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14 January 2019

9 points to ponder for 2019

2018 was a turbulent year for markets where events flew by at a pace that was equal parts stimulating and exhausting. 2019 might be more of the same. If anything, the year ahead might be chock-full of event risks, potential policy errors, and possible political commotions. Yet, wild swings in market sentiment tend to give rise to plenty of attractive opportunities. We need only be brave to seize them. It’s the year of living dangerously.

We offer 9 points to ponder as we head into 2019.

1. Slowing growth, yes. Recession, no.

On a macro level, there’s little in the way of economic data that points to the prospect of an imminent recession. Economic growth is slowing back to its long-term trend following an unusually buoyant 2017, but that itself is a far cry from expecting two consecutive quarters of negative growth. Looking at the composite Purchasing Manager Indices (PMIs) - which measures economic activity and business sentiments in the manufacturing and services sectors - across the G3 economies, China and globally, they remain firmly within expansionary territory (above 50), even after retreating from 2017 highs.

2. Also, there are a couple of reasons to remain somewhat constructive in 2019.

Potential escalation in US-China trade tensions and tighter monetary policy remain key concerns for sure, but recent events have provided some reprieve, even if temporary.

First, the US and China have agreed to a 90-day truce, paving the way for more constructive negotiations ahead.
Second, the Federal Reserve has signalled that it remains cautious about raising interest rates too quickly as they approach neutral, having revised the median expectation for rate hikes from three to two in 2019. These factors offer some much-needed breathing room as we move into the new year.

3. But turbulence will be the rule, not the exception, in 2019.

If anything, the spoils of 2017, including low volatility, was the anomaly. Volatility is likely to increase as the monetary policy environment becomes more challenging for risk assets. While we have observed a steady tightening of financial conditions resulting from recent market turbulence and higher interest rates, they are not yet at levels that would drastically hamper economic growth.

4. Monetary policy will get incrementally tighter in 2019.

Beyond the Fed, a broader set of developed market central banks including Canada, the UK, Sweden and Norway have signalled intentions to continue normalising policy rates from crisis-era lows. The European Central Bank (ECB) has ceased its asset purchase programme whilst signalling that interest rates could move higher after the summer of 2019. The bias for interest rates is higher, not lower.

Meanwhile, the overall pace of balance sheet contraction of the G3 central banks is set to accelerate in 2019, with the ECB no longer pursuing quantitative easing and the Fed shrinking its balance sheet at the fastest pace since the process kickstarted in 2017.

5. Yet, let’s not be overly negative about the prospect of broader monetary tightening.

As it stands, policy rates are low by historical standards and liquidity is still abundant. To put things in perspective, the combined balance sheet of the G3 central banks rose about US$1.8 trillion in 2016, US$1.3 trillion in 2017 and just US$0.1 trillion in 2018. By way of comparison, we should see a decline of about US$0.5 trillion in 2019. The upshot is, there is still plenty of liquidity in the system.

Also, even as the Fed continues to tighten, the Fed Funds rate is still below neutral, and policy remains relatively loose. Fed Chair Jerome Powell alluded to this point in his press conference post the December policy meeting, citing that monetary policy will still provide a “smaller boost” in 2019. This is not a policy environment where we would expect a serious economic slowdown.

With the policy environment still mildly supportive, there’s little reason to be overly pessimistic about global growth prospects, for now. Monetary policy on a broader level will get incrementally tighter over time for sure, but we remain some distance before interest rates become restrictive for growth. This is coming, but it may not be in 2019.

6. Political risks still lurk.

Europe faces political challenges from multiple fronts in 2019, ranging from uncertainty over Germany’s future leadership after Angela Merkel, to brewing tensions on the back of France’s deficit busting budget proposal (Italy is out of the red for now), to European Parliament elections in May this year.

Also, the countdown to Brexit (or not) begins as the 29 March deadline approaches. There is a chance that the end-March deadline could be lifted if necessary with the European Court of Justice recently ruling that the UK can unilaterally withdraw Article 50.

In the US, a divided Congress may throw up more episodes of potential instability with the debt ceiling increase and budget ratification used as potential political gambits to elicit concessions, whatever they may be. There have been three government shutdowns in 2018 alone, notably with a Congress under unified Republican control. One could only imagine what a divided Congress would bring in 2019. Greater policy instability is also a real possibility as rising domestic political pressures could push President Trump to flex his policy muscle on areas where the executive branch wields broad unilateral powers such as trade and national security. In this, attention will remain squarely on how the politics underlying the US-China trade negotiations develop in 2019.

7. From out of the ashes of market despair, we see opportunity.

Investors’ resolute focus on risk factors such as recession risks, US-China trade tensions and an overly-hawkish Fed in the fourth quarter has led markets sharply lower, erasing any gains for the year. Asia ex-Japan was among the biggest losers this year amidst the confluence of a stronger US Dollar, tightening Federal Reserve, escalating US-China trade tensions and slowing Chinese economy.

A key upshot of the sell-down is that valuations have returned to more reasonable levels. Cheaper valuations on the back of a benign macro-economic outlook, still supportive policy environment and robust earnings growth have opened opportunities for market entry.

8. Asia ex-Japan look particularly attractive.

Armed with healthy external surpluses and fiscal buffers, the region continues to exhibit resilience amidst a series of external pressures. US-China trade tensions remain a concern for sure, but signs of progress in recent negotiations eases that worry somewhat. Also, Southeast Asia is wellpositioned to benefit from inflows of businesses looking to move production facilities to other cost competitive regions in order to skirt trade tariffs. Barring a complete collapse of world trade, Asia ex-Japan looks well-positioned to hold its own against an increasingly unforgiving external environment.

As it stands, valuations have come off quite meaningfully, with the MSCI Asia ex-Japan index trading at a blended forward Price-to-Earnings of 10.9 times (as at 2 January), about 1.5 standard deviations below the past 5-year average and 0.9 standard deviations below the past 10-year average.

Attractive valuations coupled with relatively sound economic fundamentals keep us particularly optimistic about the region. A seemingly cautious Fed and early signs of progress in US-China trade negotiations only make the case for Asia ex-Japan firmer.

9. Stay invested, stay safe and engage risk prudently in 2019.

Constructive as we are on the macro outlook, we believe that the balance of risks is shifting to the downside. A mix of slower economic growth, gradually rising interest rates, persistent trade frictions, higher inflation, elevated financial market volatility and rising geopolitical risks translates into an increasingly difficult environment for risk assets as we move through 2019.

Despite these challenges, clients should remain invested in the markets through a diversified portfolio. As Chart 4 illustrates, missing out days when markets rebound is a real cost for long-term investors. Indeed, as a general rule, investors should look through the noise of short-term ructions and focus on the long-term fundamentals and rewards. After all, markets tend to trend higher over the long-term.

The key is to have a well-constructed and diversified portfolio in place to ride out volatile periods. Diversification, coupled with active management, can help generate returns and mitigate losses when navigating such rocky market terrain. It’s akin to having a reasonably strong vessel to navigate rough seas – the ship will get you to your destination with time, but the journey could be faster and perhaps more comfortable if the vessel were sturdier and the ship captain skilled.

In addition, diversification applies not only to an investor’s overall portfolio but also to the timing of market entry. Forget about timing the market. A disciplined dollar-cost averaging strategy tends to work better in volatile markets. Ultimately, it is time in the market, not timing the market, that leads to better and more sustainable long-term rewards.

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