Key Takeaways:

• Global growth will continue to slow in 2019

• US risks recession in 2020

• China’s focus is on economic stabilization, while downside risk remains

• Synchronous tightening cycle in the Eurozone and UK except for Japan

• Monetary tightening can be less exciting in EM

• Currency hedging strategy should focus on the long run

• OVERWEIGHT on US and EM equities; generally NEUTRAL on fixed income

A. Global growth to slow

• We expect global growth to slow from 3.6% in 2018 to 3.4% in 2019 with risks skewed to the downside as investors attuned to the US-China trade war, uncertainty on China’s growth, political noises in the Eurozone, the US Fed rate hike aggressiveness, global monetary policy tightening with central banks taking a step back from their long-standing market support from the very low interest rates for nearly a decade, emerging market debt noises and even after the US mid-term elections.

B. US risks recession in 2020

• The US economy currently presents one of the longest economic expansions in history though we noticed “mini-cycles”. Growth slowed between March 2015 and June 2016 and picked up thereafter partly supported by the expansionary fiscal policy from President Trump’s tax cuts and higher fiscal spending. Estimated increase in fiscal deficit was 1.4% of GDP for the fiscal year 2018 (covering 4Q17 to 3Q18).
• At the current growth expansion, it will soon be the longest in the US history. It has started to raise the eyebrows on when the next recession will be. For now, recession remains unlikely in 2019 unless something grossly goes wrong. The still high and expansionary fiscal policy will add 0.9% to the GDP during the fiscal year 2019 (covering 4Q18 to 3Q19). We expect GDP to grow at 2.5% in 2019 from 3.0% in 2018.

• Our bigger concern is in the year 2020. Risk for the economy to head into a recession is much higher. It is partly due to the potential waning of the growth steam in 2H2019 as the fiscal-stimulus policies run out. A modest drag should see the GDP growth dip below the 2% level. It will heighten the risk of recession as it becomes unsustainable by 2020.

• So we expect the US Fed to top its interest rate cycle in 2019 with another 1–2 rate hikes and settle around 2.75%–3.00%, slightly below the Fed’s normalisation rate of 3.50%. Such a move should avoid the economy from braking excessively. Besides, inflation remains under control. We envisage core inflation to move gradually higher in 2019 to around 2% given that oil prices are expected to be lower in 2019 to around US$65–69 per barrel compared with US$71 per barrel in 2018.

C. China’s focus is on economic stabilization, while downside risk remains

• Our focus in 2019 will be on China. Even before the heightening of the trade war with the US, we have priced in for a moderate growth due to the deleveraging efforts. But the trade tensions intensified the speed of the economic slowdown, with deleveraging efforts taking a back seat in a move to immediately stabilize the economy. So we expect the GDP to grow around 6.0% in 2019 from 6.5%.

• But our 2019 GDP projection remains gloomy. Much will depend on how severe the trade dispute becomes. Besides, the high debt/GDP ratio will considerably limit the scope for aggressive debt-financed stimulus measures that they were able to embark on several years ago.

• Hence, the longer the trade war uncertainty continues, the more likely will be that the Chinese policymakers will start to diversify their responsive channels by using a range of other tools, including guiding the exchange rate lower and reassessing their foreign exchange reserves policy.

D. Synchronous tightening cycle by Euro and UK except for Japan

• With advanced economies GDP expected to present a moderate growth in 2019 and inflation contained, we expect the monetary tightening to converge with the exception of Japan. The dovish shift in Fed’s language seems like an admission that the previously proposed path of future rate hikes was probably too aggressive. Such tone will avoid the US economy from braking excessively during a period when fiscal tailwinds are due to diminish and ultimately reverse.

• With our positive view on the US Fed dovish tone, something we much needed, it further supports our view that the US economy should start losing steam in 2H2019 with the risk of falling into recession in 2020. And so, our view of 1 or 2 more rate hikes by the US Fed in 2019 seems justifiable. Still uncertainty remains on our base case view until we get a clearer picture by end-1Q2019 on the US Fed’s behaviour and the strength of its GDP to sustain the divergence. We project the economy to grow 2.5% in 2019 from 3.0% in 2018.

