As growth slows and risks rise, investors should expect the unexpected
It’s a common and all too human mistake—extrapolating our current situation into the future and assuming that it will continue to hold. The second half of 2018 saw a deceleration in global growth, rising inflation and more hawkish central bank sentiment. This dynamic has led investors to worry that we have reached the end of the cycle and that this environment will persist, leading volatility higher and risk assets lower.
While we acknowledge that the U.S. economy is in late cycle, we believe that both the economy and markets still have room to run. U.S. economic growth should average around 3% through the middle of 2019 as fiscal stimulus continues to boost headline GDP, but beneath the surface the composition of growth will likely shift. Rising trade tensions have clouded business sentiment, and with corporate executives feeling less optimistic, the pace of capital spending has slowed. On the other hand, lower energy prices should prevent inflation from spiking much higher, which, alongside a tight labor market, should provide support for consumer spending.
As the composition of U.S. growth changes and headline growth gradually decelerates beginning around the middle of 2019, economic growth rates across global economies will likely begin to converge. European GDP growth should rebound as the manufacturing sector finds its footing, and Japan should see more stable growth as the effects of 2018’s natural disasters run their course. Ideally, healthy growth in developed markets, coupled with stimulus out of China, should provide support for the emerging world. That said, uncertainty around trade continues to act as a drag, and continued strength in the U.S. dollar would continue to undermine the pace of international expansion.
Inflation and interest rates
Tighter labor markets and rising wages have begun pushing prices higher across the developed world, while weaker currencies and higher commodity prices have lifted inflation in emerging markets. Output gaps are expected to continue to close, but the recent softening in commodity prices, and wage growth that remains below its long-term average, should cap how much higher inflation can move in the near term.
This backdrop should allow for continued adjustment in the stance of global monetary policy. The conclusion of net new asset purchases by the European Central Bank (ECB), along with balance sheet reduction by the Federal Reserve (Fed), has turned quantitative easing into quantitative tightening (EXHIBIT 1). In this environment, we anticipate that fundamentals, rather than sentiment, will be the key driver of asset prices. On the interest rate front, we expect the Fed will hike at least once in 2019 and then pause as U.S. growth softens amid waning fiscal stimulus. The recent decline in oil prices should lead headline inflation to remain below the Fed’s target, providing the central bank with additional flexibility as it determines the optimal path of monetary policy. More than anything, however, next year’s Fed decisions will be increasingly data dependent. The ECB and Bank of England (BoE) will likely hike as well. Rising rates will deliver more attractive yields to traditional fixed income investments but could simultaneously lead to market dislocation in cases where cheap liquidity has been used irresponsibly.
Quantitative easing has turned into quantitative tightening
EXHIBIT 1: GLOBAL CENTRAL BANK BALANCE SHEET EXPANSION, USD BILLIONS, 12-MONTH ROLLING FLOW
Source: Bank of England, Bank of Japan, European Central Bank, FactSet, Federal Reserve System, J.P. Morgan Global Economic Research, J.P. Morgan Asset Management. Balance sheet expansion assumes no more quantitative easing (QE) from Bank of England (BoE); tapering of European Central Bank (ECB) from 30 billion EUR to 15 billion EUR in October 2018 and zero in January 2019; tapering of Bank of Japan (BoJ) QE to 20 trillion JPY annually for the remainder of 2018 and 2019. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They serve as an indication of what may occur; actual results or performance may differ materially from those reflected or contemplated.
A rising rate environment, combined with lingering uncertainty about trade, should lead market volatility higher. The question for investors is how to respond. In late cycle, there are ways that investors can play both offense and defense using alternatives—namely, by focusing on assets that generate stable streams of income and strategies that benefit from the disruption that rising volatility often creates.
Volatility will remain elevated into the end of the cycle as central banks become increasingly hawkish and continue the process of normalization following what has been an unprecedented monetary policy experiment. It is naïve to think that quantitative tightening will not impact asset prices around the world—what goes up must eventually come down. However, we do not expect an immediate deterioration in the fundamentals but rather a gradual softening as we approach 2020. As such, the recent correction seems to be exactly that, and the re-rating in valuations has created a much larger opportunity set than the one we faced at the end of 3Q18.
It seems unlikely that 2019 will mark the end of the current economic expansion, but clearly risks are beginning to build. We do not believe this is a reason for investors to move to the sidelines but rather an opportunity to ensure that portfolios are prepared for the unexpected as well as the expected. In the following pages of this Outlook, we explore how, when and why investors can use both offensive and defensive approaches across a wide range of alternative asset classes and investment strategies.
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