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Central economic scenario: Steady as she goes – 65% probability

  • By Georgie Davey
  • News

Shamik Dhar, Chief Economist at BNY Mellon Investment Management, shares his predictions for 2019:

Our central economic forecast sees the world economy slowing in 2019, led by a slowdown in both the US and China. World trade growth slows as well, causing trade-dependent regions such as the euro area and some Asian countries (ASEAN) to disappoint. At the same time, the central outlook assumes there is more ‘room to grow’ in the US than is commonly believed.

Disappointing growth means global equity returns are notably lower in 2019-2020 than in recent years, but markets are supported by a lower path for Fed hikes. US Treasury bond yields increase and the negative bond-equity correlation established since the global financial crisis remains intact for now. Global equity market volatility remains structurally higher than in recent years, thanks in part to the transition from quantitative easing (QE) to quantitative tightening (QT) by the world’s major central banks. The dollar stabilizes or even falls a touch, oil prices stay low and trade tensions do not get significantly worse, all of which lends support to EM debt and equity markets.

Risk scenarios

We see a number of risks to this outlook.  In one, growth is somewhat stronger, economies are closer to capacity, inflation picks up strongly and interest rates go up faster.  This scenario is much worse for both equities and bonds. In another, the US Federal Reserve raises interest rates more rapidly towards ‘neutral’, with severe implications for risk assets.  In the third, markets diverge from economic fundamentals and sell off independently, because valuations look overstretched in an environment of slowing growth.

As well as these scenarios, there is a lot of idiosyncratic event risk. These include: the worsening of trade tensions between the US and China; renewed crisis in the euro area, triggered by Italy; and Hard Brexit.

Bringing this all together we foresee a tricky year ahead for investors and attach a 65% probability to our central scenario and a combined 35% to our other risk scenarios.

Technical vulnerabilities in markets, but no recession around the corner

Despite the very real near-term sentiment and technical challenges to market appreciation, we believe that ultimately that there is no recession around the corner and that the market will ultimately right itself.  Much of the data show that the US economy remains robust, driven by the healthiest labour market in nearly 50 years and tame inflation signals.

Investment conclusions: Be prudent

Although we do not anticipate a sustained rise in the VIX index, we do foresee regular jumps during 2019 that will test investors’ conviction. We expect the negative correlation between stocks and bonds to continue for now, but this relationship could weaken over time, particularly if we see a notable rise in inflation. The possibilities of higher correlations among traditional asset classes require investors to include more non-traditional hedges in portfolios to effectively navigate a choppy market path.

Additionally, valuations on the broad U.S. market, as measured by the Shiller CAPE, suggest a future of lower equity returns. Considering this, it would be prudent for investors to re-evaluate their allocations in the U.S. equity markets and ensure exposure to assets that have seen more valuation pressure over the last 12-months. Specifically, we expect high quality stocks in the value universe to hold-up better than high octane growth names during 2019.

Emerging opportunities

Emerging markets present investors with an interesting opportunity as the 2018 sell-off has re-rated these markets compared to US markets.  Before recommending a meaningful increase to EM we are closely watching trade war developments for de-escalation, and the path of further tightening by the US, both of which would keep the USD strong.  Having said that, should there be progress on the trade war front and should the Fed indicate it could pause rate increases in 2019, then we foresee a scenario where emerging markets could outperform developed markets on a relative basis due to the removal of meaningful headwinds.  Mid-2019 could present a buying opportunity.

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