Positioning for Market Risks in 2019

Investors enter 2019 facing a long list of macroeconomic and geopolitical risks. But there is some good news. Strategic approaches to equity and fixed-income markets can help investors rise to the challenges.

Will the global economy slow down, or even worse, slip into recession? Is inflation coming back? How do you navigate geopolitical risks, such as the Italian government’s fiscal plans, Brexit or trade wars? Will tighter monetary policy from central banks and rising interest rates shake financial markets? These are just a few of the questions that are keeping investors up at night these days.

In this article, we survey some of the biggest concerns hanging over financial markets as the new year begins. With a measured analysis that looks beyond the news headlines, we aim to help investors prepare for various scenarios and plan appropriately for their risk appetites.

Stay Invested as the Global Economy Slows

Fears of a global recession are palpable as the new year approaches. Yet is world economic growth likely to decline in 2019? It’s important to distinguish between a deceleration of growth and a recession—in which the economy actually shrinks.

The global economy is facing a confluence of challenges. US economic growth signals remain resilient, even though the pace of growth might be damped somewhat by monetary policy tightening. China’s economy is slowing and may require a significant dose of policy stimulus to prevent a deeper decline. Emerging markets have been hurt by a stronger dollar. Europe’s nascent economic recovery has hit some hurdles. In Japan, hopes of an end to deflation are tenuous amid anemic growth, and the government is planning various stimulus measures in 2019. Meanwhile, trade tensions add an unpredictable threat to global economic growth.

Taken together, these trends do suggest that the global economy will slow down in 2019, but probably won’t fall into recession. Investors who prepare for the worst by moving all their assets to the safety of cash might forfeit return potential if moderate growth continues, as we anticipate.

In this environment, we think it’s important for investors to stay in the market. Even today, with a global economic growth slowdown widely expected, corporate earnings are still projected to rise by 8.3% in 2019, according to consensus estimates. Equity valuations are reasonable following strong earnings and weak returns in 2018, while the global equity risk premium remains above average, even with higher rates. And although global corporate credit spreads have widened from very low levels, they don’t signal distress—and opportunities can still be found in pockets of the market.

But most importantly, it’s almost impossible to predict how financial markets will react to dynamic economic data or to perfectly time inflection points—on the way up or down. So, in our view, strategies that can help investors stick with a plan through potentially volatile markets are essential today.

Protect Portfolios from Inflation

Even as global economic growth slows, signs of inflation are starting to appear. For years, investors have grown accustomed to a low inflation world, fostered by central bank policy, globalization and technological progress. We think this may be coming to an end.

Cyclical forces, such as strong labor markets and tight capacity, are fueling higher prices. But there are also structural forces at work, such as the rise in populism in many countries, which threatens to curb the decades-long globalization trend that has supressed prices in many industries. In this environment, we still expect risk assets such as equities and credit to deliver returns, but along with that will come the significant volatility consistent with late-cycle dynamics.

If inflation persists even as growth slows, central banks may have no choice but to continue on the path of interest-rate normalization that many—particularly the US Federal Reserve—have begun. This could mean additional weakness in government bonds and other rate-sensitive assets (after a weak year in 2018). And it could create an unusual environment in which bonds and stocks underperform at the same time. Fortunately, these types of periods have tended to be short-lived. Fixed-income investors should consider including inflation-linked securities, such as US Treasury Inflation-Protected Securities (TIPS), to help offset some of the potential impact of rising inflation.

Commodities typically provide diversification and do well in rising inflation environments. But the risk for 2019 is that the slowdown in growth, particularly in emerging markets, compounded by trade tariffs, will all put pressure on commodity producers. The push-pull between weak demand and inflation may make this trade less effective than in the past. While commodities have a useful role to play, investors should be sensitive toward taking too heavy a position.

Don’t Build Investing Strategies on Politics

Geopolitical events are playing on the minds of investors. In turn, these influence investment decisions and stock market dynamics. Bad political news is always a fact of life for investors. But these days, many stresses are being driven by a retreat from globalism in many regions.

It can be tempting to think you can gain an investing edge from political insight. We think that’s a highly risky strategy. Since political outcomes are unpredictable (remember the Brexit vote?), staking any investment decision on the potential outcome of a political controversy or event is imprudent. What’s more, market responses to political outcomes can be surprising. Few investors predicted that US stocks would surge in the months following President Donald Trump’s election in November 2016.

However, political risk can be addressed in research, scenario analysis and active security selection. The key is to identify the most potent risks, avoid the most vulnerable companies and look for companies that could benefit as a political scenario plays out. However, always establish that a company’s fundamental investment thesis is not anchored to a political event or outcome.

For example, political pressures are mounting in Italy and the Italian government bond yield spread over German Bunds has widened. With every round of the Italian political game, we expect fresh bouts of volatility—although the systemic impact should remain limited. Given their large sovereign debt holdings, concerns about Italy have cast a shadow over Italian banks and the European banking sector in general—which is also creating opportunities. In fact, European banks’ fundamentals generally have improved over recent years, and we believe that their subordinated debt—in particular, Additional Tier 1 (AT1)—looks attractive now. We believe that fixed-income investors should focus more on those banks with relatively strong fundamentals and coherent business models (i.e., the more defensive stories).

