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The investment outlook for 2019 The investment outlook for 2019: Late-cycle risks and opportunities AUTHORS ã After a sharp fall in valuations in 2018, steady IN B…
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The investment outlook for 2019 The investment outlook for 2019: Late-cycle risks and opportunities AUTHORS • After a sharp fall in valuations in 2018, steady IN B R I E F economic growth and less dollar strength may • The U.S. economy should slow but not stall in 2019 provide international equities some room to due to rebound in 2019. However, the climb will be fading fiscal stimulus, higher interest rates and a bumpy and investors should ask themselves, in lack of workers. Even as unemployment falls further, inflation should be relatively contained. the short run, whether they have the right exposure within different regions and, in the long • Central banks in the U.S. and abroad will tighten run, whether their exposure to international monetary policy in 2019 – this should continue to equities overall push yields higher. In the later stages of this cycle, is adequate. investors may want to adopt a more conservative stance in their fixed income portfolios. • There are significant risks to the outlook for 2019. The Federal Reserve may tighten too much; profit • Higher rates should limit multiple expansion, margins may come under pressure sooner than leaving earnings as the main driver of U.S. equity anticipated; trade tensions may escalate or returns. With earnings growth set to slow, and volatility expected to rise, investors may want to diminish; and geopolitical strife may force oil focus on sectors that have historically derived a prices higher. greater share of their total return from dividends. • Timeless investing principles are especially relevant for investors in what appears to be the later stages of a market cycle. Investors may wish to tilt towards quality in portfolios along with an emphasis on diversification and rebalancing given higher levels of uncertainty. INTRODUCTION 2018 has been a difficult year for investors as long First, the fiscal stimulus from tax cuts enacted late last bull markets in both U.S. equities and fixed income year will begin to fade. Under the crude assumption of an have encountered strong headwinds, and immediate fiscal multiplier of 1, the stimulus from tax cuts international stocks have underperformed following would have added 0.3% to economic activity in fiscal 2018 a very strong 2017. Shifting fundamentals in an (which ran from October 2017 to September 2018), 1.3% in aging expansion have certainly played their part fiscal 2019 and 1.1% in fiscal 2020. However, it is the in slowing investment returns, as the U.S. Federal change in stimulus, rather than the level of stimulus that Reserve (Fed) has gradually tightened U.S. impacts economic growth, so this tax cut would have monetary policy, a new populist government in added 0.7% and 0.6% to the real GDP growth rate in the Italy has revived Eurozone fears and Middle East current and last fiscal years, respectively, but should turmoil has led to more volatile oil prices. actually subtract 0.1% from the GDP growth rate in the However, the single most important issue moving next fiscal year. global markets in 2018 was rising trade tensions, Second, higher mortgage rates and a lack of pent-up and this will likely also be the case in 2019. In a demand should continue to weigh on the very cyclical benign scenario, the U.S. and China come to an auto and housing sectors. agreement on trade issues, potentially allowing the Third, under our baseline assumptions, the trade conflict dollar to fall and emerging market (EM) stocks to with China worsens entering 2019 with a ratcheting up of rebound following a very rocky 2018. In an tariffs to 25% on USD 200 billion of U.S. goods. Even if the alternative scenario, an escalating trade war could conflict does not escalate further, higher tariffs would slow both the U.S. and global economies with likely hurt U.S. consumer spending and the uncertainty negative implications for global stocks. surrounding trade could dampen investment spending. While investors will likely focus attention on trade Finally, a lack of workers could increasingly impede tensions and other risks to the forecast, it is also economic activity. Over the next year, the Census Bureau important to form a baseline view of the outlook. expects that the population aged 20 to 64 will rise by just And so in the pages that follow, we outline what we 0.3%, a number that might even be optimistic given a believe is the most likely scenario for the recent decline in immigration. With the unemployment U.S. economy, fixed income, U.S. equities and the rate now well below 4.0%, a lack of available workers global economy and markets. We also include a may constrain economic activity, particularly in the section exploring some risks to the forecast and end construction, retail, food services and hospitality with a look at investing