The Federal Reserve’s (Fed) commitment to sustaining economic expansion in the US should support financial conditions globally.
After a weak first quarter, the Fed’s decision to keep its key policy rate on hold through 2019 should support domestic growth. However, if growth accelerates significantly and core inflation pressure picks up, the Fed could refocus on hikes.
A pick-up in global economic activity over the second half of 2019 is now a consensus view. In the US, Europe and emerging markets, we are looking for some acceleration to take hold near term and support risk-asset valuations.
The significant rebound in equity markets and tightening credit spreads rewarded investors during the first quarter. But now that valuations have recovered from late 2018, future gains are likely to come at a much slower pace.
Market participants currently expect government bond yields in the US, Europe and Japan to stay lower for longer. This could help keep risk asset valuations (credit spreads and equity price-to-earnings ratios) somewhat rich relative to historical averages.
Our positive outlook hinges on corporate profit growth, especially in the US, and central bank policy that remains supportive of economic and financial conditions.
US credit spreads could tighten marginally as investors reach for yield, but spreads are unlikely to reclaim the low levels seen earlier in the expansion.
The macroeconomic outlook is supportive, but corporate earnings estimates also need to hold steady
Expected default rates remain low, global growth is decent and 2019 corporate earnings are likely to rise in the mid-single-digit range. But that does not mean credit spreads are likely to revisit the lows seen earlier in the cycle.
Consensus estimates for corporate earnings could be too weak, especially if the second-half rebound in global growth turns out stronger than anticipated. However, significantly tighter spreads seem unlikely from here.
US high-grade corporate credit trends are positive across most industries. While we believe downgrade concerns about BBB-rated credits in the next economic downturn could be warranted, they may be a bit overblown.
Now that spreads have tightened meaningfully from December 2018 highs, returns relative to like-duration government bonds could be positive, but not substantial.
The global credit cycle appears to be progressing toward a later stage of expansion. But the Fed may have extended the runway before it reaches the downturn phase.
Global credit investors should be able to harvest yield and modest excess returns as long as profits and the global economy expand and monetary policy does not become too restrictive.
Dovish developed market central banks are keeping global rates low (or negative), making higher-yielding emerging market debt attractive on a relative basis.
We see modestly higher long-term government bond yields and a range-bound to slightly weaker US dollar
Weakness in the domestic and global economy prompted the Fed to adjust its 2019 rate hike projections. Inflation pressure in the US remains nonthreatening even though the unemployment rate is below 4.0% and wages generally have been on the rise. We do not expect any rate hikes in 2019.
It would take an impressive reacceleration in economic activity and solid evidence of US inflationary pressure to move the Fed back into a policy tightening regime. We expect interest rates in the US, developed Europe and Japan to remain low for some time.
By our view, the global economy is moving toward the end of a soft patch within a continued expansion. We anticipate a pick-up in economic activity in coming months but do not expect an inflationary impulse to push benchmark interest rates meaningfully higher.
Emerging market debt may be one of the more attractive areas for investors seeking to capture a yield advantage relative to the US, Europe and Japan. A range-bound to weaker US dollar would also support local-currency emerging market fixed income performance.
The consensus forward-earnings outlook has been revised lower for 2019, but mid-single-digit year-over-year growth is still expected across most regions.
Muted inflation and low developed market interest rates can lead to above-average valuations
Price-to-earnings multiples expanded during the first quarter from very low levels. They may have a bit further to rise now that Fed policy looks more accommodative and commensurate with the overall global macro backdrop.
Consensus earnings estimates reflect decent year-over-year growth in the mid-single-digit range for most regions of the world. Corporate profit growth is a key driver of the overall economy. Therefore, steady growth should keep the expansion intact, even if the pace is slower than that of 2018.
Year-to-date performance has been strong and driven by price-to-earnings multiple expansion. Further upside by year-end seems probable if economic growth begins to rebound in late spring as expected. The positive outlook for equity market performance remains dependent on corporate earnings and global growth.
US and emerging market equities appear positioned to outperform Europe and Japan during the next quarter. Valuations across emerging markets are near the low end of multi-year ranges. China may be in a bottoming zone with a relatively stable currency and fiscal stimulus underway.
US fiscal policy remains a source of uncertainty for corporate decisions makers looking to make capital investments. Clarity on trade negotiations with China and tariff rollbacks would most likely lead global equity markets higher.
If global economic activity does not turn higher soon, the global corporate profits outlook could face further downgrade risks this year and into 2020.
The Fed is committed to sustaining the US expansion. Is that enough?
While we have a high degree of confidence in our sanguine outlook for the global economy and financial market performance, recent mixed economic data needs to show improvement soon.
Economists and investors have already revised 2019 global-growth expectations modestly lower. Further downward revisions would likely generate financial-market volatility and weaker-than-expected risk-asset performance.
The ongoing trade war with China and flattening US yield curve may help restrain corporates from engaging in capital investment, a potential negative for domestic growth.
We may learn that the Fed already tightened policy beyond neutral during 2018, when temporary fiscal policy generated above-trend economic growth rates. Time will tell if the economy can hold its own now that the Fed is on hold with policy rates around 2.50%—a historically low level.
An uptick in high-frequency economic indicators such as purchasing managers’ indices would go a long way to support investor sentiment and risk assets. For now, US recession and end-of-cycle fears appear overstated. We believe the expansion should continue into next year.
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