- Further maturing in the US and global business cycles is likely to heighten uncertainty in 2019.
- Global growth remains in expansion, but the outlook has deteriorated and activity levels have likely passed their peak.
- US recession risk remains low, but late-cycle conditions have taken hold.
- The Fed raising policy interest rates suggests to us that if labor markets remain tight, the Fed may be inclined to continue reducing monetary accommodation.
During 2018, markets transitioned away from the low-volatility, mid-cycle environment that had generally been in place for several years. In 2019, we believe further maturing in the US and global business cycles is likely to heighten uncertainty, including in the policy arena where monetary conditions have become less favorable. Elevated volatility is likely, warranting smaller cyclical allocation tilts and a prioritization on portfolio diversification.
See our interactive presentation for in-depth analysis.
Most major asset classes posted negative results in 2018. US stocks' double-digit decline in Q4 led to their worst year since 2008, though they still outperformed non-US equities. After rising throughout the first 3 quarters to their highest levels since 2011, 10-year Treasury yields dropped during Q4 amid the equity sell-off and concerns about global growth. Rising credit spreads helped further spur higher-quality bonds to outperform riskier credit in 2018. For the year, the modest rise in bond yields was attributed to higher real borrowing costs, while inflation expectations dropped alongside the steep decline in oil prices, which pulled down commodity prices generally.
Economy/macro backdrop: Global growth less synchronized as manufacturing cools
Global growth remains in expansion, but the outlook has deteriorated and activity levels have likely passed their peak. Industrial "bullwhips" (leading indicators of manufacturing activity) declined materially over the past year, dipping negative in the US, China, and the eurozone—the world's 3 largest industrial economies.
China's policymakers face a difficult challenge in attempting to exit the country's growth recession, but they do not want to over-stimulate after a decade-long credit boom that left private sector debt at worrisome levels. With credit growth stagnant, China's current policy-easing measures appear insufficient to sustain a reacceleration.
Further, a budding US-China geopolitical rivalry represents a critical risk to the highly integrated global economy. China's slowdown, in addition to global monetary tightening and trade policy uncertainty, weighed on the industrial sectors in Europe and elsewhere.
Meanwhile, US recession risk remains low, but late-cycle conditions have taken hold. The late-cycle phase typically moves an economy past its peak rate of growth and tends to be less homogenous than other phases. Historically, late-cycle phases have ranged in length from less than a year to more than 2 years. In general, tight labor markets and rising wages tend to lead to tighter monetary and credit conditions and narrower profit margins.
The US consumer remains strong amid low unemployment, accelerating wage growth, and manageable financial obligations. Historically, consumer and business spending has grown in late cycle, falling only after the onset of recession, whereas housing construction has tended to decline ahead of recession.
As the cycle matures, tighter labor markets tend to pressure wages upward and generate headwinds for corporate profit margins. Corporate tax cuts and record share repurchases fueled earnings growth and rising expectations during 2018. Growth in 2019, however, is expected to decelerate materially amid slower global growth, a stronger US dollar, lower oil prices, and fading effects from 2018’s tax reforms.
In Q4, the US Federal Reserve raised policy interest rates for the ninth time this cycle, further reducing the gap between long- and short-term bond yields. Over the past 6 tightening cycles, the Fed has responded to low unemployment and rising wages by continuing to hike rates, even after the yield curve became negatively sloped. This suggests to us that if labor markets remain tight, the Fed may be inclined to continue reducing monetary accommodation.
As the Federal Reserve shrinks its balance sheet by about $50 billion per month—and with the European Central Bank (ECB) having ended its quantitative easing in December 2018—growth in major central bank balance sheets should turn negative in 2019. After unprecedented post-crisis global monetary easing, the shift toward monetary tightening is turning into a liquidity headwind that may keep asset market volatility elevated.
A relatively constructive policy backdrop for the US corporate sector during 2018 is likely to become more uncertain and less favorable in 2019. Less constructive trends include the fading boost from corporate tax cuts, the impact of global quantitative tightening, the cumulative drag from trade policy uncertainty and higher tariffs, and medium-term concerns about the trajectory of the US fiscal deficit.
Although the global economy remains in expansion, late cycle typically moves the economy past peak growth. In addition, elevated volatility may be driven by risks to the monetary, political, trade, and economic outlooks. We believe the current environment warrants smaller asset allocation tilts.
Asset markets: Risk-off quarter led to weak year for asset returns
All major equity indexes retreated for both the quarter and the year. Small-cap stocks led the decline during Q4 in both US and non-US developed markets. Gold had a strong quarter, and investment-grade bonds also posted positive results. The collapse in oil prices dragged down energy stocks along with other inflation-sensitive assets.
Historically, late cycle has exhibited the most mixed performance of any business-cycle phase and, for a diversified portfolio, has featured more limited overall upside compared with the mid-cycle phase. Average returns for most categories have been positive during late cycle, but historical patterns provide less confidence that riskier assets such as equities will outperform more defensive assets such as investment-grade bonds.
US earnings growth continued to improve on a trailing 12-month basis, helped by corporate tax reform enacted early in 2018. Non-US developed- and emerging-market profit growth, however, moderated from high levels. Forward estimates point to expectations for healthy but slower profit-growth rates for all 3 markets over the coming year.
The steep drop in US stock prices has pushed valuations below their long-term average for the first time in several years. P/E ratios for international developed and emerging markets remain lower than those for the US, providing a relatively favorable long-term valuation backdrop for non-US stocks. The US dollar generally stabilized during Q4 after a sharp run-up during the first half of the year.
We see the dollar's valuation as relatively mixed against many of the world’s major currencies.
In fixed income, credit spreads widened materially across all major categories during Q4, particularly in riskier segments such as US high-yield debt, and ended 2018 at levels above historical averages. Investment-grade spreads were 60 basis points higher for the year and 68 basis points above February's post-crisis low.
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