- Global growth slowed over the last six months. In April, the International Monetary Fund (IMF) forecast for world Real Gross Domestic Product (GDP) growth in 2019 of 3.3 percent was down 0.3 percent from 20181. Some slowdown in the U.S. was expected as benefits of tax-driven fiscal policy diminished; however, slumping exports and lower investment in emerging market economies contributed to the slowdown as well.
- Since GDP data is reported with a lag, and often subject to revisions, we monitor global Purchasing Managers Index (PMI) data, revealing additional weakness in business activity across the globe. Given the modest, but expansionary level of business activity through June, we expect corporate earnings results and management guidance to play a more prevalent role in the second half of the year.
- In response, the Federal Reserve and other central banks ended gradual and anticipated tightening of monetary policy. Central banks reiterated stand ready to deploy accommodative policy to support slowing growth.
Growth Remains, but on Less Stable Footing
Key Observation Beginning 2019 – With fewer tailwinds, the pace of economic growth should abate and may weigh on corporate earnings estimates and fuel bouts of short-term volatility as investors react more dramatically to companies missing or beating consensus estimates.
Mid-Year 2019 Update – Incoming economic data suggest the pace of global growth slowed during the first half of 2019 but remains on track with baseline expectations for slower, but still positive real GDP growth. IHS Markit Purchasing Managers Index (PMI) Composite trends revealed a slowdown in global business activity in developed markets that began in July 2018. While it is difficult to discern if growth is set to rebound in the near term, confidence that central banks can contain downside risks of slowing global growth anchored the rebound in risk-assets through the first half of the year.
Therefore, the most significant risk to this rebound and the recent decline in equity volatility is central banks losing control of this narrative. Fundamentals, particularly corporate earnings and forward earnings guidance, can be particularly informative data points to monitor. Investors will assess if already reduced estimates are low enough, as 2020 estimates begin to come into focus.
Is This the Bottom?
Global PMI Composite trends show business conditions slowed through June, strengthening the case for fiscal and monetary policy accommodation.
Investors’ Earnings Growth Expectations Have Moved Lower, but…
Earnings estimates for 2019 moved lower as business conditions slowed in the first half of this year, but 2020 estimates have not changed much.
…Investors Still Expect Operating Margin Expansion.
We are skeptical that U.S. firms can increase operating margins in a slow growth environment with tight labor market conditions.
Portfolio Impact – Despite the strong rebound in equity valuations, global business activity appears on edge. We caution against increasing a strategic allocation to equities and favor reassessing total portfolio risk tolerances.
Key Observation Beginning 2019 – With global policy divergence slowing, the U.S. dollar is less likely to continue its incessant march higher, creating opportunities among various asset classes.
Mid-Year 2019 Update – In concert with slowing economic growth and expectations for Fed policy accommodation, market-implied measures have priced in almost three 25 basis point rate cuts by year-end. In contrast, the median forecast from Fed policymakers signals zero rate cuts in 2019.
That said, seven of the 17 Federal Open Market Committee (FOMC) participants forecast two – 25 basis points cuts by year-end. We would expect the eventual outcome to fall between somewhere in between, which should curb U.S. dollar strength longer-term as interest-rate differentials narrow. The short-term risk to this scenario would be if global growth continues to slow, other central banks ease further and foreign investors seek safety in U.S. denominated assets, which could put upward pressure on the U.S. dollar.
We will learn more during the FOMC’s July meeting this week.
The Path of Convergence Matters
The meaningful gap between Fed projections and market expectations leaves room for modest U.S. dollar strength. However, a clear path of more accommodative monetary policy and interest rate parity should weight on the U.S. dollar long-term.
Resilient U.S. Dollar Strength
Despite a dovish Fed pivot in the first half of 2019, the U.S. dollar traded sideways through the first six months of the year.
Portfolio Impact – Increased probability for rate cuts in the U.S. and the Fed curbing its balance sheet normalization program provides the opportunity for long-term investors to take advantage of foreign assets with more attractive relative valuations.
Volatility is Back
Key Observation Beginning 2019 – Asset prices will likely be more sensitive to incremental information causing short-term volatility. Short-term volatility should not be confused with a decline in asset prices but should caution investors to avoid the temptation to react to short-term news.
Mid-Year 2019 Update – Volatility in 2019 has largely been to the upside as assets across the globe have moved higher. However, we believe this point stands as important today as it did in January of 2019. As markets have moved higher, they have done so with deteriorating economic growth and lower earnings expectations. That means higher market prices have largely come on the back of investor sentiment in the form of higher valuations in anticipation of more accommodative monetary policy. Failure to meet these expectations without additional support from strong economic growth or earnings would most likely manifest itself in downside volatility.
Economic Growth Waning
Despite higher prices, PMI Composite data show business activity slowed year to date.
Portfolio Impact – We continue to believe that the low volatility of recent years is less likely to persist and the stage has been set for normal (rather than recently abnormally low) volatility. Portfolio allocations should remain thoughtfully diversified with this in mind, but investors may need to reset expectations with a clear discussion of potential implications normalized volatility may have on their account balances.
Be Cautious of Credit
Key Observation Beginning 2019 – With downside risks to economic growth emerging and higher interest rates, investment- and non-investment grade corporate debt should be evaluated with greater skepticism. Today, lower-quality corporate bonds, within the investment-grade market, constitute a greater proportion of the investment grade market and may not provide less downside protection during volatile periods. The non-investment grade market may struggle to refinance debt at attractive interest rates given higher financial or operational leverage.
Mid-Year 2019 Update – Corporate debt levels are growing, particularly in the lowest-rated segment of the investment grade sector. Expectations for Fed rate cuts and more accommodative monetary policy do not change our views on the sector, but we acknowledge that the dovish pivot and yield-seeking investor behavior should give corporations cover to roll existing debt and issue new debt at lower levels for longer than expected.
Growth in BBB-Rated Corporate Debt
Lower-quality investment grade corporate debt issuance now accounts for more than half of total investment grade corporate debt outstanding.
Portfolio Impact – More tempered allocations to credit and thoughtful utilization of active bond managers to navigate the level of quality in today’s market are prudent adjustments.
International Developed and Emerging Market Equities Remain Attractive
Key Observation Beginning 2019 – Foreign markets are more attractive today than U.S.-based assets and offer an opportunity to enter or add to the asset class at reasonable valuations. However, valuation, growth and currency movements are not short-term catalysts and should be considered with a long-term time horizon.
Mid-Year 2019 Update – Trade tensions, U.S. dollar strength and political uncertainty in Europe remain sources for headline risk among international and emerging market equities, but relatively favorable equity valuations should reward long-term investors. Furthermore, as the trajectory of U.S. monetary policy tracks closer to global central bank policies, we have more conviction in foreign-denominated equities.
Global Equity Valuations
Lower valuations outside of the U.S. provide an opportunity for long-term investors.
Portfolio Impact – We continue to recommend thoughtfully adding to international allocations to take advantage of opportunities outside of the U.S.
- Source: World Economic Outlook (April 2019)
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