It's Different This Time

Investors are likely to remember 2018 as the end of the era of easy money, low volatility and steady margin expansion. Investing will be more challenging in 2019—and diversification will be more important than ever.

Among the challenges? Volatility, slower growth, less liquidity and more policy risk. When stocks sold off globally in late 2018, investment-grade and high-yield bond spreads widened, too. That’s something that didn’t happen during a similar surge in equity volatility earlier in the year. This is one of the developments that suggests to us that the current risk spike is about fundamentals and may be more severe and last longer than past ones.

In our view, this doesn’t mean disaster ahead. This is a transition from an unusually supportive environment to one that’s less so. That’s typical when the global economy is late in the cycle, and investors need to understand this new reality thoroughly to make portfolio decisions. Here are a few of the trends we’re watching closely.

Peak Earnings, Slower Capital Investment

Market multiples contracted quite a bit during the late 2018 selloff. And at this late stage of the cycle, rates aren’t likely to decline much unless growth concerns become more acute. Therefore, we are not expecting market multiples to recover much. That means earnings growth will be critically important for equity returns. But earnings expansion depends heavily on continued growth in business investment, and we expect that to slow.

Business investment has been a key driver of the market’s growth expectations. As the left side of the following Display shows, capital expenditure accounted for nearly a third of gross domestic product (GDP) growth in the US in 2018. This helps explain why economic growth rebounded from its 2016 trough.

But the spending we saw over the last two years was most pronounced in the US. When we take the US out of the capex equation, estimates show it likely slipped from 6.6% to 6.0%. Even in the US, business investment was frontloaded in 2018 and began losing momentum in the second half.

Companies have suggested that an uncertain trade environment is partly to blame for their decision to put off investment decisions. And declining business confidence and lower spending intentions suggest that capex growth is likely to slow, as indicated by the right side of the display above.

Reduced capital spending would be a headwind to global economic growth. Recent data, such as that showing a sharp decline in US manufacturing activity in December, is starting to bear this out. This is consistent with our view that earnings growth has peaked. Falling capex was a key factor in the last global earnings recession in 2015, and recent results have shown broad deterioration in earnings revisions in both developed and emerging markets.

Watch China and Global Politics

The world’s second largest economy will have a big impact on the global growth outlook, too. Even with a good amount of policy stimulus, China’s growth will likely slow in 2019 as the economy deals with deleveraging and US tariffs and worsening demographic trends. If stimulus falls short of the mark, the slowdown could be more severe and could weigh heavily on global growth and commodity markets.

Then, there’s political risk.

In today’s world, domestic politics in any major country can affect the global economy and markets. It’s happened with sudden shifts in US trade policy, the ongoing Brexit saga and the fiscal standoff between Italy and the European Commission. The popular backlash against globalization and economic inequality isn’t likely to fade soon. This suggests that the steady margin expansion many big firms have enjoyed over the past decade as they took advantage of cost differences around the world, is going to be tough to repeat.

Fed to the Rescue? Not Necessarily.

Fed Chairman Jerome Powell (and various Fed speakers) sparked a relief rally in risk assets in December by signaling that future rate moves would be data dependent been and that the Fed could pause its tightening path if the US economy weakened.

However, investors who expect monetary policymakers to continue to soothe markets may be disappointed, especially if the cycle continues. Over the last decade, central banks were able to suppress volatility by keeping rates low, growing their balance sheets and stepping in to reassure markets in times of unrest. But as economic conditions improved and deflation fears receded, the Fed began pushing rates higher and reducing its balance sheet. The European Central Bank may soon join in as policymakers in Frankfurt wind down quantitative easing.

But none of this means the Fed will reverse course just to temper market volatility. The US economy remains in solid shape—it added 312,000 jobs in December and 58,000 more than previously reported in the prior two months, unemployment is near historical lows and wages are growing. Uncertainty about the path of future Fed policy is likely to feed uncertainty generally. In other words, investors should expect tighter policy and shakier markets as the cycle matures.

The Portfolio Perspective: Defense Now, Offense Later

How should portfolios adapt to this new market reality? It helps to have a strategy that integrates a broad, diverse group of assets—stocks, bonds, diversifying exposures such as real estate and global credit and factor exposures that thrive in different economic environments. It’s also crucial to be able to adjust those exposures as conditions evolve.

Today, the environment for taking equity and credit risk isn’t quite as attractive as it was a year ago—though these exposures are still important drivers of long-term returns. Volatility should remain high and global growth will likely slow, which should shrink corporate margins and continue the deceleration in earnings growth.

Investors may also want to consider tempering exposure to cyclical assets or sectors despite attractive valuations. As markets reassess forward growth expectations, there may be opportunities to increase exposure within and across sectors as we see signs of stabilization or improvement.

There’s no doubt that investors will have to get used to heightened risk in 2019, but with risk comes opportunity. By structuring their diversified portfolios to be a bit more defensive, investors can position themselves to seize opportunities in dislocated assets as they emerge.