Brexit is also creating ongoing investment headaches. There’s little clarity on what a final deal between the UK and European Union might look like. Certainly, many domestically focused UK companies could find their businesses squeezed if the British economy gets hit hard by the economic consequences of Brexit. Yet other UK-listed companies, with multinational operations and more resilient revenue sources, may enjoy a “Brexit discount” to their share price that doesn’t reflect their true long-term earnings potential.

Meanwhile, as Chinese leaders wrestle with an already complex set of economic issues, the trade standoff is adding to the country’s problems. The truce announced in early December offers hope that a full-blown trade war can be avoided, but there are still many hurdles to a full resolution. Instead of positioning portfolios for an escalation or resolution of the trade war, we think investors should still consider the potential impact of a trade war when researching industries and companies. For example, we assessed what type of companies could get caught in the crossfire of an escalating trade war by identifying vulnerable revenue streams. We found that the technology and industrial sectors are both more exposed to trade winds than other sectors. Yet within those sectors, semiconductor and hardware industries look much more vulnerable than software and services (Display).

The US-China dispute extends far beyond trade. Technology transfer, market access and currency issues are all variables in the complex relationship between the world’s two largest economic powers. If a full resolution on trade is reached by the end of February, as targeted by the US-China truce announcement, markets will welcome the removal of a major uncertainty. Still, it’s clear that tensions between the US and China will add uncertainty to markets in 2019. Yet active investors that stay closely attuned to the developments should be able to avoid the biggest risks and uncover opportunities created by shifting trading dynamics.

Preparing for Rising Rates

Throughout 2018, investors of all types have started to consider changes to central bank policy around the world. After a decade of historically loose monetary policy, including ultralow interest rates and massive bond-buying packages, major central banks have begun to shift into tightening mode. While the specific measures, timing and pace will differ from region to region, there’s little doubt that a gradual tightening of monetary stimulus globally is underway.

The US is leading the way. After a series of official rate increases this year by the Fed, more are expected in 2019. With unemployment close to multigenerational lows and inflation close to the 2.0% target, the case for further hikes is strong—barring continued weakness in oil prices or unexpected softening/strengthening in other economic indicators.

The European Central Bank (ECB) has announced plans to phase out its QE program in December, and European interest rates are likely to rise in the second half of 2019. The Bank of Japan has also reduced its asset purchase program, though it is still in a much looser phase of its monetary policy given the country’s ongoing efforts to stimulate inflation.

Central bankers aren’t operating in a vacuum. The Fed, for example, is keeping a close watch on financial conditions to help ensure that its policies don’t harm economic growth. Big efforts are being made to ensure better communication and greater transparency during this sensitive juncture in global financial history. Still, we expect the withdrawal of monetary stimulus to provoke more market turbulence—like the bouts of volatility that we saw in February and October of 2018. Yet we don’t think a major market shock is likely.

Case Study: Europe

Europe provides a good case study. Accommodative policies have supported risk assets for several years. As a result, many investors fear that the withdrawal of support could jolt the markets and further stifle the regional economic recovery.

We think those fears are overdone. In 2011, when the euro crisis erupted, the ECB had limited tools at its disposal to manage the situation. Today, if European economies start to flag, we think the ECB has a wider range of levers to pull (Display) to keep momentum positive and to address possible problem areas, such as a spillover to the rest of the region from rising populist pressures in Italy. Increased volatility is likely as ECB buying eases. But we see this as a short-term technical factor that could create buying opportunities for investors.

Fixed Income: Recommendations for Rising Rates

So what can investors do? Fixed-income investors can follow three rules to survive a rising rate period. First, stay properly invested in the market and beware of shifting into cash. While it seems intuitive that rising rates push down bond prices, the reality is more complex. In fact, in the long run, rising rates are good for bond investors, because the income they generate in the form of coupon payments gets reinvested at higher rates. Our research shows that a simple US Treasury portfolio would initially get hit by a sudden 125 basis point rise in interest rates. Yet even so, the portfolio generates income, and investors who stay the course can reinvest that income at a higher yield over time (Display). This helps to make up for the price loss and eventually offsets it altogether.

Second, make sure that there is an appropriate balance of interest-rate risk and credit risk in the asset allocation. A key risk as rates rise is that investors reduce duration and overallocate to credit—both of which reduce the defensive nature of a bond portfolio in a risk-off environment. Third, diversify by combining different types of bonds. Within credit for example, blending exposure to high-yield bond sectors—European banks, US energy companies—with positions in select emerging-market debt and US securitized assets offers a good mix of credits that can generate high levels of income. In government bonds, you can improve outcomes by diversifying across global yield curves.

Equities: Recommendations for Rising Rates

Equity investors can also take steps to prepare for rising rates. First, pay close attention to the debt levels of companies. As interest rates rise, companies that borrowed too much during the easy money years may struggle to meet their financing costs. This, in turn, could squeeze earnings and profitability and eventually hurt stock prices. Our research shows that the stocks of US companies with high leverage underperformed the stocks of companies with low leverage by 7.2% as of this year through the end of October. Equity investors should always focus on balance sheets, but these days, we think it’s more important than ever.

Second, beware of defensive stocks that might be vulnerable to rising rates. In the quest to find defensive assets, don’t overlook potential risks. For example, utilities stocks tend to be sensitive to rates and may underperform if rates rise. In consumer staples, another defensive sector, many companies are facing disruption from technology and changing consumer tastes, and may not be as safe as they were in the past.

Finally, look for companies that can continue to grow earnings and invest capital profitably regardless of the external macroeconomic and political risks.