Our Chief Investment Officers 2019 outlook

A look back at 2018

The postscript to 2018 is that politics has played a significant part in making this year difficult to navigate successfully. A majority of risk assets have produced negative returns with the turning point clearly centred on trade and the determination of the Trump administration to reduce the trade deficit via a protectionist agenda.

In addition, fiscal stimulus in the US has encouraged the Federal Reserve to tighten monetary policy which has driven the US dollar higher. The strong dollar effectively restricted global liquidity, dampened momentum of global growth and inflicted pain on the emerging market economies. Oil prices also rallied 80% year on year thanks to the US withdrawal from the JCPA with Iran, tightening financial conditions even further through higher prices at the pump.

In Europe the ongoing saga of Brexit and the Italian Budget proposal have damaged confidence and changes in emissions regulations have hit vehicle production levels quite materially year on year. In China, the authorities have also sought to slow the growth of credit to limit debt accumulation in the economy and elections in Brazil, Turkey and Mexico have caused significant angst and uncertainty.

Markets are driven by change rather than levels and on that basis, 2018 is a fairly easy comparison. Equity markets are much cheaper than at the beginning of the year and investors are no longer complacent about the future – conditions that imply a lot of bad news is in the price. With global growth slowing, the move to tighten monetary conditions will be less urgent and on a fiscal front, we have a modestly positive fiscal impulse in 2019, with planned increases in government spending across the major world economies. Therefore, two of the three key tenants of our investment process, valuation and fiscal growth are positive and the third, namely monetary policy, is negative but moderating, leaving a positive overall picture for 2019.

Outlook on asset classes

Fixed income

Sovereign bonds

With more Central banks (including the European Central Bank) halting quantitative easing and interest rates rising in the US, monetary conditions are beginning to normalise. Most developed market sovereign real yields remain too low on a fundamental basis and so are ultimately vulnerable to normalisation.

This normalisation is more advanced in the US than in Europe and in 2019, Europe is likely to see an element of catch-up. A 50 basis point rise in 10-year gilt or bund yields (to 1.75% and 0.75%, respectively) would imply a total return of -3% in local currency terms. In the US the scope for higher yields is more limited, implying a minimal but positive total return. On this basis, short duration US bonds (less than 3 years) look reasonably appealing.

Inflation-linked bonds in Europe offer low or negative real yields (reflecting the fact that their fixed coupon markets are expensive) and break evens are around Central bank inflation targets. US inflation-linked bonds (TIPS) offer better fundamental value in terms of both real yields and break evens – currently 0.9% and 1.9%, respectively for 5-year bonds. Therefore, US TIPS pay a decent real yield while offering some hedge to the risks elsewhere in our portfolios. We prefer short-dated issues to avoid duration risk.

1-10 Year Government Bond Indices

Investment grade corporate debt

A flight to quality, the possibility of the US yield curve inverting and the increasing vintage of the credit cycle have resulted in credit spreads notably widening in the last quarter of 2018. Hence, credit is no longer as expensive as it was and the likely absence of a recession in 2019 adds further support, for now.

In sterling investment grade debt, assuming a further 30 basis points of spread widening as part of the normalisation process, the expectation of a 50 basis point rise in underlying gilt yields results in a projected total return of -2.2%. Short duration sterling investment grade debt, however, generates a modest positive return on the same basis, reflecting its lower duration and the benefits of “roll down”. Therefore, short duration investment grade debt is our preferred asset in fixed income.

Investment Grade Credit Spreads

High yield debt

Assuming another 100 basis points of spread widening over sovereign bonds and marginally higher US Treasury implies a US dollar return of +6.6%, reflecting the short duration and high running yield of the asset class. However, both the high yield and leveraged loan markets are currently the most obviously expensive on a fundamental/historical comparison and both markets are likely to prove especially prone to any further flight to quality or credit cycle concerns. The yield is as tempting as a flame to a moth but we remain wary of defaults this late in the business cycle and liquidity in tougher conditions.