• Both the Eurozone and UK will face strong headwinds in 2019 from continued geopolitical uncertainty. The UK’s most serious question as London heads to the March 2019 Brexit deadline is whether a deal has been reached by the its government that is hit with internal disagreement, and Brussels negotiators giving little room to make the exit easy in fear of allowing more breakaways. Our base case suggests there is a deal and so we are pricing in for 1 rate hike by 25bps in 2019. We project the GDP to grow around 1.4% in 2019 from 1.3% in 2018. If a no deal happens, a combination of heightened uncertainty and prospective fall in the sterling by about 10% in nominal terms in the first six months of the period is high. It will halt rate hikes with the possibility of a rate cut as the economy will slow down.

• Economic recovery in the Eurozone, improving wage growth and promising signs of a pick-up in underlying inflation gave the ECB the confidence to end its asset purchase programme by end-December 2018. And the ECB is now more likely to raise interest rates after the summer of 2019 which we expect will be around 10–15 basis points (bps) to the deposit rate with a full 25bps hike to all its rates six months later. But the downside risks lie on the trade war between the US and China, Brexit, erosion of Chancellor Merkel’s support in Germany, budget stand-off between Italy and the European Commission, which we expect a compromise to emerge, and the euro growth outlook. After a surprisingly strong growth in 2017 that lowered unemployment to 9.1%, the Eurozone’s leading indicators weakened in 2018 to suggest a slower growth of 1.9% in 2018 from 2.5% in 2017 and 1.6% in 2019.

• Japan’s economic performance was very uneven in 2018 after a certainly set-high water mark GDP at 1.7% in 2017. The GDP contracted in 1Q2018 followed by a solid rebound in 2Q2018. Natural disasters in mid-2018 added to the data turbulence. Still, growth is expected to remain above potential in 2018, reflected by the tightening labour market. There are already 163 job vacancies for every 100 applicants. But the Bank of Japan is expected to maintain the current monetary policy. Inflation remains well below the target, removing any chance to tighten its monetary stance. More so with the authorities’ commitment to raise the value-added tax (VAT) in October. Since the VAT will roll off in October, it will have a limited impact on 2019 annual numbers to allow us to hold our GDP at 1.2%. But 2020 could be a very different story. So, the BoJ is expected to maintain the short-term policy rate at minus 0.10% through to the end of 2019 while the 10-year bond yield is anticipated to be at 0.10% at end-2018 and reach 0.15% end-2019 with continued purchase of JGBs at a pace of about 80 trillion yen (US$712bil) per year in a flexible manner.

E. Monetary tightening can be less exciting in EM

• But what can complicate things in 2019 will be the direction of domestic inflation although most Asian countries inflation presented a surprised downside figures. Countries with their inflation outlook to be less than 2% in 2019 like Malaysia, Singapore and Thailand have more room to manage their monetary policy.

• With Malaysia’s inflation being well contained added with moderate growth that is being supported by private consumption and private investment should see Bank Negara Malaysia maintain the current 3.25% policy rate in 2019.

• For Thailand, inflation has not been a policy concern for now, with the focus more on growth. With the balance of economic risk tilted towards growth and not inflation, the possibilities for Bank of Thailand to throw out rate hike policy in 2019 can happen if growth remains under 4%. For now, we expect the policy rate to end at 1.75% in 2019.

• As for China and Indonesia, their inflation level should be hovering around 2% and 4% in 2019. With China facing a double threat of trade war and deleveraging, the central bank is more likely to use its accommodative monetary tools like open markets operations, reserve requirement ratio and various types of PBOC loans to the Chinese banks to funnel credit to the parts of the economy that needs it to support growth besides outright monetary easing. So, we expect another 150bps cut in reserve requirement ratio to 13% in 2019 while doing more to unclog the lending channels.

• Bank Indonesia has been one of Asia’s most aggressive central bank in 2018 by lifting rate 150bps since mid-May and draining foreign-exchange reserves by more than 10%. With financial stability as their priority, which means there is room for further tightening cycle in 2019. Much will depends on the rupiah, outlook of current account deficit that needs to establish a clear narrowing trend to tamp down concerns and Elections in April 2019. However, our base case suggests no rate hikes in 2019.

