This year is likely to be the ebb tide of the economic cycle rather than its demise, with slowing global growth, benign inflation and low bond yields. However, 2019 will host a number of unpredictable but critical political and geopolitical events, creating choppy waters for investors and policymakers to navigate.
The flattening of yield curves, a good but at times flawed predictor of recessions, begs the question of when the expansion will end. We suspect that it is more likely to be in 2020 than 2019, allowing the mature US economy to record its longest cycle on record.
That noted, global growth is moderating as financial conditions tighten, and the US economy is expected to slow more abruptly towards the end of the year. With key central banks still missing inflation targets, monetary policies yet to normalise, and growth slowing, the economic environment is more vulnerable to the issues that lie ahead.
From the unfathomable Brexit playbook and the continued prominence of populist ideology, to unconventional US foreign policy and the retirement of Draghi, the highly respected ECB president, uncertainty prevails.
There are, however, key issues that will likely define the year ahead. The US-China relationship is one that we feel goes beyond simple tariffs. As China tries to emulate Korea and Japan as one of the few emerging nations able to bridge the middle income trap, the relationship with the US will be pivotal in achieving this.
We suspect positions will become more pragmatic by the end of the year, helping global trade and investment as a result, but progress is unlikely to be smooth, with many vested interests at work.
US monetary policy is another defining issue. Despite a still booming economy, the shrinking of the Fed’s balance sheet by per month and December's quarter-point rate hike are starting to bite.
With the interest-rate-sensitive housing and construction markets weakening appreciably, and inflation having only just managed to kiss target before falling back, it seems that time is on the Fed’s side. A pause in rate hikes after December would be appropriate, although it appears unlikely just yet.
Despite the challenges, our view of the year is constructive. Growth is expected to ease back to around its long-term average and, while capacity constraints are becoming more noticeable in developed economies, inflation is not expected to rise meaningfully.
Financial conditions continue to tighten globally, however, and along with trade uncertainty it is impacting investment. The US is running into capacity constraints, most notably in qualified labour, which is likely to crimp the pace of expansion. Labour shortages are helping to lift wage growth, but at a modest pace. As noted, the Fed’s policy response will be critical.
The Eurozone is never far from the centre of angst. The Italian budget is the current focus, though compromise is likely to win-out in finding a grudging acceptance with the EU. Further elections, however, seem inevitable later in the year given the unstable government construct and the rising popularity of the dominant League party within the coalition.
In aggregate, Eurozone growth is expected to be decent and above trend, with the first half of the year likely to experience a bit of a bounce following idiosyncratic issues in the latter part of 2018. Continued loose monetary policy and higher fiscal spending will lend support.
The outlook for Asia remains mixed. The delayed impact from significant policy tightening in a number of countries is likely to take its toll on growth.
We are encouraged by developments in China, where a coordinated and targeted approach is being applied to stabilise activity and keep the country on track to double the size of the economy between 2010 and 2020. Supporting evidence is expected through the first half of 2019, which will help to boost other emerging market prospects and lift investor sentiment.
More broadly, from an investment perspective, we see mixed fortunes in 2019.
Bond yields should remain subdued given easing growth and benign inflation, and it is likely that the bulk of the US yield curve will invert in the months ahead. Bunds seem the most vulnerable at current levels, with yields likely to move higher should risk aversion diminish, while periphery spreads will require better news out of Italy to tighten meaningfully.
Credit markets are expected to remain under the cosh, with excessive leverage and low interest coverage a risky combination at the late stages of the cycle. More defensive segments, such as ABS and covered bonds, should perform relatively better.
Equities remain our favoured asset class following a disappointing 2018.
Multiples have compressed appreciably, and some markets, including emerging markets, are looking attractive on a fundamental basis. Performance is likely to be patchy, however, requiring a deft touch to capture returns in an environment where volatility is expected to be high.
Choppy waters indeed, but another year of growth affords further time to bolster a still fragile macro environment before the next recession finally emerges.
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Read the full Zurich economic and market outlook 2019