We maintain our bearish assessment of the prospects for the global economy. The negative demand shock in China, combined with persistent economic and political uncertainty globally, has hurt capital investments in most developed economies, as companies are putting their investment plans on hold. This was amplified by a squeeze in profit margins. We think that this will eventually limit employment growth and slow private consumption growth. Although we do not foresee a global economic recession in 2019, growth in developed countries will remain moderate.
Confronted with weaker-than-expected economic data from the major economies and ongoing uncertainty about potentially highly damaging contingencies, such as trade wars and Brexit, the major central banks have turned more dovish in recent months. The Federal Reserve (Fed) will suspend further tightening, whereas the European Central Bank (ECB) is moving closer to the global dovish shift. Consequently, we do not expect the era of negative rates to end in 2019. Japan is about to mark the 20th anniversary of its zero-rate policy, while China is implementing additional monetary stimulus on top of fiscal stimulus to prop up economic growth.
The dovish shift boosted sentiment on the financial markets. Global equity markets rallied, and bond yields declined. But because of an underlying fundamental weakness, equity markets will struggle to stay at these elevated levels, and we remain tactically cautious.
Increasing financial risks and imbalances
In the longer term, we see the risk building up in the global economy. Our current capitalist system does no longer deliver enough income growth for the middle classes. According to a recent OECD study these get squeezed between higher costs and stagnant income growth. Increased uncertainty and lack of perspective on future growth of wellbeing is leading to growing dissatisfaction and disenchantment, which in turn translates into changing voting behaviour and growth of the political extremes. If this problem is not solved, social unrest will only increase. The upcoming European elections will show if the growing economic inequality will translate into political fragmentation.
Accommodative monetary policy leads to abundant liquidity in the economy. This not only encourages financial risk taking, resulting in overvaluation of asset prices, it also leads to the creation of zombie firms: firms that under normal circumstances would not be profitable enough to service their debt. As a consequence, global debt is at unprecedented highs and misallocation of capital towards unproductive sectors widespread. Financial risks are (again) building up in the global economy, according to the IMF.
In our view, this misallocation should be avoided, and capital invested in productive sectors. That is the way to change finance and our way to invest in the economy.
Brace for correction
The sharp market correction at the end of last year was followed by a remarkable recovery in the first months of 2019. Its speed, strength and breadth of took us by surprise, the more so as it came with a complete lack of volatility.
Investor sentiment improved on the waves of easing financial conditions, which followed the more dovish stance taken by central banks. We do not think, however, that this positive sentiment will prevail. Given the speed with which the markets priced in the Fed’s dovish stance, they will expect it to strongly reaffirm this stance. Yet, fundamentals are weakening. Global economic growth is slowing, company guidance on future earnings growth is becoming more cautious, and analysts are downgrading their corporate earnings forecasts across the globe and across all sectors. The reality of this combination will, at some point, hit the markets and spoil the party.
We brace for this correction and remain tactically cautious on equity. The best way to guard against the possibility of a market correction is by shifting to a more defensive sector allocation for equity.
We keep our neutral stance on bonds and prefer to be slightly long duration. Government bond yields did not follow the equity rally during the first months of 2019. Ten-year government bonds continued the downward trend that started in October last year. Being much less optimistic about the economy than equity investors, bond investors probably have a more realistic view on the state of the (world) economy. Materialisation of one or more of the many geopolitical risks may take longer yields even lower, especially of the proverbial safe havens. We do not expect the longer government bonds yields to rise significantly in the near term and keep our neutral to slightly long duration position.
The dovish pivot of the central banks also gave credits a boost, driving the corporate bond market in two ways. First, it leads yield-based investors down the credit curve. Second, the increase in liquidity makes defaults less likely. However, the slowing growth makes us increasingly cautious when it comes to credits. We prefer to invest in high-quality names.
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