BNP PARIBAS - Investment Outlook 2019_watermark

Exhibit 3: US bull market has kept on running and running; 1990-2018

(S&P 500 index; weekly data)

Source: Bloomberg, BNP Paribas Asset Management; November 2018

In this environment, markets are likely to be more sensitive to factors that affect market dynamics such as sentiment, volatility, liquidity and positioning. We use these indicators along with our in-house dynamic technical analysis to assess the prospects for market dislocations. Note that these dislocations may or may not reflect news or data on fundamentals.

It is these factors which, for example, signalled to us to reduce risk generally in September and to underweight US IT stocks relative to the overall US equity market. Sentiment indicators looked stretched at the time, volatility was historically low, and US companies were in a news blackout period that meant any share buybacks would be less supportive of prices. 

Investors are likely to be more sensitive to factors that affect market dynamics such as volatility and liquidity

Daniel Morris

Senior Investment Strategist

Whereabouts are we in the credit cycle?

Simply looking at measures of the credit cycle, for example, ratings upgradedowngrade ratios or default rates, the environment still appears fairly benign. In the US, the ratio is improving, and not showing the signs of deterioration that are often seen ahead of a recession. In Europe, the balance is quite positive (see exhibit 4).

Exhibit 4: Investment-grade credit upgrade-downgrade ratio, 2000-2018

(six-month moving average)

Source: Data as at 31 October 2018. Source: Bank of America Merrill Lynch, BNP Paribas Asset Management

For high-yield credit in the US, excluding commodities, the rate of issuer defaults has been declining from the surge that began in 2016. In Europe, the rate remains low (see exhibit 5).

Exhibit 5: Changes in default rates of US and European high-yield debt, 19982018 (trailing 12-months)

Source: Data as at 31 October 2018. *Excludes commodities. Source: Bank of America Merrill Lynch, BNP Paribas Asset Management

We are nonetheless in the later stage of the US economic cycle and it should be just a matter of time before worries about growth drive investors to favour government bonds over corporate debt. We are worried about a lack of discipline among corporate debt issuers. The stimulus from the tax cuts should eventually fade, while the US Federal Reserve will still be raising rates to forestall an increase in inflation and will still be reducing the size of its balance sheet. It is then that the build-up in corporate leverage over the last few years will likely become a problem for company treasurers. The asset class has seen significantly lower fund inflows compared to 2017 as investors began to anticipate rising interest rates.

In contrast, the eurozone economy may not have shown the same vigour as that of the US, but as far as credit is concerned, it has the virtue of the tortoise versus the hare. The Bloomberg Barclays eurozone credit index outperformed the euro government bond index as at 31 October 2018. By contrast, in the US, only highyield (slightly) bettered government bonds.

Europe, however, faces the prospect of a much steeper normalisation of monetary policy in 2019 as quantitative easing ends (including the ECB’s Corporate Sector Purchase Programme (CSPP)) and the ECB may begin to raise interest rates. While this normalisation has already progressed reasonably far in the US (Treasury yields are well above the levels seen in the QE-era from 2010), yields of Bunds are still quite depressed (see exhibit 6).

Exhibit 6: Variations in the yields of selected benchmark 10-year government bonds, 2010-2018 (in %)

Source: Data as at 31 October 2018. Source: FactSet, BNP Paribas Asset Management

It should be just a matter of time before worries about growth drive investors to favour government bonds

Emerging markets had a difficult 2018. How do you assess their prospects for 2019?

The key surprise in 2018 was the focus placed by President Donald Trump on trade. The fear of protectionism and trade wars contributed to a sharp rise in the US dollar and equally sharp falls in emerging market (particularly Chinese) equities.

Trade and the US dollar aside, however, the macroeconomic outlook for EM remains broadly positive. The prospects for 2019, then, depend on how the trade environment evolves.

Whenever President Trump ‘tweeted’ about trade, or announced higher tariffs on US imports, the US dollar generally strengthened. This explains much of why the dollar rose in 2018 after having declined from 2016 (see exhibit 7).

Exhibit 7: Changes in US dollar against emerging market currency index and US interest rates, 2000-2018

Source: Data as at 31 October 2018. Source: JPMorgan, FactSet, BNP Paribas Asset Management

We had expected the dollar to continue its depreciation in 2018, despite rising US rates, because we believed the currency was overvalued. It was the surprise increase in the dollar’s value, combined with rising US rates, that put so much stress on emerging market assets in 2018.

We expect the Fed to continue raising interest rates through 2019, so pressures on emerging markets will only increase. Whether they will be able to withstand the pressure will depend on whether the dollar reverses course. If the trade tensions diminish (without entirely vanishing), we believe the prospects for a fall in the dollar are good, clearing the way for a rebound in emerging market equities and (local currency) fixed income markets.

There has nonetheless clearly been a negative impact on growth in emerging markets from the rising USD-interest rate combination. While purchasing manager indices (PMIs) for most markets have remained in positive territory (readings above 50 indicate expansion, those below 50 point to contraction), the trend over the last six months for many countries has been downwards (see exhibit 8).

A fall in the US dollar would clear the way for a rebound in emerging equities and (local) fixed income

Do you think we have seen the high for global equities in this cycle?

We do not see a near-term trigger for a sustained, negative trend in global equities, though the “leader board” will likely be different in 2019. The most likely catalyst for a broad downturn would be a US recession. With consensus forecasts for GDP growth of 2.5% in 2019 and 2.0% in 2020, recession is clearly not what economists expect. A recession will occur, but with US tax cuts and fiscal stimulus still stoking economic growth in 2019, and US inflation contained (allowing for only modest additional rate rises from the Fed), a recession is still a reasonably distant prospect.

