Investment Management’s Global Fixed Income Team notes that headwinds for the U.S. and China will have broad implications in 2019. Will it be a hard, bumpy or soft landing from the highs of 2018?
As we enter 2019, the two largest economies in the world, the U.S. and China, both face challenges. First, will U.S. financial markets have a soft, bumpy or hard landing following the peak earnings and growth cycle seen in 2018? Second, will stimulus policies in China stabilize growth conditions in the year ahead?
Resolutions for both will have significant global implications for economies and financial asset prices alike.
My colleagues and I at Morgan Stanley Investment Management’s Global Fixed Income Team believe these challenges can be represented thematically as the Four C’s for 2019: Caffeine, Credit, China and Chameleons.
Caffeine represents the fiscal boost that the U.S. experienced from tax policy, which led to an earnings and growth cycle that exceeded the expectations of many forecasters and catalyzed U.S. dollar appreciation against other major currencies.
We believe this caffeine boost could wear off in 2019, which begs the question: Will the U.S. economy have a soft, bumpy or hard landing when it happens?
Consensus expectations is for full-year growth to slow to 2.6% in 2019, however, on a 12-month rolling basis—fourth quarter 2018 to fourth quarter 2019—growth is expected to trough at 1.7%, a level we think is about equal to potential growth.
If the U.S. Federal Reserve engineers a soft landing and growth temporarily falls only to potential, then we think this will produce a positive outcome for financial assets. This is the soft-landing scenario.
If growth slows to levels slightly below potential and is perceived as transitory, lasting only a few quarters before rebounding to above 2%, we consider this a bumpy landing.
However, growth levels falling to below potential for what the market perceives to be an extended period—which may include a recession—would result in a hard landing. In that scenario, and possibly even the bumpy one, the Fed would likely to ease policy.
Which scenario comes to pass depends on how inflation evolves. If inflation remains well-behaved, meaning rising gently (or maybe not at all), the probability for a soft or bumpy landing rise significantly.
Corporate growth and earnings in 2019 will directly impact credit asset performance. High levels of leverage in the post-quantitative-easing (QE) era—where the Fed is no longer buying Treasuries—have left corporate credit especially vulnerable.
Although a U.S. recession isn’t our base case scenario in the next couple of years, the risk premia for corporate credit has risen and will likely rise further, widening the spread between government and corporate bond rates to reflect the increased weighting of this risk. But this also assumes corporations won’t change their behavior. If credit conditions deteriorate further, it’s hard to believe corporates will do nothing.
The credit cycle is intricately linked to how Fed policy will influence the economic landing in the post-peak growth and earnings period. Investment-grade credit is particularly sensitive to this, given the increased level of leverage in the aftermath of QE policies.
A simple, somewhat oversimplified rule of thumb might be to expect a soft economic landing if the Fed ends its rate-increase cycle with policy rates at 3% or less, bumpy from 3% to 3.5%, and hard if rates spike to above 3.5%. Market concerns right now seem skewed to the worst-case scenario.
Credit Concerns Are Greater Today Than During the Global Financial Crisis
(Google Keyword Search: "Credit Cycle")
China policy significantly influences the global economic cycle. Back in 2017, China began tightening policy considerably, increasing short rates by more than 200 basis points—as measured by one-month fixings on the Shanghai Interbank Offered Rate (SHIBOR)—and the yuan strengthened by more than 7%.
In 2018, China’s economy felt the impact of tightening even more deeply due to the deterioration in U.S.-China trade relations. In response, China has engaged in aggressive easing with stimulus polices, such as reducing the same SHIBOR by more than 200 basis points in 2018 and required reserve ratio cuts of 250 basis points.
Additionally, the central bank has eased banks’ lending standards and is expected to expand government borrowing by as much as 3% of GDP—or approximately $400 billion.1
We are already seeing early signs that such stimulus has stabilized asset prices. Since the effects of easing policies tend to lag behind the impact of stimulus, we may see further stability, and possibly even a rebound, in 2019, which will be supportive of global asset prices, especially in, but not only confined to, emerging markets.
Finally, the last “C”—chameleon—refers to the need for investors to be flexible, nimble and prepared for change, since different investment opportunities will arise in the unfolding post-peak growth and earnings period.
At this point, it’s unclear whether the market will experience a soft, bumpy or hard post-peak landing. Asset prices are still incorporating this uncertainty and adjusting risk premia higher.
Serving as our base-case scenario, we interpret the recent volatility in the market as a mid- to late-cycle reset, not an end-of-cycle hard landing. For the sake of simplicity and clarity, our outlook favors a soft to bumpy landing scenario. Our base case assumes that the Fed will be responsive to a tightening of financial conditions, namely, in the form of higher interest rates, a strengthening of the U.S. dollar, wider credit spreads and weaker equity prices.
Perhaps the Fed needed an acknowledgement from markets that the peak in growth and earnings was behind us since the Fed is now responding. The Fed is finally getting the tightening it aimed for—the key will be to avoid over-tightening and creating a policy error that might lead to a hard landing. We believe that the Fed won’t make that mistake.
The market likely will also acknowledge that the peak yield of the benchmark 10-year Treasury will stay below 3.50%. In this scenario, where peak earnings are in the rear-view mirror and economic growth differentials between the U.S. and the rest of the world narrow, funds will flow away from the dollar. Once these first steps to ease financial conditions have occurred, funds will flow to assets that have sold off well beyond their fundamental valuations. However, investors will need to be patient because this may not occur until mid-2019, or later.
Valuations Have Fallen Further and Faster Than Implied by Fundamentals
(Global PMI vs. S&P 500 Forward P/E)
Emerging markets stand out as an asset class that has sold off extensively, beyond fundamental valuations. High-yield and investment-grade credit also generated greater-than-expected losses, and the U.S. dollar, which gained so much in 2018, stands to reverse course in the year ahead.
We expect interest rates to remain largely in a benign range-bound environment, though we expect investment opportunities to be idiosyncratic, driven by extreme misvaluations relative to economic fundamentals. We believe that active and flexible strategies can best take advantage of these idiosyncratic opportunities.
Given the risks facing the world, some of which could easily come to pass, we don’t see 2019 producing systematic index opportunities that favor passive investment strategies. Having a diversified, flexible, chameleon-like approach, capable of adapting to the world’s zigs and zags, is, in our opinion, more likely to produce superior investment results.
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