21 Sep 2018
Our quarterly investment outlook provides a representative summary of the views of our investment teams across asset classes. The global economy has been slowing throughout 2018 and our proprietary leading indicator is signalling this will continue. While we are undeniably ‘late cycle’, market dynamics in this period still tend to be positive for riskier assets - but selectivity and differentiation is ever more important.
The three main headwinds to global growth – tightening US dollar liquidity, a slowing China and high oil prices – have continued to intensify through the year and should remain in place in Q4. In addition, rising trade tensions and related uncertainty could also turn into a more significant drag. This backdrop is particularly unfavourable for emerging markets.
However, with the US economy still benefitting from the fiscal stimulus and global financial conditions remaining broadly accommodative, particularly in developed markets, global economic expansion has further to run, albeit at a more moderate pace. In addition, rising trade tensions and related uncertainty could also turn into a more significant drag.
At a glance: Macro outlook
Gap between the US and the rest will narrow
The growth differential that opened up this year between the US and the rest of the world is likely to start narrowing in Q4. Some US indicators are pointing to late cycle dynamics as the economy is clearly hitting its capacity constraints, especially in the labour market. Concerns of overheating should see the US Federal Reserve stick to its current plan of quarterly hiking, at least to the end of this year. However, Governor Jay Powell may have a tough choice to make if the impact of further rate hikes, combined with quantitative tightening and increased Treasury issuance, becomes too much for the US economy and the rest of the world to handle, especially for emerging markets.
China caught in two minds as growth slows
While the US determines global financial conditions, it is China that shapes global growth. As the stimulus of 2015-2016 has been withdrawn over the past year, China’s growth has slowed, mainly driven by a sharp deceleration in infrastructure investment and the negative credit impulse as the squeeze on shadow financing continues. While the authorities have clearly been concerned about the overall direction of the economy, the relatively small policy easing measures they have enacted are not yet sufficient to engineer a meaningful rebound. This balancing act, involving supporting growth with small stimulus on the one hand while pressing on with reform on the other, is a very delicate and difficult tightrope to walk. While a hard landing scenario is not our base case, the risk of a policy mistake that would have serious repercussions for global growth is not trivial.
Emerging market woes look set to continue
With the Fed normalising policy and China slowing, emerging markets are facing a double blow. The most vulnerable countries are already being punished for irresponsible policies of the past decade. But while ongoing crises in Argentina and Turkey might seem idiosyncratic, these are all symptoms of the post crisis search-for-yield-exuberance created by the global low rate environment. Turkey’s stress has the potential to become systemic, spilling over to other emerging markets.
Predicting the end of the cycle in real time is inherently difficult. It is reasonable to suggest, however, that the global economy is now in the later stages of the post-crisis economic expansion. It is worth repeating that despite the ticking clock implications of being ‘late cycle’, market dynamics in this period tend to be positive for risky assets. But differentiation across asset classes, regions and sectors is ever more important.
At a glance: Asset class outlook
Equities
US: We expect the recent outperformance of the US to continue for now, driven by strong earnings, robust economic growth and a pickup in capex. We don’t expect a dramatic change in the narrow market leadership by the tech giants.
Europe: Although slowing, economic momentum remains robust and we expect the corporate environment to remain supportive.
Asia Pacific: The overall outlook has turned more negative but this means valuations look more attractive especially compared to the US. Developments in China will be critical.
Japan: We expect above-trend growth to continue for the time being, supported by rising capex and consumption, and think valuations are attractive at current levels.
Emerging markets: We expect sentiment to continue to be hindered by tightening dollar liquidity and dollar strength, although there are a few notable areas of strong performance, such as India.
Global sectors: Our most favoured sectors are technology, healthcare and financials, while our least favoured sector is materials.
Fixed income
Government: We expect the US yield curve to flatten from here but there are technical reasons for this and we’re not thinking about a recession.
Inflation-linked: Inflation-linked debt in the US, the UK and Europe broadly looks in line with our fair value estimates. We have a structurally positive view on US breakevens but momentum will be a headwind over the coming quarter.
Investment grade: Investment grade debt looks attractive on the basis of momentum, liquidity and mean reversion factors. However, spreads below historical averages and corporate fundamentals showing late-cycle characteristics warrant caution in some areas of the market.
High yield: High yield continues to benefit from good earnings momentum, but it will be difficult for credit spreads to tighten further in Q4. Coupon-like returns are therefore our base case scenario.
Emerging markets: Valuations in some parts of the market have adjusted to account for the macro challenges that emerging markets face. However, one last leg lower could come in September.
Alternatives
European commercial real estate: The lagged monetary cycle in Europe – compared with the US and the UK – continues to support the real estate market on the continent, bolstered by strong domestic demand and labour markets.
UK commercial real estate: We expect Q4 2018 to be fairly quiet for UK commercial real estate as market participants await clarity on the terms of Britain’s departure from the European Union.
Commodities: The outlook for commodities is mixed. Solid global growth and late-cycle dynamics should boost demand while the continued slowdown in China’s industrial sector will weigh on sentiment.
Alternative strategies: We expect long/short equity and global macro hedge funds to perform well in the coming months, although we note that the large spread in performance makes it important to choose wisely.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in small and emerging markets can also be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority and Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0918/22524/SSO/NA