In developed economies outside the US, a recession seems even less likely. The recovery of the eurozone has been gradual compared to that of the US. Inflation remains well below the ECB’s target and there is still spare capacity in the economy.

Equity valuations are nonetheless high in some markets, but high valuations in and of themselves are rarely the cause for a market downturn. It is only when the justification for the high valuations fails that multiples decline. And in any event, it is only in certain markets that valuations appear particularly stretched (see exhibit 9).

Exhibit 9: Relative equity market valuation metrics (z-scores)

A recession is still a reasonably distant prospect

Valuations for several markets by many measures are near their long-term averages (a z-score of 0 in the above table). Japanese multiples are still well below average.

The clear outlier for valuations is the US, but this more notably concerns the technology sector (including internet retail). Price-to-forward-earnings multiples are only 0.2 standard deviations above the long-run average but 0.9x and 1.2x above on price-to-book and price-to-sales. The PEG (price-earnings-to-growth) multiple, however, shows that there may still be opportunities in the sector (and hence the US market). The PEG is below zero, that is, below the long-run average, suggesting that the price investors are paying for the index is not excessive relative to the earnings growth outlook. Unfortunately these growth estimates come from equity analysts and hence are likely to be unduly optimistic, but we still believe the medium to long-term outlook for the sector is very promising.

Importantly, earnings revisions are still good across the major markets. US tech not surprisingly has the best profile, followed by emerging markets (see exhibit 10).

Exhibit 10: Forward earnings estimates, Oct 2017-Oct 2018 (Oct 2017 = 100)

Source: Data as at 31 October 2018. Note: Indices in local currency, EBITDA for US indices. Source: Bloomberg, BNP Paribas Asset Management

The projections still show

the potential for further equity market appreciation

JEAN-CLAUDE JUNCKER

President of the European Commission

Jean-Claude Juncker (Luxembourg) has said he will not stand again.

Term length: 5 years

Term expiry: October 2019

The "Spitzenkandidat" system allows the largest political group in parliament to name the candidate for president. The candidate still needs to be approved by an absolute majority of MEPs and be endorsed by the European Council.

DONALD TUSK

President of the European Council

Donald Tusk (Poland) cannot renew his term for a second time.

Term length: 2.5 years, renewable once

Term expiry: November 2019

The president is elected by a quali•ed majority of members of the European Council (heads of state or government, the president of the European Council and the president of the European Commission).

ANTONIO TAJANI

President of the European Parliament

Antonio Tajani (Italy) could be reappointed, but the role usually rotates between EPP and S&D.

Term length: 2.5 years, renewable once

Term expiry: July 2019

The president is elected by an absolute majority of MEPs.

Since the 1980s, the terms have alternated between the EPP and the S&D.

AUSTRIA

Rotating presidency of the Council of the EU

Term length: 6 months

Term expiry: December 2018

The presidency is held by a national government. Austria will be followed by Romania (January-June 2019) and Finland (July-December 2019).

MÁRIO CENTENO

Eurogroup president

Mário Centeno (Portugal).

Term length: 2.5 years

Term expiry: July 2020

The president is elected by a simple majority of group members.

MARIO DRAGHI

ECB president

Mario Draghi (Italy).

Term length: 8 years, non-renewable

Term expiry: October 2019

Appointed by a quali•ed majority in the European Council (all heads

of eurozone states and governments), after consulting the European Parliament and the ECB's governing council.

L. Bryan Carter

Head of Emerging Market Fixed

Income

We have long argued that there is a real reason to worry about the fundamentals of many emerging markets (EM): too many countries have recklessly racked up debt in the low-interest rate environment of the past few years with economic policies that have not warranted such accelerated borrowing. Equally, the proceeds have not always been invested productively. However, we must stress that this does not relate to all EMs. A duality has emerged, with a small, but growing number of EMs now at real risk of imminent debt distress. We have already witnessed a pickup in default rates and we expect that increase to gain pace as US interest rates continue to rise.

On the other side of the duality, however, a great number of EMs appear increasingly robust. Inflation is structurally low in most big EMs and current account balances are better across the board. Growth has improved in Brazil, Russia and India. Governance has improved in South Africa, Malaysia and Chile. Indeed, the adherence to economic orthodoxy and the liberal global economic order is currently stronger in China and eastern Europe than it is in the US and UK.

We believe the 2018 correction in EM asset prices exposed the value on offer in this asset class, particularly among the strong performers. Globally, central banks are still likely to remove monetary policy accommodation cautiously, with China embarking on fiscal easing measures to ensure a soft landing. Furthermore, the long-running trade disputes appear to be near resolution, in our view.

CONTAGION RISK

The impact of rising US interest rates on large borrowing programmes in US dollars was felt most directly in Argentina and Turkey. The knock-on effect shook investor confidence in the broader asset class over the summer of 2018 and led to modest outflows from EM debt funds, triggering limited contagion in countries with similar fundamentals or close trade relationships (see exhibit 1).

Exhibit 1: Returns of selected emerging market fixed income debt sectors

EM hard currency sovereign

EM local currency sovereign (in USD terms)

EM hard currency corporates

Source: BNP Paribas Asset Management, JPMorgan; mid-November 2018

Turkey’s vulnerability was not entirely a surprise given the poor fundamentals: high external debt balances with major reliance on foreign funds to fuel economic growth; significant inflationary pressure worsened by a depreciating currency; a poor central bank reaction function and issues around government involvement.