Summary of the report february 2019
Despite increased uncertainty about both the economy and corporate earnings, we expect positive returns for most asset classes in the coming 12 months. Decelerating growth and political turmoil will be offset by smaller key interest rate hikes and by more attractive valuations and investor positioning after the stock market decline late in 2018. Early in 2019, we are somewhat overweight in equities and corporate bonds, but greater uncertainty suggests continued large price fluctuations.
Expected returns, next 12 months
|Emerging market equities||8.3%||10.8%|
|Fixed income investments||Return||Risk|
|Corporate bonds, investment grade (Europe)||0.5%||2.2%|
|Corporate bonds, high yield (Europe)||3.3%||5.0%|
|Emerging Market Debt (lokal valuta)||6.2%||7.1%|
During the last few months of 2018, stock markets were shaken by a variety of negative forces. This was mainly related to the fact that we are in a late-cyclical phase of the economy, when the rate of growth decelerates. As a result, many investors reallocated their portfolios towards lower risk. Looking ahead, we are still in the same late-cyclical phase, but what is different today is that asset valuations are lower and investor positioning is less aggressive, while political leaders and central banks have also been exposed to market volatility and are thus perhaps more inclined to make decisions that do not unnecessarily challenge investors. Overall, this will mean that we will see another year when volatility will be highly variable, as it was in 2018, but when average volatility will probably be lower than we experienced late last year.
Macro and other market drivers
The American economy is at the front of the cyclical process, as reflected in record-low unemployment and high capacity utilisation. Due to resource shortages and potentially temporary negative effects from the US-Chinese trade conflict early in 2019, we will see a deceleration. But we foresee no recession, "only" slower growth.
In the euro zone, demand is weakening. We expect growth to stabilise somewhat above today’s levels, but slower than before. Growth is being maintained by business investment needs and a good outlook for households, but various political problems are dampening the mood, while weaker global demand is hurting vital exports.
China’s economic policy shift and deceleration are proceeding as planned. Other emerging market (EM) countries have also seen slower growth, but domestic demand is strong in most places. We thus expect the EM economies to remain an important engine of the world economy.
Overall, we expect global economic growth of 3.5 per cent in 2019. This is somewhat less than before, but still a relatively good level. We thus do not expect a recession, although the risk of one has increased somewhat. We believe there is a 20-25 per cent probability that a recession will occur in 2019-2020.
It may seem remarkable to be discussing a recession when growth is healthy. The first reason for this is that the current economic expansion has been going on for longer than usual. The second is that some classical economic warning signals have begun flashing. As for the duration of the upturn, it is indeed lengthy, but this recovery has occurred at the slowest pace of all recoveries since the 1950s (in the US). The warning signals include things like very low unemployment and narrow gaps between short-term and long-term bond yields. Historically, these signals have pointed to an imminent recession. But this has happened after a time lag, as long as two years.
Examples of risks
During the past quarter, leading indicators continued to signal a deceleration in the economic growth rate. This is one of the main risks, since a dramatic deceleration has not been discounted in today’s pricing. A situation of lower underlying economic strength, also hampered by possible political troubles (hard Brexit, Italian fiscal problems, trade barriers between China and the US), has boosted the risks of a recession. Another risk would be that stronger-
than-expected demand finally drives up inflation, with rapid and sharply rising interest rates and yields as a consequence. We believe that the US Federal Reserve is already in a situation where it needs to proceed cautiously unless growth is strong enough.
Our recommendation is to keep a total risk level of around or just above a neutral stance, and make sure not to have an overly concentrated portfolio, since the risk of stepping on a land mine is higher than usual.
Support from valuations, mild slowdown
Earnings forecasts for 2019 have been adjusted downward to an unusually large degree over a short period. When such a revision trend reverses, it usually lasts for a while. Since our main scenario is for somewhat slower economic expansion but no recession, corporate earnings growth should be 2-6 per cent this year. We expect the downward revision trend to level off by the end of June, provided that our optimistic macro scenario is correct.
When stock markets have lost their footing, the macro picture is unclear and the earnings trend is uncertain, valuations become an interesting gauge for assessing whether it is worth buying shares or not. Based on a forward-looking price-earnings or P/E ratio (share price/earnings per share), which is 13.8 for the MSCI world index, share prices have not been cheaper for five years. An average P/E ratio of about 15.5 during the same period indicates that normal share valuations are 12 per cent higher than today.
However, we expect further downward earnings revisions of a few percentage points, ending with reasonable potential share price gains of 6-8 per cent. The low interest rate environment is helping support valuations and boost capital flows into stock markets, since the risk-free interest rate in large parts of the world generates no return at all. Substantially larger negative earnings revisions than those we expect would be needed to justify today’s valuations. As we wait for the economic picture to become clearer and for volatility to decline, it is a good idea to own companies with stable operations that show some growth and offer high-quality earnings.
Structural growth a focus as cyclical support fades
In 2018 our line of reasoning was closely linked to our view that earnings growth, not valuations, would be the critical factor for future returns. Earnings growth has driven equities for the past 2-3 years and will probably do so going forward. We view investments that include a large element of structural growth as especially attractive. Digitisation and sustainability are two shining examples of segments that show significant structural growth.
Fixed income investments:
Central banks slow their pace of normalisation
A more uncertain economic outlook presents central banks with new challenges, but low inflation pressure is enabling them to slow their pace of normalisation. We expect only a few rate hikes by leading central banks. This also suggests limited upturns in long-term bond yields. We are choosing to maintain a limited interest rate risk in our portfolios. In the credit market we see potential in the high yield segment, after yield spreads between government and corporate bonds widened during the autumn. Emerging market bonds are showing signs of recovery and in some cases may be bolstered by weakened currencies.