principles and how they can industries. help investors weather what could be a volatile year ahead. Under this scenario, the U.S. unemployment rate should fall further. Real GDP growth impacts employment growth with a lag, and a few more quarters of above-trend economic U.S. ECONOMICS: FINDING MORERUNWAY growth could cut the unemployment rate to 3.2% by the Entering 2019, the U.S. economy looks remarkably healthy, with end of 2019, which would be the lowest rate since 1953. a recent acceleration in economic growth, unemployment near a However, we do not expect the unemployment rate to fall 50-year low and inflation still low and steady. Next July, the much below that level, expansion should enter its 11th year, making this the longest U.S. as remaining unemployment at that point would largely expansion in over 150 years of recorded economic history. be non-cyclical. However, a continued soft landing, in the form of a slower but still steady non-inflationary expansion into 2020, will require both luck and prudence from policy makers. On growth, real GDP has accelerated in recent quarters and is now tracking a roughly 3% year-over-year pace. However, growth should slow in 2019 for four reasons: Civilian unemployment rate and year-over-year wage growth for private production and non- FIXED INCOME: TIME FOR THE BUBBLE PACK supervisory workers U.S. fixed income investors have faced a tough EXHIBIT 1: SEASONALLY ADJUSTED, PERCENT environment in 2018. Faster growth, growing fiscal deficits and balance sheet reduction pushed the U.S. 10-year yield from 2.40% at the end of 2017 to 14% 50-year avg.  Unemployment rate 6.2 % 3.15% by mid-November. The Bloomberg Barclays 12%  Wage growth 4.1% U.S. Aggregate has fallen 2.3% year-to-date, looking Nov. 1982:10.8% 10% May 1975:9.0% Oct. 2009: 10.0% set to end 2018 in negative territory –only the fourth Jun. 1992:7.8% year since 1980 that the benchmark has registered 8% Jun. 2003: 6.3% Oct. : 2018 an annual decline. So what might 2019 hold for 6% 3.7% investors in bonds? 4% Oct. 2018:3.2% The Fed should continue to raise rates early in 2% 2019, adding two more rate hikes by mid-summer 0% and pushing the federal funds rate to a range of ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10 ’15’18 2.75%-3.00%. However, if economic growth slows Source: BLS, FactSet, J.P. Morgan Asset Management. in the second half of 2019, inflation should remain Guide to the Markets –U.S. Data are as of October 31, 2018. remarkably stable for this late in the cycle. This could allow the Fed to pause its hiking cycle at that As unemployment continues to fall, wage growth point, and economic data may not give them may rise somewhat further, as it did in October, as reason to resume tightening again. shown in Exhibit 1. However, the lack of responsiveness of wages to falling unemployment A number of other central banks will also join the this far in the expansion speaks to a lack of Fed in gradually tightening monetary policy in 2019. bargaining power on the part of workers that The European Central Bank will finish purchasing should persist into 2019, holding overall wage assets by January 2019 and should begin raising inflation in check. rates by mid-2019. Other central banks, such as the Bank of England and the Bank of Japan, should Finally, consumer inflation should remain relatively engage in some form of modest tightening. stable in 2019. A mild acceleration in wage growth will, undoubtedly, put some upward pressure on Some investors may see this global tightening as a consumer prices. However, a recent rise in the U.S. concerning development since, in many ways, dollar and fall in global oil prices should both work central banks have provided the training wheels to to keep inflation in check. Higher tariffs might, of help stabilize markets over the course of this cycle. course, add to consumer inflation in the short run. However, the gradual removal of these training However, their depressing effect on economic wheels shows that central banks believe economies activity would likely counteract this. With or without can now cycle on without their support –a sign of higher tariffs, we expect consumer inflation, as strength, not of weakness. Nevertheless, while the measured by the personal consumption removal of this support should be viewed as a deflator, to end 2019 in much the same way as 2018, positive, it could trigger increased volatility and very close to the Fed’s 2.0% long-run target. gradually rising yields. With regards to the U.S. dollar, the currency may So how should investors be positioned going into face some further upward pressure early in 2019 as next year? As we get later into this economic cycle, it U.S. growth remains strong and uncertainty around is important that investors begin to bubble pack trade abounds. However, later into the year, the their portfolios. This, in effect, means dialing back on combination of a slowing U.S. economy, a more some of the riskier bond sectors and seeking the cautious Fed and tightening by international