As pronounced bouts of market volatility – in January/February and again in October – reminded investors in 2018, swings in sentiment are never far away, especially in times when “stars” such as a growth recovery, muted inflation and a pro-growth monetary policy are no longer aligned, as they were in previous years. Does that mean regime change looms in 2019? It probably does. Does that spell poorer times for investors? It does not have to, as a range of experts from BNP Paribas Asset Management argue in this Investment Outlook for 2019.
The issues persist, but there has been time to prepare
Broad-brush, some of the larger issues of 2018 will likely linger on in 2019. The US-initiated trade commotion should smoulder, keeping market concerns about its impact on growth and inflation alight. In the same corner, the wider US-China tussle for world hegemony and the accompanying tensions could well spark fresh geopolitical jitters in the markets, while Russia might seek to benefit from the rivalry, at a risk of fresh sanctions, possibly affecting its bond market and its banks.
Geopolitical clouds might also form out of the tension between Italy and the EU, spooking euro bond markets and the euro itself and fanning break-up concerns in a year that will marked by the UK’s departure from the EU in one form or another. The deal/no deal uncertainty should end by March 2019, though at the time of writing it is by no means what the divorce arrangements will look like, so it remains too early to discard the prospect of a disorderly split and its high-impact consequences, not just for UK growth and inflation.
In fact, though, those ‘unknowns’ are generally known and markets have had time to draft scenarios, so while extreme outcomes could set off volatility and drive investors to safe havens, this is not what we on the whole expect. Our central scenario for 2019 focuses robust, but weakening growth; gradually rising inflation; and continued monetary policy normalisation.
A shift in the paradigm? Yes, but still a benign environment
Does that represent a regime change? Well, it would in the sense that the decades-long bull market in bonds now looks to be definitely over and that on the side of equities, the US bull market – one of the longest in history – could increasingly be threatened. As the post-crisis recovery matures, the correlations between asset classes that investors have grown used to look set to unwind.
While this may sound gloomy, we believe the 2019 investment environment is in fact quite benign. Growth looks set to slow, but a recession is not in sight. In the US – the world’s largest economy – government and consumer spending should sustain growth, while for the runner-up – China – a slowdown to a growth rate of less 6% looks unlikely amid government action to offset any impact of the US trade tariffs. The recovery in the eurozone can be expected to continue.
Inflation remains caught between, on the one hand, some upward pressure from the (years of) economic recovery, falling labour market capacity – first and foremost in the US and gradually also in the eurozone – as well as trade tariffs and, on the other, the mitigating effects of technological advances and improved productivity. On the whole, muted inflation should remove any pressure on the leading central banks to do more than gradually take away the extraordinary post-crisis measures and return to normal monetary policy regimes slowly but surely. Here too, a sudden step-up in the pace and the size of interest-rate rises could upset markets, but this looks unlikely at this point.
Undeniable, but manageable risks
What then could be the risks to this scenario for 2019? The US economy could overheat, taking inflation to boiling point, but given that the US Federal Reserve is proceeding on the rate-rising path, albeit cautiously, such an outcome now seems unlikely. On the US trade action, it appears the risk of a globalised conflict has become more remote. Now that the Trump administration has concluded agreements with various international partners, the fears of widespread protectionism have receded, leaving the focus on the US-China tug of war. That should mean that tariff implementations by the two sides will have only a limited impact on (global) growth and hence financial markets.
Apart from a disorderly Brexit, political risk in the eurozone could become a meaningful issue. Italy’s populist government is persisting with budget plans that contravene EU rules and is shrugging off Brussels’ rebuke, setting up a clash that could reawaken investor concerns over stability in the eurozone despite Italian efforts to defuse the stalemate as well as the country’s assertions that it will not leave the euro. The spectre of Italian debt reaching unsustainable levels is likely agitate markets and create bouts of volatility in 2019.
European parliamentary elections, changes at the top of the European Commission and perhaps most importantly, the arrival of a new ECB president should also help ensure that political developments in Europe will grab as much market attention as Donald Trump’s policy agenda.
Our allocation views
Where does all of that leave investors? We believe that risky assets will feel the heat of higher risk-free rates as major central banks tighten monetary policy (further). However, we also expect the positive growth outlook to offset the additional cost of debt resulting from policy tightening.
Accordingly, we would choose to be neutral on equities and underweight fixed income in 2019. On the equity side, our focus would be on developed markets and on the fixed-income side, on the eurozone where – unlike the US – interest-rate rises have yet to begin. While there is a chance that the ECB will tighten faster than the Fed, a slowdown in eurozone growth to a more sustainable pace might temper ECB action.
In terms of the relatively high equity valuations, we see justification in the earnings outlook which we regard as promising in the US. It is more modest in Europe and the UK, but overall, we believe there is potential for further equity appreciation.
As for high-yield debt, our underweight position would target the US in particular in light of the relatively high sensitivity of US credit to rising interest rates and given the substantial build-up in US corporate leverage. By comparison, the cycle looks benign still in Europe, although a steeper monetary policy normalisation is a potential threat.
Turning to emerging markets, US dollar gains and skirmishes over trade are likely to remain threats to investment performance and be causes of market volatility, just as much as they were for EM currencies in 2018. Hence, there is a chance that local central banks will come under pressure to take action to defend their currencies again in 2019. Overall, however, the macroeconomic outlook is broadly positive on the back of known factors including favourable demographics – a relative young population – and more resilient economic and corporate earnings trends.
Priority number 1: investing for a sustainable future
Amid the prospect of more market volatility and another year of known and unknown uncertainties, for BNP Paribas Asset Management, there is one constant. We believe that as an asset manager and asset owner, we must act as a future maker and pursue efforts that lead to a sustainable world. That is a world in which we can earn long-term returns for clients, while implementing sustainable financing and investment, and engagement, shape the kind of future that we want for ourselves, our clients and the generations that follow.
For us, these are important priorities. Accordingly, expect BNP Paribas Asset Management to take initiatives in the area of innovative SRI products, engagement policy and ESG reporting in 2019.
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