Executive summary

5 minute read

The tide goes out

We expect global growth to moderate somewhat in 2019, although to remain above potential in all the major advanced economies (Figure 1).

With growth in the United States accelerating sharply on the back of large tax cuts in early 2018, a material divergence in global growth occurred as other major economies slowed from their rapid pace of growth in late 2017. While we do not expect that divergence to increase in 2019, nor do we expect there to be much in the way of growth convergence among advanced economies.

A modest convergence between advanced and emerging market economies reflects the more moderate growth outlook for the former. That somewhat slower growth backdrop, which has already become evident in a range of data over the second half of 2018, is likely to lead to a continuation of the recent challenging period for risk assets.

In a slowing growth environment, market participants are likely to focus even more on the downside risks. And there are indeed a range of important downside risks, including an escalation in trade protectionism, the impact of tighter global liquidity, Brexit and political pressures in Europe. However, while growth is expected to slow across all the major economies, we expect it to remain above potential or trend. That should provide a basis for positive, but probably somewhat mixed returns across risk assets.

Figure 1. Global growth projections

Above-trend growth should result in a further erosion of spare capacity in major economies. That should mean unemployment rates continue to decline and wage pressures continue to steadily rise.

Wage growth across the major economies accelerated through 2018 to rates last seen before the Global Financial Crisis (GFC). We expect those gains to sustained in 2019, even in the face of slower overall growth. While headline inflation is likely to be dragged down in 2019 by the recent decline in oil prices (Figure 2), robust wage growth should put further steady upward pressure on underlying inflation, which we expect to be at or closing in on central bank targets in 2019.

Given that, we believe the era of lower for longer monetary policy has come to an end. We expect the Federal Reserve to raise rates three times in 2019 to take them into slightly restrictive territory. In addition, we expect the European Central Bank to start the process of moving away from negative rates in the second half of 2019 and see some prospect of the Bank of Japan adjusting their policy framework to deliver a steeper yield curve. Other advanced and emerging market central banks, such as the Bank of England, Riksbank (Swedish central bank), Bank of Canada, Central Bank of Brazil and the Mexican central bank are all expected to tighten policy in 2019.

With somewhat less priced into rates markets than we expect to materialise, and with term premia still at very low levels, we prefer to be underweight duration heading into 2019.

Figure 2. Global inflation projections

US exceptionalism

According to the IMF, annual global growth in each of the past two years has been similar, and rising at the fastest pace since 2011. However, the composition of those growth outcomes was notably different in 2018 compared to 2017.

The global growth upswing that began in the middle of 2017 saw all the major advanced economies accelerate in a synchronised way. That upswing was driven by a sharp improvement in global trade volumes and manufacturing.

Heading into 2018 we expected some moderation in growth, particularly in economies such as the euro zone, which was growing far in excess of potential. However, the euro zone slowed more sharply than we expected (although still grew above potential), as did Japan and China. Meanwhile, the United States continued to power ahead in 2018, on the back of the large scale personal income and corporate tax cuts enacted early in the year.

As a result, there was a significant growth divergence in 2018 between the United States and other major economies (Figure 3). That growth divergence was likely to be an important factor in the relative outperformance of US assets compared to the rest of the world.

Looking into 2019, a key question for relative asset market performance is likely to be whether the world moves from one of divergent US growth to one of convergence. While we do not expect a further divergence, nor do we expect terribly much convergence in 2019. Indeed, we see all the major economies slowing down moderately, to something closer to their long-run potential. As such, the US growth exceptionalism remains a theme for 2019, with growth convergence likely to be another year away.

Figure 3. US growth outperformance

Difference between growth in US and other major economies

Just as the upswing in 2017 was driven by global trade and manufacturing, the slowdown that began in mid-2018 had a similar source.

While that slowing pre-dated the imposition of tariffs by the US on steel and aluminium, and then on a much larger scale on Chinese imports, the concerns around the potential impact of future tariffs may have impacted sentiment and trade ahead of time. In particular, the slowdown in euro zone growth can almost entirely be attributed to weaker external demand, with a similar story for Japan.

Some of that weakness appears to be related to the slowdown in Chinese growth in the second half of 2018, but also more broadly from other emerging market economies as well. While we expect Chinese growth to be a little slower again in 2019, in part due to the tariffs imposed by the US, they have embarked on a significant fiscal and monetary stimulus that should ensure that growth remains supported. While the meeting between Presidents Trump and Xi at the G20 summit at the end of November appeared to call at least a temporary truce to the trade conflict, the risk to global growth remains that the US will ultimately pursue ever more punitive trade and financial barriers with China.

With all the major advanced economies growing above potential, unemployment rates continued to fall in 2018. Indeed, compared to the pre-GFC low in unemployment, the US, UK and Japan are now all running with even tighter labour markets, while the euro zone is expected to reach the pre-GFC lows by the end of 2019 (Figure 4).

Figure 4. Tightening global labour markets

Difference between current unemployment rate and pre-GFC low

As wage growth has picked up in 2018, with further gains expected in 2019, central banks have either begun tightening policy or strongly signalled that they will begin to do so in 2019. The era of cheap money is coming to an end. The US is in the lead in the normalisation process, but we believe still has some way to travel. Others are only just setting out on the journey.

But with both policy rates rising and central bank balance sheets no longer expanding (and in the case of the US contracting), the suppression of risk premia and general support for asset prices is steadily being removed. We think that transition (alongside the various risks already highlighted) can partly explain the challenging year faced by nearly all asset classes in 2018 (Figure 5). Risky assets have performed particularly poorly in 2018, with emerging market equity, debt and currencies all falling sharply. Developed market equities outside the US did not fare much better, and as we had expected, duration assets did not provide a useful hedge to those losses in 2018.

Figure 5. 2018 YTD global macro asset returns

As we approach 2019, while we remain constructive on global growth, the combination of an expected moderation, tighter global liquidity and the concerns around a range of downside risks, continues to temper our return expectations for global equities. As such we prefer to have only a moderate overweight, with a preference for US, Japanese and emerging markets over European equities. While valuations in Europe look attractive, they are less compelling than other markets, while the downside risks around the Italian budget and Brexit continue to weigh on the outlook. On the other hand, emerging markets significantly de-rated in 2018, making them a more attractive proposition. However, with the tighter global liquidity expected over 2019 we favour only a small overweight. The de-rating of the US market in 2018, where earnings rose by over 20 per cent, have left it much closer to fair value. With US growth outperformance expected to continue, that is where we prefer to be most overweight. Given our expectations that central banks will look to tighten policy in 2019, absent a realisation of one of the downside risks, we expect bond yields will continue to move higher. Hence our preference to be underweight nominal government bonds, albeit only moderately (Figure 6). We prefer to somewhat more underweight credit (including the duration component) as despite the recent widening, spreads remain relatively tight by historical standards. We continue to prefer European to US high yield due to the lower leverage and reduced sensitivity to oil prices. Finally, we have a slight preference for being long US dollars, with the main underweight being against Australia given both domestic challenges there, as well as Chinese growth risks.

Figure 6. Asset allocation view