- Although the odds of a downturn appear above average given where we are in the economic cycle, we believe a global recession is a relatively low risk in 2019.
- We believe markets will face disruption stemming from diverging monetary policies, technology amplifying valuation disparities, and geopolitical uncertainty.
- Correctly identifying the winners and losers in this era of significant change will be key to investment outperformance.
Disruption in its various forms—technological, political, economic, and monetary—is likely to determine the direction of global financial markets in the coming year, T. Rowe Price experts predict.
With the U.S. moving into the later stages of the business cycle, the U.S. Federal Reserve raising interest rates, and monetary and credit conditions diverging widely across the other major global economies, the potential for renewed volatility in both equity and fixed income markets remains high.
Political risks are adding to the uncertainty. These include the trade dispute between the U.S. and China, the possibility of a disorderly Brexit in March, and renewed fiscal conflict between Italy’s populist government and European Union (EU) officials.
These are among the key observations offered by three leading T. Rowe Price investment professionals—David Giroux, chief investment officer (CIO) for U.S. equity and multi‑asset and the firm’s head of investment strategy; Justin Thomson, CIO, equity; and Andy McCormick, head of U.S. taxable fixed income. McCormick takes over as head of fixed income effective January 1, 2019.
Disruption Is Shaking Markets
The global corporate landscape continues to be transformed by a revolutionary combination of technological innovation and changing consumer preferences, which is upending established business models. Although disruption creates risk, it also can generate potential opportunities for investors with a disciplined strategic approach. Correctly identifying the winners and losers in this competitive struggle will remain the key to portfolio outperformance, Giroux contends.
“I’d argue that the disruptive environment we’re in is why active management will be well positioned over the next decade,” he says. “High‑quality active managers can benefit from having a longer‑term horizon, which allows them to make the kind of investments that potentially will add value in our clients’ portfolios over the next five to 10 years.”
Over the shorter term, however, global investors may need to buckle up, as political, monetary, and trade uncertainty could generate more of the sudden spikes in market volatility seen in 2018. In recent discussions, Giroux, Thomson, and McCormick have identified six key disruptive forces that they believe will play out in 2019 and beyond.
Estimated share of S&P 500 market capitalization that is challenged by disruption
IMF forecast of global real GDP growth in 2019
Global Growth Momentum Is Slowing
October 2018 forecasts by the International Monetary Fund (IMF) projected that growth will slow across the developed markets and in China in 2019.
While the U.S. is farthest along in the economic cycle, and the risks to growth are tilted to the downside, a healthy private sector, strong consumer demand, and the lingering effects of the 2017 tax cut stimulus should continue to sustain the expansion through the first half of 2019, T. Rowe Price economists say.
European economies are earlier in the cycle, but growth has been slowing since the fourth quarter of 2017, Thomson notes. The UK economy continues to suffer from Brexit uncertainties.
In the eurozone, the German labor market shows some signs of overheating, but unemployment is significantly higher in most other continental economies, curbing inflation pressures but also limiting income gains. Efforts by European households to rebuild savings could dampen eurozone growth in 2019.
The IMF forecasts that Japan, which saw economic momentum slow sharply in 2018, will decelerate further in 2019. On the positive side, Japanese corporate profitability is at an all‑time high, according to Thomson, suggesting the risk of deflation has eased.
Can China Shift Back into Higher Gear?
China’s economic outlook is a particular focus of concern, as official economic reports in late 2018 showed a slowdown in growth. Independent indicators of consumer demand, such as auto sales and Macau casino revenues, also have shown weakness, Thomson says.
“What’s crucial is the extent to which China restimulates,” Thomson adds. “Beijing is trying to reduce indebtedness in its corporate sectors. But they do have scope for selective tax cuts in certain areas, or for reducing banking reserve requirements, which is a way of loosening policy as well.”
Overall, growth in the emerging markets (EM) is expected to remain stable in 2019, the IMF predicts, with the slowdown in China offset by recoveries in some other major EM economies.
Higher Rates, Flattening Yield Curve Create Downside Risk
Although U.S. growth is slowing, T. Rowe Price economists expect the U.S. unemployment rate to continue to fall, putting upward pressure on inflation. Higher interest rates, plus a flattening U.S. yield curve, could increase the risk of a sharper economic slowdown in 2020.
Global Growth Is Slowing
Actual and projected real GDP growth
As of October 2018
Source: IMF/Haver Analytics.
Disparities in Global Equity Valuations Require Selectivity
U.S. Equity Valuations Appear High Versus Rest of World
12‑Month forward price/earnings ratios
As of October 31, 2018
Sources: FactSet Research Systems, MSCI, and T. Rowe Price.
U.S. = MSCI USA Index, Europe = MSCI Developed Europe Index, Emerging Markets (EM) = MSCI Emerging Markets Index, Japan = MSCI Japan Index.
As of the end of October, U.S. equity valuations appeared relatively high compared with those in Europe, Japan, and the emerging markets—especially the latter. However, differing sector weights also need to be taken into account, Giroux says.
The U.S. market, with its large technology, health care, and business services sectors, tends to sell at a higher average price/earnings (P/E) ratio than most European markets, which have smaller tech sectors and tend to be more heavily weighted with financial stocks that typically feature lower P/E multiples.
Adjusted for sector mix, relative valuations between the U.S. and Europe appear to be within historic norms, Giroux adds. “Maybe you can still make the argument that Europe is earlier in the cycle and thus more attractive, but it’s not just because of valuations.”
U.S. Valuations Need to Be Seen in Context
Relative to their own history, U.S. equity valuations do not appear excessively rich, Giroux says. As of mid‑November 2018, the S&P 500 Index was trading at roughly 15.5 times expected forward earnings, within range of the 20‑year historical average of 15.9. However, with the U.S. moving into the later stages of the business cycle, that multiple might be less attractive than the long‑term average would suggest, he cautions.
“What we’ve typically seen is that once you hit an earnings peak, it can take between three and five years to get back to that peak,” Giroux observes. “So, the S&P 500 might actually be selling at 15.5 times 2024 earnings, which is saying something very different.”
Boosting the appeal of EM assets, in Thomson’s view: extremely undervalued EM currencies. “History suggests that you want to buy EM equity and debt when EM currencies are cheap, and we’re certainly seeing that at the moment,” he says.
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