Morgan Stanley strategists say investors should brace for more challenges in 2019, as multiyear trends make decisive turns, but emerging markets could present key opportunities.
In 2018, slowing growth, rising inflation and tightening monetary policy paved the way for what Morgan Stanley Research strategists called a “tricky handoff." Looking ahead for 2019, these shifts are set to continue, along with the changing relative macroeconomic narrative, especially for the U.S. vs. the rest of the world.
“The result suggests a challenging year, but also one where key multiyear trends make sharp, decisive turns, aided by extreme relative valuations," says Chief Cross-Asset Strategist Andrew Sheets.
On the positive side, many asset classes have already endured significant price declines. “We've already had a rolling bear market," says Sheets. “Looking at ranked real return across asset classes, in U.S. dollars, 2018 has actually seen a larger breadth of underperformance than in 2008."
In Morgan Stanley’s 2019 Global Strategy Outlook, Sheets and his colleagues look at how significant changes in the macro narrative in 2019 could impact the relative investment prospects of regions and asset classes.
Major themes include a cyclical peak in the U.S. dollar—which Morgan Stanley strategists estimate is 15% overvalued against other major currencies—a decisive transition from U.S. quantitative easing to quantitative tightening, and the end of the “winner take all” era for U.S. equities. To be sure, they believe that value is set to take the lead from growth, and assets in many emerging markets should best their developed market peers.
On the whole, Morgan Stanley's position is now neutral for equities, underweight credit (-5%), neutral government bonds and overweight cash (+4%). Yet, within this defensive stance, the investment outlook for 2019 is nuanced. Opportunities still abound, especially in areas that have experienced extreme divergences, or where investors are understating the impact of a new macroeconomic narrative.
Here are five key investment themes for 2019—notable since they are non-consensus, materially different from market pricing, or both.
#1: Global Equities: Emerging Markets Outperform
As Morgan Stanley’s economists explain in their 2019 Global Macro Outlook, rising U.S. rates, a strengthening dollar and lingering trade tensions left emerging markets nearly defenseless in 2018. Even so, most of these countries maintained fiscal discipline, setting them up for solid growth as the headwinds subside.
Against this backdrop—and in light of the extreme valuation differences between U.S. and emerging-markets equities—Morgan Stanley strategists have issued a double upgrade for emerging markets, moving from underweight to overweight. Their base case forecast calls for an 8% price return for the MSCI EM index in 2019.
“A slowdown in U.S. growth with EM re-accelerating means EM earnings growth should exceed that of the U.S. in 2019 after lagging in 2018. But we think this will be a different bull market from 2017, led by Financials and Mining stocks and not Tech. Our top picks are Brazil, China, India, Indonesia and Thailand,” Garner adds.
Looking to developed markets, Morgan Stanley also has an overweight position on Japan, where the base-case outlook calls for an 11% return for the benchmark Topix index.
Contrast this with U.S. equities, which must contend with slowing earnings-per-share (EPS) growth and valuation pressure from rates. As such, Morgan Stanley recently began underweighting U.S. equities; its base forecast estimates a 4% increase for the S&P 500 next year. Turning to Europe, strategists now have an equal weighting on equities and a base forecast of 4% in returns for the MSCI Europe index.
Morgan Stanley Top-Down Bull, Base and Bear Target Prices for 2019
#2: Value Outperforms Growth
Growth stocks have outperformed value stocks for years, but a major reversal in this trend began in September 2018—and is likely to continue in 2019 in all geographies. Morgan Stanley’s equity strategists believe that forward EPS growth expectations could be far more achievable in value than in growth, in what remains a challenging top-down macro environment, particularly for the consumer. Value stocks could also offer a better hedge against the risk of upside moves in core government bond yields, beyond the fixed-income team's base case range-bound view.
Considering sector skew, the firm’s equity strategists find that value stocks are concentrated in financials, materials, energy and utilities (in that order) across the MSCI ACWI Index. At a global level aggregating across their regional views, they are overweight all four of these sectors.
#3: U.S. Treasuries Back in Favor
With central banks now at different stages in their policy cycles, Morgan Stanley economists expect them to take different stances in the year ahead. That includes a pause in the Fed's policy-tightening cycle, following two increases in 2019; a continuation of the Bank of England's policy-tightening cycle; a start to the European Central Bank's policy-tightening cycle; and a fine-tuning of the Bank of Japan's sustained policy-easing cycle.
This could lead to a convergence in government bond yields, says Matthew Hornbach, Global Head of Interest Rate Strategy. He and his colleagues advocate what they call a “Ryder Cup of Bonds,” named for the golf tournament that Europe has won nine of the last twelve times. Their trade entails going long U.S. 10-year Treasuries and Canadian government bonds, and short German Bunds and UK gilts.
“In the world of 10-year government bonds, as in golf, North America has underperformed Europe since 2016," he says. “However, we believe that the recent North American underperformance will reverse in 2019 and the 'Ryder Cup of Bonds trade' will return to North American shores."
#4: The U.S. Dollar Hits a Cyclical Peak
The underperformance of U.S. growth stocks could result in relatively less tightening from the Fed, which should drive dollar weakness, especially given its expensive starting point. With the broad trade-weighted dollar less than 1.1% from its 2017 peak—and dollar sentiment unusually bullish—the set-up looks ripe for reversal, as the market struggles to add more rate increases into the expected Fed path.
The flip side of dollar weakness should be euro and yen strength. Both Japan and Europe have sent significant amounts of capital into U.S. financial markets, particularly into risk assets.
Morgan Stanley’s FX Strategy Team expects both economies to see capital demand increasing. Private capital expenditures in Japan are poised to pick up, and fiscal expansion in Europe is looking more probable, as central banks turn more hawkish. Improving domestic conditions and capital demand, coupled with a worsening U.S. outlook, should turn 2019 into the year of the euro and yen.
#5: Emerging-Market Local Bonds Best Corporate Credit
Morgan Stanley strategists have been preaching prudence about corporate credit for quite some time, particularly high-yield U.S. debt. A combination of slowing growth and tighter Fed policy means late-cycle risks could morph into end-of-cycle fears, hitting leveraged finance markets hardest.
In fact, the bear market for credit has likely already begun, says Adam Richmond, head of U.S. Credit Strategy. This trend is apt to continue over the next year, as high-yield bonds and, eventually, loans underperform; downgrades and even defaults will likely follow.
On the upside, the emerging-market debt team has changed its stance on local markets to bullish, thanks to improving GDP growth relative to developed markets, coupled with the weakening dollar.
“Emerging-market assets are cheap and a rebalancing in global capital flows should lead to local currency strength," says James Lord, Head of Emerging-Market Fixed Income Strategy. Moreover, relative to corporate and securitized debt, emerging-market hard currency sovereign debt recently reached its widest spread since the financial crisis.