• For India and Philippines, inflation is projected to stay above 4% in 2019. In the case of Reserve Bank India, it left the repo rate at 6.50% and reverse repo rate at 6.25%. We expect the central bank to maintain the policy rate supported by the benign headline inflation outlook due to unexpected softening of food inflation and collapse in oil prices in a short period. Trade tensions, tightening of global financial conditions and slower global demand pose some downside risks to the domestic economy. The central bank will start to lower the statutory liquidity ratio by 25bps each quarter until it reaches 18% of deposits starting 1Q2019 which is currently at 19.50%, a move to see banks lend more rather than park their cash in safehaven government securities.

• The issue with Philippines is more of domestic than external, suggesting an easing in external pressures will not take its struggles away. A significant build up in debt and credit growth which is running roughly twice the pace of GDP added with huge inflation are the key challenges. A boost to inflation in 2018 from tax changes will fade in early 2019, and legislation around the rice supply should help damp price growth. These, together with the softer oil prices may ease some level of the inflationary pressures. Thus, our base case suggests there will be no change to the policy rate.

F. Currency hedging strategy should focus on the long run

• The USD displayed unexpected strength in 2018 from a tighter monetary policy, stronger US growth and trade uncertainties. While these factors are expected to support the USD into early 2019, its impact is poised to ease as we move into 2019.

• Our attention is on the Fed’s tone in 2019. The Fed has started to turn dovish with the message pointing towards 1 or 2 rate hikes in 2019. The decision to raise rates by 1–2 times is in line with our view as well as the Fed Funds futures as of December 2018. Reduction in aggressive rate hike could be due to fiscal-stimulus policies expected to run out of steam and will cause a modest drag on growth. We feel the 2% growth level could become unsustainable by 2020. Besides, the risk of falling into a recession in 2020 is high.

• Our other focus will be on the trade war disputes. We feel the current temporary halt is not a suspension of the trade war but a suspension of the escalation of the trade war. And the big questions remain about the readiness by China to allow international access to their huge market to a level that will please US administration and hence prompt the US to completely halt the trade war. If resolved more swiftly than anticipated, slower rate hike by the US Fed is expected and ease gains in the USD. It will be a boost to riskier assets including emerging market currencies and stocks. Meanwhile, we feel the US and China are trying to fix a long-term problem that cannot be solved in the near term.

• Hence, in 1H2019 we feel the US fiscal stimulus, added with additional US Fed rate hikes and trade war noises, are likely to add to the already impressive US short-term yield advantage and support the USD in the early period of 2019, despite the USD being expensive versus its long-run valuation. But towards the start of 2H2019, we foresee markets beginning to anticipate the US exceptionalism has run its course. With the US policy rate and growth cycle slowing, added with slower global growth, it will soften the USD pressure. This will be our base case.

• Still, we feel it remains uncertain if our base case scenario will materialise. What is important will be 1Q2019. It will be a period we need to get a clearer picture. By which time more insights into the US Fed’s behaviour and the strength of the US growth are adequate enough to sustain the US divergence will be shed. If Europe and emerging markets do start to show signs of catching-up as we move along 2019, it will hamper the USD. We expect currencies like the EUR and AUD to outperform. Also, several emerging market currencies are set to outperform.

• Alternatively, if the rest of the world slows enough to spur the fear of recession with the US slowing down even faster, then we expect the USD will be better supported while the less cyclically-sensitive JPY will likely outperform the growth-sensitive AUD. We foresee some pressure on emerging market currencies. In such a scenario, it is difficult to predict the EUR moves, as it usually holds up reasonably well in a negative environment. But investors will be quick to price out any hope of an ECB rate increase.

• But if we see too rapid an acceleration of monetary policy tightening by the US Fed in relation to the US growth, it will likely result in bouts of risk aversion, supporting the JPY, CHF and, to some extent, the USD regardless of the specific policies in those countries. This will not augur well for the emerging market currencies, heightening the risk of a debt crisis.

• So, we feel the hedging strategy should focus on the long run. We believe the currency movement in the short term in 2019 could provide opportunities for strategic investors to alter their hedge strategy in preparation for the currencies to revert to fair value over the medium term. Cyclical currencies that are over- and under-valued can directly adjust the relative competitiveness of countries as well as their inflation rates. This will cause a return to equilibrium. So, investors could aim to use the shorter-term dislocations as a means to capitalize on longer-term reversions to equilibrium through currency hedging.

