4). The Chinese authorities face a difficult balancing act of maintaining the “quality over quantity” agenda and reducing excesses and leverage in pockets of the economy, but at the same time sustaining a sufficient level of growth to support employment. Easing measures will be targeted and of a smaller scale than in 2008, but we expect growth to remain supported in the region of 6%.

Stable growth in China will likely support neighbouring Asian countries, but elsewhere in emerging markets, growth and earnings are likely to continue moderating in reaction to the tighter policies that were deployed in 2018 to defend currencies. The outlook for emerging economies remains highly divergent.

The Chinese authorities are back on the accelerator

EXHIBIT 4: CHINESE LOCAL GOVERNMENT BOND ISSUANCE

RMB billions

Source: CEIC, Ministry of Finance of China, J.P. Morgan Asset Management. Data as of 30 November 2018.

BREXIT PROGRESS—BUT EUROPEAN POLITICAL CHALLENGES REMAIN

European corporates are plagued not only by geopolitical uncertainty but also by political challenges at home. At the time of writing, there is still considerable uncertainty about UK prime minister Theresa May’s ability to pass the Brexit deal through UK Parliament. Our baseline assumption is that the threat of either another referendum, or a general election, will eventually bind a majority in the House of Commons together and the deal will pass.

Beyond Brexit, there remain challenges for the European authorities in 2019. Centrist politicians are still struggling to head off populist parties. With critical European Parliament elections coming up in May, the risks are rising that Eurosceptic alliances will take a greater share of the vote. In which case, investors may become sceptical about both the longer-term prospects for integration as well as the ability of Brussels to provide meaningful leadership in the next downturn.

The stand-off between Brussels and Rome also looks set to continue. Italy is likely to be placed under an Excessive Deficit Procedure, but this is not a particularly rare occurrence. France has been in equivalent monitoring for 15 of the last 17 years (see Exhibit 5). We don’t expect Italy to consider leaving the euro, but the eurozone’s third-largest economy is slowing sharply as credit conditions tighten.

Excessive Deficit Procedures are not uncommon

EXHIBIT 5: YEARS SPENT IN EXCESSIVE DEFICIT PROCEDURE (EDP)

Number of years

Source: European Commission, J.P. Morgan Asset Management. Data as of 30 November 2018.

These political fragilities, together with a more lacklustre pace of growth, could limit the ECB’s ability to lift interest rates in the second half of the year in line with their current guidance. In which case, negative interest rates will continue to pose a challenge for the profitability of Europe’s banks for some time yet.

Although the eurozone domestic economy in aggregate looks fine for now and wages are rising, ongoing weakness in global trade is likely to deter firms from hiring, in the same way as they are slimming down investment intentions. However, the recent collapse in the oil price is supportive for Europe, and consumers are still showing appetite to spend (see Exhibit 6), so we expect European growth to hover at around 1,5% for much of 2019. That will be enough to see a sizeable narrowing between the performance of the European and US economies over the course of the year (see Exhibit 7).

Eurozone households are still planning on spending

EXHIBIT 6: EUROZONE CONSUMER CONFIDENCE

Source: European Commission, Thomson Reuters Datastream, J.P. Morgan Asset Management. Data as of 30 November 2018. The growth gap is likely to narrow in 2019

EXHIBIT 7: US GDP GROWTH DIFFERENTIAL WITH UK AND EUROZONE

% points real GDP (quarter on quarter, seasonally adjusted annualised rate)

Source: BEA, Eurostat, ONS, J.P. Morgan Multi-Asset Solutions, Thomson Reuters Datastream, J.P. Morgan Asset Management. Forecast from Q4 2018 from J.P Morgan Multi-Asset Solutions group. Data as of 30 November 2018.

ASSET ALLOCATION CHALLENGES

What does this global picture mean for various asset classes in 2019?

For equities, the convergence in GDP growth in the developed world should also coincide with a narrowing of relative earnings growth (see Exhibit 8).

In the US, margins are likely to be slowly eroded due to a combination of higher tariffs, wages, and debt servicing costs.

US corporate earnings outperformance unlikely to be as stark in 2019

EXHIBIT 8: EARNINGS PER SHARE GROWTH ESTIMATES

% change year on year

Source: IBES, FTSE, MSCI, Standard & Poor’s, Thomson Reuters Datastream, TOPIX, J.P. Morgan Asset Management. Earnings estimates are for the full year in local curency. Past performance is not a reliable indicator of current and future results. Data as of 30 November 2018.

The tech advantage the US has enjoyed has also lost at least some of its lustre as investors fret over the structural earnings potential of US technology giants, particularly in the light of increased regulatory scrutiny.

Altogether, an outperformance by the US stock market of the scale seen in 2018 looks unlikely, so regional diversification makes more sense. Given that 73% of FTSE All-Share earnings are made overseas, UK investors will also need to bear in mind the potential implications of a positive Brexit outcome, which would be likely to result in higher sterling, hitting repatriated earnings for large cap UK companies, even if they look attractive from a dividend yield perspective.

