Earlier this year, we shared our long-term capital markets outlook for 2019 and the key five themes that framed our expectations. Now that we’ve hit mid-year, we want to explain how our thoughts on the original themes have evolved.
While we don’t recommend a rebalance right now, we do caution and advise against investors attempting to reach for risk, given the potential for slower growth, full valuations and macroeconomic uncertainty.
A few points to keep in mind:
Global growth slowed over the last six months. In April, the International Monetary Fund forecast of 3.3% for world Real Gross Domestic Product (GDP) growth in 2019 was down 0.3% from 2018. Some slowdown in the U.S. was expected as the benefits of tax-driven fiscal policy diminished; however, slumping exports and lower investment in emerging market economies also contributed to the slowdown.
GDP data is reported with a lag and is often subject to revisions. That’s why we monitor global Purchasing Managers Index (PMI) data, which reveals additional weaknesses in business activity across the globe. Given the modest, but expansionary level of business activity through June, we expect corporate earnings results and management guidance to play a more prevalent role in the second half of the year.
In response, the Federal Reserve and other central banks ended gradual and anticipated tightening of monetary policy. Central banks stand ready to deploy accommodative policy to support slowing growth.
Growth Remains, but on Less Stable Footing
Initial Key Observation – With fewer tailwinds, the pace of economic growth should abate and may weigh on corporate earnings estimates and fuel bouts of short-term volatility as investors react more dramatically to companies missing or beating consensus estimates.
Mid-Year 2019 Update – Economic data suggests the pace of global growth slowed during the first half of 2019; however, it remains on track with baseline expectations for slower, but positive real GDP growth. IHS Markit Purchasing Managers Index (PMI) Composite trends revealed a slowdown in global business activity in developed markets that began in July 2018. While it is difficult to determine if growth is set to rebound in the near term, confidence that central banks can contain the risks of slowing global growth anchored the rebound in risk-assets through the first half of the year.
Therefore, the most significant risk to this rebound and the recent decline in equity volatility is central banks losing control of this narrative. Fundamentals such as corporate earnings and forward earnings guidance can be particularly informative data points to monitor. As 2020 estimates begin to come into focus, investors will assess if already-reduced estimates are low enough.
Is This the Bottom?
Global PMI Composite trends show business conditions slowed through June, strengthening the case for fiscal and monetary policy accommodation.
Investors’ Earnings Growth Expectations Have Moved Lower
Earnings estimates for 2019 decreased as business conditions slowed in the first half of this year. Estimates for 2020 barely changed.
But Investors Still Expect Operating Margin Expansion
We are skeptical that U.S. firms can increase operating margins in a slow growth environment with tight labor market conditions.
Portfolio Impact – Despite the strong rebound in equity valuations, global business activity appears on edge. We caution against increasing a strategic allocation to equities and favor reassessing total portfolio risk tolerances.
Initial Key Observation – With global policy divergence slowing, the U.S. dollar is less likely to continue its incessant march higher, creating opportunities among various asset classes.
Mid-Year 2019 Update – In concert with slowing economic growth and expectations for Fed policy accommodation, market-implied measures have priced in almost three 25 basis point rate cuts by year-end. In contrast, the median forecast from Fed policymakers signals zero rate cuts in 2019.
That said, seven of the 17 Federal Open Market Committee (FOMC) participants forecast two 25 basis points cuts by year-end. We would expect the eventual outcome to fall somewhere in between, which should curb U.S. dollar strength longer-term as interest-rate differentials narrow. The short-term risk to this scenario would be if global growth continues to slow, other central banks ease further and foreign investors seek safety in U.S. denominated assets. These factors could put upward pressure on the U.S. dollar.
We will learn more during the FOMC’s July meeting.
The Path of Convergence Matters
The meaningful gap between Fed projections and market expectations leaves room for modest U.S. dollar strength. However, a clear path of more accommodative monetary policy and interest rate parity should weigh on the U.S. dollar long-term.
Resilient U.S. Dollar Strength
Despite a dovish Fed pivot in the first half of 2019, the U.S. dollar traded sideways through the first six months of the year.
Portfolio Impact – Increased probability for rate cuts in the U.S. and the Fed’s curbing of its balance sheet normalization program provide the opportunity for long-term investors to take advantage of foreign assets with more attractive relative valuations.
Volatility is Back
Initial Key Observation – Asset prices will likely be more sensitive to incremental information causing short-term volatility. Short-term volatility should not be confused with a decline in asset prices but should caution investors to avoid the temptation to react to short-term news.
Mid-Year 2019 Update – Volatility in 2019 has largely been to the upside as assets across the globe have moved higher. However, we believe this point stands as important today as it did in January.
As markets have moved higher, they have done so with deteriorating economic growth and lower earnings expectations. That means higher market prices have largely come on the back of investor sentiment in the form of higher valuations in anticipation of more accommodative monetary policy. Failure to meet these expectations without additional support from strong economic growth or earnings would most likely manifest itself in downside volatility.
Economic Growth Waning
Despite higher prices, PMI Composite data show business activity slowed year-to-date.
Portfolio Impact – We continue to believe that the low volatility of recent years is less likely to continue, and the stage has been set for normal (rather than the recently abnormally low) volatility. Portfolio allocations should remain thoughtfully diversified with this in mind; however, investors may need to reset their expectations through a clear discussion of potential implications normalized volatility may have on their account balances.
Be Cautious of Credit
Initial Key Observation – With downside risks to economic growth emerging and higher interest rates, investment- and non-investment grade corporate debt should be evaluated with greater skepticism. Today, lower-quality corporate bonds, within the investment grade market, constitute a greater proportion of the investment grade market and may not provide less downside protection during volatile periods. The non-investment grade market may struggle to refinance debt at attractive interest rates given higher financial or operational leverage.
Mid-Year 2019 Update – Corporate debt levels are growing, particularly in the lowest-rated segment of the investment grade sector. Expectations for Fed rate cuts and more accommodative monetary policy do not change our views on the sector. However, we acknowledge that the dovish pivot and yield-seeking investor behavior should give corporations cover to roll existing debt and issue new debt at lower levels for longer than expected.
Growth in BBB-Rated Corporate Debt
Lower-quality investment-grade corporate debt issuance now accounts for more than half of total investment-grade corporate debt outstanding.
Portfolio Impact – More tempered allocations to credit and the thoughtful utilization of active bond managers to navigate the level of quality in today’s market are prudent adjustments.
International Developed and Emerging Market Equities Remain Attractive
Initial Key Observation – Foreign markets are more attractive today than U.S.-based assets and offer an opportunity to enter or add to the asset class at reasonable valuations. However, valuation, growth and currency movements are not short-term catalysts and should be considered with a long-term time horizon.
Mid-Year 2019 Update – Trade tensions, U.S. dollar strength and political uncertainty in Europe remain sources for headline risk among international and emerging market equities, but relatively favorable equity valuations should reward long-term investors. Furthermore, as the trajectory of U.S. monetary policy tracks closer to global central bank policies, we have more conviction in foreign-denominated equities.
Global Equity Valuations
Lower valuations outside of the U.S. provide an opportunity for long-term investors.
Portfolio Impact – We continue to recommend thoughtfully adding to international allocations to take advantage of opportunities outside of the U.S.
It’s always wise to periodically re-evaluate your portfolio in light of market changes and your risk tolerance. If you have questions about this update on our 2019 Market Outlook or would like to talk about your portfolio, contact an advisor at Fi3.
 Source: World Economic Outlook (April 2019)