Local currency emerging market debt

The asset class has staged a modest revival of late. This reflects the facts that the headline-grabbing problems in Turkey and so on have not spread, many countries now offer sound fundamental value after the market’s indiscriminate weakness, the US dollar is showing signs of topping out and there is hope that Trump has a growing incentive to reach a deal with China on trade. While higher volatility can be expected, we believe there is an opportunity here for contrarian investors and a better option than high yield debt.

Emerging Market Debt

Equities

UK

While earnings growth has continued to be ahead of trend, the political concerns relating to Brexit have positioned UK equities as being relatively attractively valued going into 2019.

Lack of clarity regarding the future relationship with the EU has been hurting sentiment and poses risks to the domestic economy. However, in the absence of a totally disorderly exit, there is the potential for a boost to the economy if pent-up demand in the form of consumption and business investment is realised.

It should also be remembered that the UK stock market is fairly global in nature, being home to a significant number of multi-nationals, such that the majority of the revenues generated by listed companies come from overseas.

As a result, the outlook for UK equities is tied to the global economic outlook, with the additional benefit that any weakness in currency benefits these companies through currency translation effects.

MSCI UK price and earnings expectations

Rest of the world

With politics weighing on sentiment, earnings growth has continued to power ahead creating a compelling valuation argument as we look to the year ahead. Weakness in the markets could also provide the catalyst for resolution to the trade dispute primarily between the US and China, though it is unlikely to have the same impact with the European political challenges.

Fundamentals are still strong but there are clearly storm clouds gathering on the horizon, which makes the investing landscape more challenging. Continuing strength in the US is a positive factor, but there are early signs of capacity constraints which could ultimately lead to overheating, and the ongoing tightening of monetary policy throws grit in the wheels of the global economy.

However, there are still opportunities to be had. Valuations look attractive despite the less supportive backdrop, particularly in emerging markets which have been in a technical bear market through 2018 (a fall of more than 20%), which look oversold to us.

Global Forward Price/Earnings Ratios (a measure of valuation)

Property

Commercial property has had a decent year with income growing at around 5% and capital values at around 2%. The strongest performing sub-sector has been the industrial sector which is up around 16%, while unsurprisingly the laggard is the retail sector with a total return of around 1.5% for the year. The continued growth of online retailing, with its need for more distribution facilities, is a major factor behind increased demand in the industrial sector and we can expect this trend to continue in 2019.

Lower levels of construction in the offices sector have kept supply tight and vacancy rates below the 20-year average. In the meantime, providers such as WeWork have been taking up existing space as large companies move into new office buildings – with operators in this space becoming increasingly popular, this is another trend we can expect to continue into 2019. We can also expect to see a softening of London office values and rental yields in 2019.

While markets have performed better than expected since the EU Referendum vote, there is still astonishing uncertainty surrounding Brexit – and business uncertainty around the decision of whether to relocate or not. Whether we have a Soft Brexit, Hard Brexit or No Deal will play a big role in returns for 2019. Currently, we expect a mid-single digit return from UK property in 2019, with weakness expected to come predominantly from retail and Central London offices, with slower growth in industrials.

Rental Value Growth by Sector

Gold

When UK government bonds offer a negligible or negative real yield, the risk/reward profile for gold is fairly asymmetric. The rationale for holding gold is that it will perform better than fixed income in sterling terms in a deflationary environment.

In such a condition, bond yields at current levels have little room to fall or prices to rise, while gold will respond positively to the potential monetary stimulus or quantitative easing. On the other hand, if rates rise in response to a stronger economy, since gold has no yield it will lag but the marginal cost of mining new gold supply is likely to limit the downside.

In our portfolios gold is positioned as a hedge against the risk of deflation, whether induced by Brexit, trade wars or other external shocks, with a small cost of carry in sterling terms.

Gold Price Over The Last 5 Years

Oil

The recent agreement by OPEC+ to reduce collective output by 1.2 million barrels per day offers a technical underpinning to markets at current levels, as does West Texas Intermediary at US$50 (shale breakeven). Our base case is that growing global demand will lend an upward bias to oil in 2019.

In summary

2019 Expected Returns

Please see the important information below for more details on these figures.

For more information or if you have any questions, please get in touch by calling 020 7189 2400 or emailing contact@tilney.co.uk.