Investors' Outlook March 2019

Time to pause and reflect

Japanese gardens combine the basic elements of water, plants, and rocks with simple, clean lines to create a tranquil retreat. Adhering to Zen philosophy, these gardens were intended to be viewed during seated meditation − or zazen − and served as places to pause and reflect. Taking inspiration from their contemplative quality, we take time to step back and ponder the U.S. central bank’s latest policy shift and what it means for financial markets and the most important asset classes.

After the U.S. Federal Reserve (Fed) had shifted its policy guidance in a less hawkish direction, emphasizing the need to be “data dependent” and “patient”, other central banks were quick to follow suit. The European Central Bank (ECB) downgraded its risk assessment for the Eurozone’s growth outlook from “balanced” to “tilted to the downside”, pushing back market expectations for a first rate hike well into 2020. Soon, other central banks from around the world joined in with calls for patience and flexibility in adjusting monetary policy. Notable examples include England, Australia, Canada, Japan and − in emerging markets − China and Brazil.

In other words, central banks shifted from “tightening mode” to “pausing and reflecting”. We believe this policy reversal is justified given the meaningful risks financial markets are facing today. In essence, these include the global economic weakness morphing into a significant downturn (a very close possibility in Europe), falling inflation, Brexit and many more.

At least on the U.S.-China trade war front, we see first signs of a potential deal in the coming weeks. However, it is still unclear how the U.S. will act on car tariffs, especially European ones. The Department of Commerce submitted its research to President Trump but he has not had time to pause and reflect − nor tweet, which might change any time.

Amid these risks, markets cheered the dovish tilt from central banks and a weaker U.S. dollar in 2019; as a result, the most important asset classes have posted positive returns so far. As shown in the graph, increased central bank liquidity has been the main driver of positive asset returns across the investment spectrum. Cash, probably the most crowded asset going into 2019, has thus largely underperformed.

The pause that refreshes

Below are the main expectations of our normalization scenario, the one we currently consider most likely:

• China’s measures to support the economy, which start to be visible in early indicators (such as measures of money supply), will have a positive effect on Chinese GDP and support other regions like Europe and Japan.
• Therefore, Europe is likely to recover from an economic slowdown later in the year, dodging a significant downturn.
• The Fed will be able to conclude the rate-hiking cycle by increasing the base rate one or two more times, but without being perceived as too hawkish. Consequently, the U.S. dollar will likely be about to peak against most other currencies.

So, does this all mean then that investors are in for a nice ride? Well, not exactly. Our normalization scenario assumes no further escalation of the trade war, China stabilizing, a relief in emerging markets and no recession in Europe. Clearly, should one or more of these assumptions fail to materialize, this would pose a major risk for markets to keep climbing higher. Thus, apart from the macro data, it will be important to carefully watch corporate earnings; in a normalization scenario, strong earnings will be the key driver for asset prices.

Overall, we maintain a positive outlook, which is above consensus views. However, given the risks mentioned − and the low level of visibility − we advocate prudent risk taking and believe a neutral stance on bonds and equities is warranted. Within bonds, we take the “short U.S. dollar view”, i.e. we prefer emerging market local debt and corporate bonds to government bonds. Within the equity allocation, we prefer emerging markets over Europe where we see the former profiting more from Chinese stimulus and a weaker U.S. dollar while the latter is exposed to political risks and a looming car tariff threat. Further, commodities remain supported by three main factors: a recovery in China, a U.S. dollar that has likely reached its peak and solid demand typically seen during the late stage of the economic cycle. Regarding the greenback, we remain neutral for now but are looking for opportunities to go short.