G. Overweight on US and EM equities and generally Neutral on Fixed Income

• We are of the view that capital flow will move out of the US and go abroad. The upside to the US stock market may have peaked, especially if the Fed goes dovish in 2019. Our base case suggests that the Fed would raise rates by 1 or 2 times in 2019 and should see the USD weaken. Hence, it will ease pressure on the emerging markets with the risk of sparking a contagion debt crisis. Thus, we expect funds to go into emerging markets.

• For sure, the biggest themes for 2019 will be the US-China trade war, the Fed, European politics and Brexit. With the US and China now having a 90-day ceasefire, it means no more tariffs until April which is a positive news for the near term.

• Besides, the Fed is on the top of our mind. We are looking at a 50% chance for a rate hike in March that will drive emerging market sentiment in 1Q2019. Higher interest rates in the US tend to mean a stronger USD which is a turnoff for anyone building their emerging markets’ exposure, especially those from the low-risk, institutional-money side.

• European politics is hurting since the Greek bailout and Brexit, with limited sign of improvement. But we believe that unless something goes strongly wrong like a debt default in Italy or major banking crisis triggered by one of the big banks, we believe the European-induced volatility will be short-lived.

G1. Global Equities

• We are OVERWEIGHT on the US although valuations are high. Solid corporate earnings and strong economic growth underpin our positive view. We have a growing preference for quality companies with strong balance sheets as the 2019 macro and earnings outlooks become more uncertain. Healthcare is among our favoured sectors.

• As for Europe, it remains UNDERWEIGHT. Its earnings growth is relatively muted with weak economic momentum and political risks are challenges. Besides, their equity market is heavy on lower-quality, cyclical companies that tend to lag in late cycle. So a value bias makes Europe less attractive without a clear catalyst for value outperformance. We prefer higherquality, globally-oriented names.

• We remain NEUTRAL on Japan. Although we see a weaker yen, solid corporate fundamentals and cheap valuations as supportive, it awaits a clear catalyst to propel sustained outperformance. Other positives include shareholder-friendly corporate behaviour, central bank stock buying and political stability.

• EM is OVERWEIGHT due to its attractive valuations and a backdrop of economic reforms and robust earnings growth. They are cheap depending on the country. With the USD expected to lose steam, it reduces the risk of financial contagion risks. Uncertainty around trade is likely to persist, though much has been priced in. We see the greatest opportunities in EM Asia as the economic backdrop is encouraging with more domestic dynamics at play. China’s focus will be on economic stabilization. But we recognize that a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.

• Quality is key as the cycle matures. We see quality, minimum volatility and large caps offering attractive risk-adjusted returns in 2019. Our markers for quality include strength in free cash flow, growth and balance sheets.

G2. Global Bonds

• Looking at the US government bonds, we are NEUTRAL. The higher yields and a flatter curve after a series of Fed rate hike made short-to-medium-term bonds a more attractive source of income. Longer maturities are also gaining appeal as an offset to equity risk. This is especially so if the Fed gets closer to its neutral rate and upward rate hike pressure is more limited.

• We are UNDERWEIGHT on European sovereigns. Their yields are relatively unattractive and vulnerable to any growth uptick. Rising rate differentials have made European sovereigns more appealing for global investors with currency hedges. We believe the Italian spreads reflect quite a bit of risk.

• As for the emerging market debt, we are OVERWEIGHT. Here, we prefer hard-currency over local-currency debt and developed market corporate bonds. Besides, broadly strong EM fundamentals, added with slower supply, add to the relative appeal of hard-currency emerging market debt. Meanwhile, trade conflicts and a tightening of global financial conditions suggest we need to adopt a selective approach.

• We are OVERWEIGHT on Asia papers. We believe the stable fundamentals, attractive valuations and slow supply will be supportive. Besides, China is rising in the region as a bond universe. Higher-quality growth and a focus on financial sector reform are long-term positives. But a sharp slowdown in China poses a challenge.

Source: AmInvest Research - 14 Dec 2018