The key issues as we set our sights on 2019 are the progression of the global economic cycle, the inflation outlook, US and euro area monetary policies, globalization and world trade, political risks, the corporate performance outlook, valuation levels and the status of emerging countries.Over the past few years global economic growth has been experiencing a strong and sustained recovery and the underlying trend continues to be positive. However, economic indicators for the first half of the year have fallen short of expectations and in 2018 GDP growth will not reach the anticipated level of roughly 4%. Many economists have lowered their forecasts for global growth due to political uncertainty and changes in global trade.
The long continued growth cycle is nearing it’s end
The US economy’s growth has become one of the longest on record and some sectors are beginning to show signs of overheating. Unemployment has fallen to 3.8%, a level last seen during the fast-paced years of the turn of the millennium. Before that, the last time unemployment was that low was in the late 1960s. A tightening labor market, growing private consumption and rising import prices further increase the risk of accelerating inflation. US consumer prices are currently rising at a rate of 2.7%.
With a fiscal policy that is quite light-handed thanks to President Trump, the economic outlook is positive. US economic growth is widely expected to only change course and enter moderate recession in 2020. All in all, the risk of recession has somewhat grown now in the USA but is not alarming. Continued earnings growth is a key outlook indicator and as yet there are no signs of its reversal.
Europe is changing but not as hoped
Europe is between a rock and a hard place. Political risks have risen again into a force decelerating effect. The main risks are British domestic policy, Brexit and Italy. In Germany, Chancellor Merkel now has less room for manoeuvre and in France, the popularity of President Macron is waning. The European elections in 2019 are unlikely to have any economic impact but they do reflect the general sentiment in Europe. The strengthening of nationalist views influences the actions of the EU as a whole and slows down the progress of structural reform.
China’s growth is expected to slow down slightly next year. An anticipated easing of fiscal policy will soften the impact of a slowdown in manufacturing and private consumption. In the trade war between the USA and China both sides will lose. The traditional model of economic relations where China produces and saves and the USA consumes and takes on debt is being reversed. As the Chinese economy grows, so does Chinese consumption. The question is, who will make the goods that the Chinese want? Trade tensions are unlikely to ease in the near future.
The fears of the impacts of political risks around the world will add to market volatility and may lead to ‘mini crises’. As far as known elections go, next year will be a minor year. Premature elections in Britain due to Brexit and in Italy, where the coalition Government may be at risk due to disagreements over the EU, may change this, though. In Italy, political risks are high.
The positive factors in our 2019 scenario are the sustained growth of the US economy, company earnings growth and China’s stimulus to combat the effects of slower foreign trade. In the positive scenario the world economy will adjust faster than expected to changes in global trade and robust economic growth will continue. Inflationary pressure is increasing, however, and central banks are not tightening their monetary policies quickly enough.
In our basic scenario adjustment and finding new trade structures will take time. Political uncertainties will sustain a cautious sentiment. Global growth may slow down slightly from the current level next year. However, the negative factors are expected to dissipate in a few years. Inflationary pressure will not increase until later.
In our negative scenario the global economy will suffer more lasting damage as investment dries up, manufacturing and consumer confidence weaken and payment defaults increase. Central banks have limited ability to correct such a situation.
Corporate earnings growth is slowing
A weaker global growth environment is slowing corporate earnings growth. On the global level, the economy should grow at about 3% to generate earnings growth. Earnings are especially high in the USA. The strong earnings growth experienced in the USA in 2018 will decline from the current level of over 20% to under 10%. In Europe earnings growth is still around 5% to 10%, with the Nordic countries slightly above this.
Equity market valuation levels will not be particularly high in 2019 given the expected profit performance. Forward Price-to-Earnings (P/E) figures have in fact declined somewhat in the USA and Europe.
On the other hand, we will continue to face headwinds in the emerging markets. A strong dollar, the Fed’s tightening monetary policy and trade concerns will weaken local currencies and growth. China’s reduced economic activity will also have a negative impact. In some countries interest rates are up, which also slows growth. The deceleration of the growth cycle may nevertheless be only temporary and many economists expect another growth surge next year.
Higher inflation can give a surprise
Global inflation is beginning to rear its head. Western countries have reached a non-accelerating inflation rate level of unemployment (NAIRU), which will increase wage pressures and is feared to raise inflation. In the USA, inflation expectations have increased somewhat during 2018. Fear of rising interest rates is a major risk because inflation is accelerating and central banks will either raise interest rates or cut stimulus. An unexpected acceleration of inflation in 2019 may spook fixed income markets because central banks have so far reduced monetary stimulus only moderately. Long-term inflation expectations have nevertheless remained relatively unchanged.
The US Fed does have its foot on the brake, however. Its monetary policy has reached a neutral level. The Fed has been continuously tightening monetary policy since 2015, and is expected to make three to four more 0.25 percentage point rate raises in 2019. There are already signs that the US economy may turn but it is still premature to forecast weaker economic growth. From the present perspective the Fed will continue on its chosen path until circumstances take a more substantial turn for the worse.
The discontinuation of the ECB’s purchase programs is a prelude to the normalization of monetary policy in the euro area. As long as inflation remains low, the ECB does not intend to speed up the process. Underlying inflation has nudged slightly upward. The general assumption is that the refinancing rate will be raised closer to the end of the year and after this more raises will take place at a sluggish pace. Money market interest rates are only expected to rise above zero in 2020. There is still ample liquidity in the euro area. Choosing a successor for the ECB President Mario Draghi is adding another twist to the bank’s operations.
Value in corporate bonds
Nevertheless, euro-denominated corporate bonds are still boosted by the ECB’s monetary policy, a low frequency of bankruptcies and investors thirst for yield. Also, corporate indebtedness has not increased in any meaningful way in Europe and the supply of new bonds has been moderate. The issuer-weighted default risk of European High Yield bonds is 1.0%, which is below the 7-year average (1.7%).
The risk premiums of both Investment Grade and High Yield bonds are at the 20-year median level, which means that credit risk has been priced rather neutrally. Euro-denominated corporate bonds are also protected by their duration, which is on average more than two years shorter than government bonds; in other words, they have a lower interest rate risk. However, political risks are also the most serious risk for corporate bonds. The credit risk derivatives of bank bonds do not currently price disruption, which reflects banks’ improved capital adequacy. In our opinion, Nordic corporate bonds and B-rated issuers offer the best yield potential.
Text: Tomas Hildebrandt
Tomas Hildebrandt is a senior portfolio manager for institutional clients. He is a member of Evli’s asset allocation team and is also working as a market strategist. Tomas joined Evli in 1996 and has been working in capital markets for nearly 30 years.