We expect the market and macroeconomic environment this year to be determined by the degree to which tightening financial conditions impact heavily indebted borrowers.
My 2018 outlook did not make for particularly cheery reading: I suggested that the withdrawal of central bank liquidity would reveal structural problems associated with excess debt, deteriorating demographics and poor productivity – ultimately weighing on risk assets.
Unfortunately for markets, that bearish view came to pass with some ferocity.
In my 2019 outlook I note that over the longer term, technological developments should partially offset the economic drag from excess debt and weak demographic trends. But over the shorter term, we believe large corporate borrowers left behind by such technology shifts are particularly vulnerable to quantitative tightening, the reversal of years of accommodative monetary policy.
This means that if economic activity slows, there could be downward pressure on corporate credit ratings, possibly triggering a wave of downgrades that investors may struggle to digest. Many of these issuers are traditional companies that employ a lot of people, adding to the economic gloom.
A stabilization of the macroeconomic backdrop could prompt a decent market recovery, however, resulting in (temporary) tradable rallies. But I would be wary of ‘catching a falling knife’.
Central banks are in a bind
The last time that monetary policy tightening resulted in a growth scare, back at the beginning of 2016, markets were saved by central bankers turning the liquidity taps back on. Today, however, policy makers makers are far more constrained.
And despite a change in tone of late from the Federal Reserve (Fed) – which has more room to ease than other major central banks – the US economy would probably need to get worse before the monetary guardian intervenes with a significant policy response.
We believe all this entails the following market implications:
Interest rates are likely to remain very low in Europe, Japan and the UK
Weakening growth prospects should keep a cap on longer-term US yields, spurring curve-flattening before an eventual bull-steepening as growth concerns build
A cautious approach to equity exposure makes sense, in our view
Credit is likely to remain under pressure, but there should be opportunities to invest in viable entities at distressed levels
The outlook remains structurally dollar-bullish as liquidity conditions tighten; this context may be more positive for dollar-denominated emerging market debt versus local currency paper
There are obvious downside risks for sterling and growth-sensitive UK assets, but valuations are more aligned to this observation than 12 months ago
Commodities would likely be impacted by disappointments in economic growth. A new stimulus programme from China would clearly be very positive, though
But there are also tail risks – extreme events that fall outside what is normally expected, such as a renewal of Europe’s debt woes in earnest. Such events could spark significant price dislocations (also presenting opportunities for investors to deploy portfolio liquidity to pick up potential bargains).
Against this backdrop, we are focused on managing risk to achieve long-term financial goals. At the same time, we continue to integrate environmental, social and governance factors into our investment processes, as we believe that by doing so we can help to mitigate a wide range of risks for investors other than those posed by the macroeconomic outlook.
Considering if and when China’s economy will bottom out this year is one of the most pertinent questions for investors. Credit growth has historically been the best leading indicator for Chinese activity, so what is it saying this time around?
Will 2019 be the year the US finally decides to repair its crumbling infrastructure? Probably not. Nevertheless, in the Asset Allocation team we have bought a basket of stocks that are exposed to US public infrastructure spending. Confused? Let me explain.