central safety of traditional fixed income asset classes. This banks should cause the U.S. dollar to end 2019 flat step may involve sacrificing some upside in the short to down compared to the end of 2018. term for additional protection. At this point in the cycle, investors should EQUITIES: A LITTLE MORE DEFENSE AS THE remember the diversification benefits of core LIQUIDITY SAFETY NET IS REMOVED bonds, as highlighted in Exhibit 2. Exhibit 2 The end of 2018 has served as a reminder that stock market shows that higher yielding, riskier asset classes, volatility is alive and well. Investors have recognized that such as EM debt or high yield, may offer more trees do not grow to the sky, and that the robust pace of yield, but with stronger correlations to the S&P profit and economic growth seen this year will gradually fade 500. Therefore, if in 2019 as interest rates move higher. While history suggests equities fall sharply, riskier bond sectors will not that there are still attractive returns to be had in the late provide much protection. In short, higher yield stages of a bull market, the transition away from quantitative equals higher risk. easing and toward quantitative tightening has contributed to Late in the cycle investors should remember broader investor concerns. Many equate this new higher yield equals higher risk environment to walking on an investment tightrope without EXHIBIT 2: CORRELATION OF FIXED INCOME the liquidity safety net that has been present for over a SECTORS VS. S&P 500 AND YIELDS decade. 8% Higher risk  US government sectors  USnon-government While it is true risks are beginning to build, there are still 7%  International  Euro HYz some bright spots. First, earnings growth looks set to slow 6%  EMDUSD  USHY from the  Italy  EMD local +25% pace seen this year, but does not look set to stop, as 5% Safety shown in Exhibit 3. Consensus forecasts point to annual Sectors 4%  USIG earnings growth of 10%-12% next year; risks to this forecast  Spain  EuroIG MBS Globalx-US  Germany  France UK US agg  EU  ABS are to the downside, but earnings could still grow at a mid to 3%  US30y  Canada  TIPS  UUSS150yy  Australia US 2y Japan  Munis  Floating high single-digit pace in 2019, providing support for the 2% stock market to move higher. -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 S&P 500 year-over-year EPS growth Source: Bloomberg, FactSet, ICE, J.P. Morgan EXHIBIT 3: ANNUAL GROWTH BROKEN INTO Asset Management. Data are as of July 7, 2018. REVENUE, CHANGES IN PROFIT MARGIN & 60%  Margin 17.7% 3.8% International fixed income sector correlations are in CHANGES IN SHARE COUNT47%  Revenue Share count 9.1% 1.7% 3.0% 0.2%  40% EPS Shareof TotalEPS 28.5% Growth3Q18Avg.’01-’17 6.9% 3Q18* hedged US dollar returns as 27% 27% 29% 24%  U.S. investors getting into international markets will 20% 19% 19%    13% 15% 15% 15% 17%      11% typically hedge. EMD local index is the only  0%  5%  6%  0%  exception – investors will typically take the foreign  -6%  exchange risk. Yields for all indices are in hedged -20% -11% returns using three-month London interbank  -31% -40%  offered rates (LIBOR) between the U.S. and -40% international LIBOR. The Bloomberg Barclays ex- -60% ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11’12’13’14 ’15’16’171Q182Q183Q18 U.S. Aggregate is a market-weighted LIBOR calculation. Data are as of September 12, 2018. A common theme in this cycle has been the hunt for yield, with investors moving Source: Compustat, FactSet, Standard & into unfamiliar asset classes searching for higher returns to offset the low yields Poor’s, J.P. Morgan Asset Management. in core bonds. This isn’t necessarily an incorrect strategy in the early or middle Earnings per share levels are based on stages of an economic expansion; however, in the late cycle this approach annual operating earnings per share becomes riskier. Instead, investors should consider trimming higher-risk sectors except for 2018, which is quarterly.*3Q18 earnings are calculated and rotating into safer, higher- quality assets. Areas like short duration bonds using actual earnings for 68.3% of S&P offer some yield to investors with downside protection. 500 market cap and earnings estimates The key takeaway for investors is that central banks will continue to tighten for the remaining companies monetary policy in 2019, inflicting some pain on bond-holders. However, at this Percentages may not sum due to stage in the cycle, the focus should begin to switch from yield maximization to rounding. Past performance is not downside protection. In short, now is the time to start adding bubble pack to indicative of future returns. Guide to the portfolios. Markets – U.S. Data are as of October 31, 2018. The risks to earnings, however, lie in profit margins and trade. expectation for higher volatility. As such, higher-income 2018 has seen profit margins expand significantly on the back sectors like financials and energy look more attractive than of tax reform, but with both wage growth and interest rates