Valuations are no longer particularly lofty anywhere—at least on a forward price-to-earnings basis (Exhibit 9). Valuations in emerging markets look compelling, but there will need to be sufficient risk appetite for investors to confidently return to emerging market equities. A more hesitant Fed will help. The ideal backdrop for emerging markets is one in which US economic growth slows to 2% but stabilises. In the near term, however, investors are likely to be nervous about the prospects of a continued global slowdown.

The recent correction has lowered valuations across the board

EXHIBIT 9: GLOBAL FORWARD PRICE-TO-EARNINGS RATIOS

x, multiple

Source: IBES, MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Chart uses MSCI indices for all regions/countries, except for the US, which is the S&P 500. EM is emerging markets. Past performance is not a reliable indicator of current and future results. Data as of 30 November 2018.

Fixed income faces a number of challenges that investors will need to navigate carefully. At this stage of the cycle, when investors should be, and are, thinking about reducing the amount of risk in portfolios, it is natural to head towards the shelter of fixed income. But at this juncture, investors need to be careful about where in the fixed income universe they land.

The quality of investment grade benchmarks has deteriorated considerably in the past decade (49% of the US investment grade market is now BBB bonds, vs. 33% in 2008). Fundamentals in the high yield market are less worrying today, but concern about the durability of the recovery and the potential for higher defaults may also weigh on the sector in time. And it will be important not to underestimate the influence of quantitative tightening on both the volatility and the absolute level of yields in fixed income as central banks step away from their role of buyer of last resort.

European investors may need to be especially mindful about how fixed income will work to insulate a portfolio. Exhibit 10, from our Long-Term Capital Market Assumptions2 publication, captures the problem. The chart presents expected Sharpe ratios—so, J.P. Morgan Asset Management’s expected returns for various asset classes over the next 10 years, adjusted for risk. It shows quite clearly that, for US investors, government bonds are back. US investors can expect a higher risk-adjusted return from government bonds than equities, given that US rates have risen more than elsewhere. The same cannot be said for European investors. As the Fed has more room than other central banks to cut rates when the cycle ends, a global approach to fixed income investment will be key.

Longer-term return expectations, after adjusting for risk, still favour equities over bonds in Europe

EXHIBIT 10: EXPECTED ASSET CLASS SHARPE RATIOS

Source: J.P. Morgan Asset Management Multi-Asset Solutions, J.P. Morgan Asset Management. LTCMA is J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions publication. Data as of 30 November 2018.

The challenge for UK investors is most acute. A good Brexit deal may be good news for the economy and coincide with a bounce in growth in 2019. But it will pose significant challenges for those in search of asset returns, because stronger sterling will likely drag on the FTSE’s international revenues, while a faster pace of interest rate normalisation will weigh on government bonds.

Currencies: As US growth differentials fade, the market is likely to pay more attention to the structural challenges to the dollar from ever-rising government debt and a large current account deficit. The dollar is likely to nudge lower on a broad basis against European and emerging market currencies by the end of 2019, unless the slowdown does turn into something more globally systemic.

The shift against sterling is likely to be the most stark if we are right about the eventual Brexit outcome. We expect sterling to appreciate significantly when the Withdrawal Bill gets passed through UK Parliament, but only when the Bank of England acknowledges that rates will have to move more swiftly (see Exhibit 11) will we see the full extent of the upward pressure on the currency.

Brexit uncertainty has caused a wedge between UK and US interest rate policy

EXHIBIT 11: US AND UK GOVERNMENT BOND YIELDS

% yield

Source: Thomson Reuters Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 30 November 2018.

CONCLUSION

In 2019, the US economy is not expected to outperform on the scale it did in 2018, so a regionally diversified portfolio makes more sense, particularly given the potential for a change in the direction of the US dollar.

Although the risks to corporate earnings are building globally, for European investors the relative attractiveness of fixed income as an alternative to equities is limited. So we should be more conservative about the near-term returns we can expect to achieve from a balanced portfolio in 2019.

It will also be important to be wary of becoming over-reactive to political noise and opting for dramatic shifts in allocation. For one, decisions and sentiment can change quickly. The US and Chinese authorities could yet return to the negotiating table and stem trade tensions. Indeed, the more that bad news builds in the near term, from either the economy or the markets, the higher the incentive for politicians to consider a more amicable conversation.

At this stage, therefore, we would consider relatively small changes to improve the resilience of a portfolio. Within equities, look for regional diversification and consider moving to larger cap stocks, with a bias towards quality and value styles over growth. Fixed income should play a greater role, but be selective and consider alternatives such as macro funds to add ballast to a portfolio (see On the Minds of Investors – How should we prepare portfolios for the next downturn?3).

This flight may be getting closer to its destination. But those that adopt the brace position could lose sight of the controls, and the ability to make the most of the opportunities that present themselves in periods of turbulence.


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1 On the Minds of Investors – Should we worry about quantitative tightening? Vincent Juvyns, J.P. Morgan Asset Management, November 2018.

2 Long-Term Capital Market Assumptions, J.P. Morgan Asset Management, October 2018.

3 On the Minds of Investors – How should we prepare portfolios for the next downturn? Michael Bell, J.P Morgan Asset Management, October 2018.

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Karen Ward

 

Managing Director, Chief Market Strategist for EMEA

























































































































John Bilton


 

Head of the Global Strategy Team for the Multi-Asset Solutions Group.


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