Negotiating a tricky year ahead for investors
Despite a benign economic scenario, expect a tricky year ahead for investors, with three risk scenarios on the horizon, plus others deriving from destabilizing idiosyncratic events
Our central economic scenario is relatively benign. We see a modest slowdown in global growth in 2019, with limited inflationary pressure. The implication is that interest rates rise only gradually in the US and not at all in the euro area and Japan, while China loosens policy. We see a number of risks to this outlook and focus on three scenarios in particular.
In one, growth is somewhat stronger, economies are closer to capacity, inflation picks up strongly and interest rates go up faster. We believe this scenario is much worse for both equities and bonds. In another, the US Federal Reserve (Fed) raises interest rates more rapidly towards "neutral", with potentially 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 are standalone risks that could materialize in, exacerbate or even trigger any of our downside economic scenarios. Three key risks include: (i) worsening trade tensions between the US and China; (ii) renewed crisis in the euro area, triggered by Italy and (iii) Hard Brexit.
We attach a 65% probability to our central scenario and a combined 35% to our other risk scenarios. The balance of risks to our benign central scenario is skewed to the downside. Technically this implies that the mean, or probability-weighted average of outcomes lies below the central projection for asset returns. It is important to remember good investment decisions take the whole distribution of possible outcomes into account.
How do these forecasts compare with what is priced into markets?
Our equity return forecasts were more pessimistic and our bond yield forecasts more optimistic than the market at the beginning of Q4. But the equity market selloff and bond market rally have changed the relationship somewhat. More anecdotally, equity markets appear to be nervous about slowing growth (the "second derivative") and there are concerns about high-yield credit and the leveraged loans market.
In the face of uncertainty about how asset classes will react to global tightening, market participants have become sensitive to the degradation of fundamentals, even as the data remains overall positive and showing growth. Some of this is captured in our “financial crash” scenario.
Bringing this all together, we foresee a tricky year ahead for investors. Our forecasts are for modest equity returns, with risks skewed to the downside. Bond returns should be positive, though the upside has fallen with recent market moves. Credit markets look vulnerable in places. In the absence of a strong directional beta call, the focus shifts to alpha and cash. A discriminating approach, favouring multi-asset strategies, high-quality equities and bonds, US and EM equities, value over growth, active versus passive.
By Shamik Dhar, chief economist, BNY Mellon Investment Management. He is responsible for conducting proprietary research and analysis in order to provide clients with macroeconomic and investment perspective.
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21 Mar 2019