The last week’s market highlights:
Quote of the week:
“What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” — Mark Twain
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2019 Outlook :
- U.S. economy: A slowdown, not a recession
- Global economy: Amid lower expectations, emerging markets could surprise to the upside
- Policy watch: Fewer tailwinds, stronger headwinds
- Fixed income: Rates likelier to rise than fall
- Equities: Late cycle but good value
- Asset allocation: A neutral stock-bond view
Global economy: A slow ride. Take it easy.
More than a year ago, in its January 2018 World Economic Outlook, the International Monetary Fund (IMF) presented a case for “brighter prospects” and “optimistic markets” fueled by “notable upside surprises” in Europe and Asia. At the same time, the U.S. was poised to add further ammunition to economic expansion thanks to recently passed tax reform. Against that bullish backdrop, the IMF revised up its global growth forecasts for 2018 and 2019 to a healthy 3.9%, and why not? Some 120 economies, accounting for three quarters of world GDP, had just seen an increase in year-over-year GDP growth—representing the broadest synchronized global growth upsurge since 2010.
Last week, the IMF published its April 2019 outlook, and it tells a much different story. Instead of upside surprises, the IMF now sees a “precarious recovery” and a “growth slowdown,” including a cumulative 0.6% cut in its global GDP forecast, to 3.3%. This dimmer view came as little surprise, considering bond markets were already expressing their pessimism in the form of negative yields on about $10 trillion of debt worldwide. A number of potential headwinds are on the IMF’s radar, including:
- Aggressive trade policy, which could severely disrupt global supply chains.
- A slowdown in China and its knock-on effects throughout emerging-market (EM) and developed economies.
- Missteps by central bankers, as the IMF believes monetary policy will need to remain data dependent, be well communicated and ensure that inflation expectations stay anchored.
A “no-deal” Brexit was also listed as a downside risk, although we’ve now passed the scheduled April 12 deadline and will have to wait longer to see how the uncertainty will be resolved. Last week, the U.K. and EU agreed to an October 31 “flexible extension” deadline, allowing the two sides to continue negotiating.
The IMF’s report wasn’t entirely grim. Indeed, it anticipates that global growth will pick up in the second half of the year. With inflation worldwide generally expected to stay benign, major central banks—including the Federal Reserve, European Central Bank, Bank of Japan and Bank of England—should remain exceptionally accommodative, keeping borrowing costs low.
Moreover, China has amped up fiscal and monetary stimulus in order to jumpstart its economy. These latest measures, which include tax cuts for non-state-owned companies, may well be more effective than prior stimulus packages, which were focused primarily on infrastructure spending. And hopes continue to build that the U.S.-Chinese trade dispute will end soon. That said, just as Washington and Beijing appear closer to compromise, the White House is now considering a broad swath of tariffs on European exports.
With China’s outlook improving, other EM economies have benefited from capital inflows and stronger currencies relative to the dollar. (A weaker dollar makes it easier for EM companies to service, roll over and repay dollar-denominated debt.)
We find a lot to agree with in the IMF’s outlook. Even if the first quarter turns out to be better than initially feared, the U.S. economy is extremely unlikely to return to last year’s 3% pace of expansion. China seems to be finding a tentative bottom, while the eurozone is still searching for one. The important question for investors is how global financial markets will be able to perform in a more tepid economic environment. We think global equities will struggle to rise further, while interest rates are unlikely to break sharply higher given the lower ceiling for growth.
Fixed income: We don’t see a bond bubble
According to the IMF, debt is at record levels in advanced and EM economies. Much of that debt, though, was accumulated in the aftermath of the financial crisis in order to keep the global economy afloat. Still, not all borrowing has been allocated productively, in our view. China, for instance, has often funded real estate projects rather than build a social safety net that could have incentivized its consumers to spend more, thereby diversifying its economy away from manufacturing.
In the U.S., corporate borrowing as a percentage of the overall economy has been rising since 2011 and now sits close to its record high. Should investors be concerned? Former Fed Chair Janet Yellen sounded the alarm bells last December, warning of a spike in bankruptcies if the economy were to turn south. But we don’t think the pickup in corporate IOUs is a significant threat right now, for the following reasons:
- Much of the new issuance over the past decade or so has been used for stock buybacks. In this way, elevated corporate debt levels can be viewed as a structural change in how companies manage their balance sheets, rather than a ramping up of risk appetite.
- Moreover, corporate balance sheets are healthy, offering considerable flexibility. Take the Communication Services sector, where companies tend to issue a lot of debt while also generating plenty of cash. This enables them to pay off loans at the most opportune time.
- As corporate spending and borrowing have increased, so, too, have profits, which are quite high as a percentage of U.S. GDP.
- With the U.S. enjoying steady economic growth, and the risk of recession seemingly falling, not rising, default levels are low and are expected to stay low.
In addition to overall debt levels, some investors have expressed concern about the growth in bonds rated BBB—the lowest quality investment-grade tier and one notch above high yield. These issues make up about 50% of the fast-growing investment-grade universe, up from 35% in 2006. This surge has fueled speculation that the bond market will be hit by a deluge of downgrades (to below investment grade) when the credit cycle turns. We think this risk is overblown. BBB issuance has grown in large part because many companies view BBB as the debt/equity “sweetspot.” They’re unlikely to make further acquisitions or add debt if doing so would imperil their investment-grade status.
In contrast, higher-quality corporate borrowers have the “room” to do just that and therefore run a greater risk of being downgraded. (For example, IBM was downgraded in October, to A from A+, after acquiring software solutions provider Red Hat.) However, such companies frequently take steps to keep their rating above investment grade.
We tend to think investors are better served by tuning out headlines—both good and bad—and focusing on their long-term objectives. Allocating across a wide range of high-quality fixed-income assets as part of a broadly diverisifed portfolio is a time-tested strategy for generating income, cushioning against stock market delines and lowering overall portfolio volatility.