- Global growth remains positive but has become more uneven, which is likely to continue to stir up market volatility.
- China has entered a growth recession, and policymakers face a variety of challenges that make it more difficult to incite a sustained reacceleration.
- US recession risks remain low, but late-cycle conditions are likely to prevail in 2019.
- The policy backdrop is likely to become more uncertain and less favorable in 2019, with monetary headwinds rising and trade policy remaining a source of uncertainty.
As we projected a year ago, 2018 will be known as the year the markets began to transition away from the low-volatility, mid-cycle environment that had generally persisted for several years. (See the Leadership Series article 2018 Outlook: Global Expansion to Continue, but Markets Likely More Volatile.)
In 2019, further maturing in the US and global business cycles is likely to heighten uncertainties and keep investors guessing about which of a variety of crosswinds will gain the upper hand.
Within that context, here is our outlook for major market themes in 2019 and their asset allocation implications.
More uneven global growth
- The synchronized upswing in global trade and industrial activity has given way to a more uneven environment that is likely to persist in 2019.
- Global growth remains positive, but the growth rate has passed its peak and the outlooks for major economies are more varied.
- Industrial bullwhips (leading indicators of manufacturing activity that measure the difference between new orders and inventories) have declined materially over the past year, remaining solidly positive in North America while dipping negative in the euro area and China.
- China slipped into a growth recession in late 2018 and its policy-easing measures so far seem insufficient to sustain a reacceleration.
- Chinese policymakers are caught in a difficult balancing act, facing weak growth but not wanting to overstimulate after a decade-long credit boom that left private sector debt at worrisome levels.
- The mixed signals of more prudent debt management and growth stimulus have blunted the transmission mechanism for monetary policy easing, leaving credit growth stagnant.
- Policymaking challenges are further complicated by US monetary tightening and uncertainty around US-China trade policy.
Late-cycle conditions in US
After a mid- to late-cycle transition phase over the past year, late-cycle dynamics are likely to dominate the US landscape as we enter 2019.
- Recession risks remain low, with US consumers continuing to benefit from improved job conditions and repaired balance sheets.
- Tighter labor markets continue to put upward pressure on wages, which serves as a headwind for corporate profit margins and a motivation for the Federal Reserve to focus on removing accommodation.
- Corporate profitability and cash flow should remain sturdy in 2019, but the pace of earnings growth will likely decelerate materially in the face of slower global growth, lower oil prices, a stronger dollar, and the fading impact of the 2018 tax cuts.
Policy crosswinds add to potential market volatility
While the Fed's rate hikes receive the most attention, the dominant policy theme for financial markets is the switch to global quantitative tightening that has reduced global liquidity growth.
- Major central bank balance sheets grew by nearly $2 trillion in 2017, a tremendous liquidity tailwind spurred by quantitative easing in Europe and Japan.
- In 2018, the Fed’s balance sheet wind-down and the European Central Bank's taper brought liquidity growth to near zero by the end of the year, and further reductions will turn this to an outright liquidity headwind in 2019 (see chart below).
Overall, a relatively constructive policy backdrop for US assets in 2018 is likely to become more uncertain and less favorable in 2019.
- The US corporate and economic backdrops will likely continue to receive support from deregulatory policies and fiscal stimulus, but the one-time boost to corporate profit growth from tax cuts will continue to fade (see chart below).
- The impact of global quantitative tightening and Fed rate hikes may move from a normalization phase to a more outright monetary headwind.
- US trade policies are likely to continue to be a source of uncertainty for both businesses and financial markets and exacerbate late-cycle pressures on inflation and profit margins.
Asset allocation implications
The sum total of the major macro trends described here is likely to be elevated uncertainty and potentially higher market volatility throughout 2019.
- The net trend appears to be an accumulation of headwinds, but there is tremendous uncertainty around crosscurrents and timing. Meanwhile, low recession risk implies it's too early to have high conviction in extremely bearish scenarios.
- Overall, our expectation is for this late-cycle environment to provide a less favorable risk-return profile for asset markets than during recent years.
- The historical business cycle road map suggests that relative performance among asset classes is much less consistent during the late cycle compared with the mid-cycle.
- This implies less confidence that riskier assets such as equities will outperform more defensive assets such as investment-grade bonds, due to their lower historical frequency of outperforming during the late cycle (see chart below).
- For a more detailed description of the late-cycle playbook, read Investing Strategies for a Maturing Business Cycle.
A maturing business cycle may influence relative asset performance patterns and can be used to help create portfolio tilts over the intermediate term, but it’s important to remember that cyclical allocation tilts are only one investment tool.
- Any adjustments should be considered within the context of long-term portfolio positioning, driven by the risk-return objectives of the overall investment strategy.
- Understanding the dynamics of a maturing business cycle may help investors manage and monitor risks, but cyclical tilts are typically not effective tools for rapid market timing or making wholesale changes to a portfolio.
- At this point, smaller cyclical tilts are warranted and diversification should be prioritized. Consider rebalancing closer to strategic portfolio weights (long-term asset allocation mix).
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