technology and consumer discretionary, and we would lump expected to rise further next year, margins should begin to the new communication services sector in with the latter come under pressure. Importantly, we believe that profit names, rather than the former. However, given our margins should revert to the trend, rather than the mean, expectation of still some further interest rate increases, it and as such we are not expecting a sharp adjustment from does not yet seem appropriate to fully rotate into defensive current levels. sectors like utilities and consumer staples. Rather, a focus Trade is a less quantifiable risk –we believe an escalating trade on cyclical value should allow investors to optimize their war with China could have a significant direct impact on S&P upside/downside capture as this bull market continues to 500 profits, and could have further indirect costs depending on age. the extent of Chinese retaliation and the dampening impact of INTERNATIONAL EQUITIES: DOES THE FOG LIFT IN the turmoil on business confidence and the globaleconomy. 2019? However, on a close call, we believe that the U.S. and China will Going into 2018, we had expected international equities to avoid escalation beyond an increase in tariffs on USD 200 billion continue the climb they began the prior year. As the year of Chinese goods, scheduled for January 1st, and a predictable comes to a close, major regions outside of the U.S. seem Chinese response to this move. set to deliver negative returns in U.S. dollar terms. Looking A backdrop of rising rates will not only pressure profit margins at a breakdown of international returns in 2018, as shown and earnings, it will also pressure valuations. Years of in Exhibit 4, it is easy to see that the climb was halted not quantitative easing by the world’s major central banks pushed because the plane itself was not solid, but because there was investors into risk assets –most notably equities –as they a lot of fog on the runway. Said another way, fundamentals sought to generate any sort of meaningful return. However, themselves were positive in 2018, but a multitude of risks short-term interest rates are now positive after adjusting for dented investor confidence, causing significant multiple inflation, creating some viable competition for stocks. With the contraction and currency weakness across the major regions. Fed expected to hike rates at least two more times in 2019, As a result, the question for 2019 is whether the fog will higher yields seem set to remain a headwind to stock market begin to lift, improving sentiment toward international valuations over the coming months. investing and permitting international equities to take off once again. Slower earnings growth and more muted valuations certainly do not seem like an ideal fundamental backdrop for equities. 2018 was a year of souring sentiment towards international While it is true that the outlook is beginning to look less bright, EXHIBIT 4: SOURCES OF GLOBAL EQUITY RETURNS, it is important to remember two things: markets care about TOTAL RETURN, USD  Total return  EPS growth outlook (local) 25% changes in expectations more than they care about  Dividends  Multiples 20% expectations themselves, and the stock market tends to  Currency e¦ect 15% generate solid returns at the end of the cycle. 10% 3.0%  As prospects for slower economic growth become clearer in 5% the middle of next year, the Fed may signal it will pause. Such a 0% -6.7%  -9.4% -10.6% signal, or a trade agreement with China, could lead multiples to -5%   -15.4% expand, pushing the stock market higher and potentially adding -10%  years to this already old bull market. However, even if the bull -15% -20% market does end in the next few years, it is important to U.S. Japan Europe ex-UK ACWI ex-U.S. EM -25% remember that late-cycle returns have typically been quite strong. This leaves investors in a tough spot –should they focus on a Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management. fundamental story that is softening, or invest with an expectation that multiples will expand as the bull market runs All return values are MSCI Gross Index (official) data, except the U.S., which is the S&P 500. Multiple its course? The best answer is probably a little bit of each. We expansion is based on the forward P/E ratio and EPS are comfortable holding stocks as long as earnings growth is growth outlook is based on next twelve month actuals positive, but do not want to be over-exposed given an earnings estimates. Data are as of October 31, 2018. The first factor affecting confidence abroad was For Japan, 2018 also brought some economic disappointment around economic growth. In disappointments, with some clearly temporary as a absolute terms, global economic data remained on result of a multitude of natural disasters. Growth much more solid footing in 2018 compared to the should pick up a bit above 1% next year, as nascent crisis-filled years of 2011 to 2016. This allowed bu
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