Valuations contracted as a number of risks kept investors on edge. Risk assets are looking cheap in several markets.
The market is now priced for several risks, including slower global growth, Federal Reserve tightening, US/China trade relations, global political disruptions and lower-than-anticipated oil prices. These risks are likely to suppress risk asset valuations unless positive resolutions emerge.
Fed tightening is likely to continue in 2019, with hikes forecasted at mid-year and at year-end. Slowing the pace of hikes should support interest rate-sensitive areas of the US economy, where higher borrowing costs have already started to curtail activity.
The US/China trade truce remains in effect until March 1, 2019, but we are skeptical that both sides will make meaningful progress during the truce. An extension of the truce is possible.
The global political environment has grown increasingly complex. The Brexit saga, protests in France and security concerns related to cross-border technology manufacturing should continue to keep investors on high alert.
Forward valuation for many asset classes has improved through credit spread widening and contraction of price-to-earnings multiples.
We do not expect substantial spread tightening, even if risk asset volatility subsides.
Certain Macro Drivers Look Supportive, but the Best Could Be Behind Us
Estimated default rates remain low, global growth is decent and 2019 corporate earnings are likely to rise between 5% and 9% in aggregate. However, these positive factors do not mean credit spreads can revisit the lows seen earlier in the cycle.
Spreads have been rising across global credit markets, but further widening does not look necessary if consensus expectations for growth and inflation come through over the course of 2019.
We estimate excess returns over government bonds will be positive but not substantial, especially if spreads remain range-bound at current higher levels as the global credit cycle progresses.
A US recession does not seem imminent. However, we believe credit market valuations are likely to stick at current adjusted levels, especially if the Fed continues to tighten financial conditions.
Wider spreads have restored meaningful risk premia to credit markets, increasing the value proposition. Our sanguine outlook would be at risk if corporate profitability expectations prove too lofty.
Credit investors should be able to harvest yield and achieve modest total returns as long as corporate profits remain healthy, the global economy continues to expand, and monetary policy does not become too restrictive.
It may take another catalyst, like much slower US growth, to spark a sustainable rally across emerging markets and other foreign currencies.
We See Modestly Higher Government Bond Yields and Limited US Dollar Upside
The Fed is likely to continue hiking short-term rates in 2019, but at a slower pace than previously anticipated. We believe the Fed is reacting to softer economic activity, tighter financial conditions, and core inflation hovering at or below target levels.
Consensus expectations for global growth have been revised lower and fiscal stimulus in the US could fade in the coming quarters. We view this period as a soft patch in a continued expansion that likely leads economic growth back toward levels consistent with the global economy’s long-run potential.
In 2018, the US dollar benefited from the high level of US growth and interest rates relative to those of other countries. However, if the US economy slows next year as expected, the dollar may come off its recent trend higher and establish a trading range.
We estimate the soft patch to end and growth to stabilize, which should drive high-quality government bond yields modestly higher while inflationary pressure remains subdued.
We expect mid- to high-single-digit earnings growth across global markets in 2019. Price-to-earnings multiples are compelling.
Valuations Look Compelling, but Volatility Could Stay Elevated
Macro risks are likely to dominate the equity landscape during the next few quarters, despite decent earnings growth and valuations reaching the most attractive levels in several years.
Late-cycle threats like tighter financial conditions and accelerating wage growth may lead to increased volatility, particularly when compared with earlier periods of the expansion. Trade wars and global economic softness are additional key risks likely to remain in the near term.
The severe challenges of 2018 left many equity sectors firmly in bear market territory. Equity markets need time and patience to repair the technical damage endured by even the highest-growth areas of the market.
Equities could have meaningful upside if the macro backdrop becomes a bit more supportive. We believe US stocks are most likely to lead an equity recovery. Emerging markets could also present an attractive opportunity—especially if the US dollar remains range-bound or trends weaker.
We estimate mid- to high-single-digit earnings growth across several global and domestic equity markets in 2019. Higher interest expenses and labor costs could slowly erode profit margins, but price hikes may soften the blow.
An upturn in developed or emerging market economic data could spark a global risk asset rally, but watch for volatility ahead.
Market Pricing Reflects a Distressing Backdrop
Financial markets and the overall investment outlook could deteriorate if the domestic and global economy cannot work through tighter financial conditions brought on by Fed rate hikes and other headwinds.
Economists and investors have revised 2019 global growth expectations modestly lower to reflect a slowdown. Further downward revisions would likely generate financial market volatility.
The US's trade policy, including the ongoing trade war with China, and the flattening US yield curve create an uncertain outlook for the US economy. This uncertainty may prevent corporations from engaging in capital expenditures and would be negative for domestic growth.
Further downside risks are present, but an upturn in global economic data could boost investor sentiment and ignite a recovery across global markets.
Discernible risks took down asset valuations in 2018. Positive political or economic developments could go a long way to support investor sentiment and risk asset performance.
Disclosure
This commentary is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis do not represent the actual or expected future performance of any investment product. Information, including that obtained from outside sources, is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This information is subject to change at any time without notice.
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