Tug of war Q&A about 2019 - Nordea Group...Trade war The trade war has deeper roots than just the...

Tug of war – Q&A about 2019 Global Asset Allocation Strategy December 2018

Investments │ Wealth Management

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EQUITY STRATEGY: OW EM, UW Europe

FIXED INCOME STRATEGY: Underweight HY bonds

• The recent weakness in equities was caused by monetary

conditions, macro and political issues. However, we have not

seen a markedly deterioration in fundamental factors.

• Given the still supportive economic and earnings growth, we

remain overweight equities, as the recent sell-off has improved

risk/reward.

• Next year we expect a tug of war between tighter monetary

conditions and still strong growth dynamics that will cause higher

volatility.

OVERWEIGHT EQUITIES VS. FIXED INCOME

December 2018

• We recommend to overweight EM equities as we expect

Chinese stimulus to eventually bite.

• Europe remains an underweight given political headwinds and

lacklustre earnings growth.

• We move towards a slightly more defensive stance in the sector

strategy.

• We reduce risk in the bond portfolio as well, by moving HY to

underweight and government bonds to overweight.

• Federal reserve is tightening its monetary policy, which creates

upward pressure in the short end of the yield curve, tightens

financial conditions and hence causes headwind for risky bonds.

• With default rates bottoming out in a mature cycle, spreads are

vulnerable going into next year.

Tug of war


Market performance & recommendations

Growth worries has led to renewed weakness in markets

Current allocation Previous allocation

ASSET ALLOCATION - N + Comments

Equities

Fixed Income

EQUITY REGIONS - N +

North America

Europe

Japan

Asia excl. Japan

Latin America

Eastern Europe

Denmark

Finland

Norway

Sweden

EQUITY SECTORS - N +

Industrials

Cons Discretionary

Cons Staples

Health Care

Financials

IT

Comm. Services New sector

Utilities

Energy

Materials

Real Estate

BOND SEGMENTS - N +

Government

Investment Grade

High Yield

Emerging Markets

Source: Thomson Reuters / Nordea


2018 – Mean reversion; last years winners are this years losers


-15,0 %

-10,0 %

-5,0 %

0,0 %

5,0 %

10,0 %

15,0 % Returns YTD 2018, EUR (unless otherwise stated, updated 30 November)


2007

1992

1987 2012

2018 1984 2010

2015 1978 2006 2017

2011 1956 2016 1988 1999

2005 1948 2014 1986 1996

1994 1947 2004 1979 1983 2013

2001 2000 1970 1916 1993 1972 1982 2009 1997

1973 1977 1990 1960 1912 1971 1964 1976 2003 1991

1966 1969 1981 1923 1911 1968 1952 1967 1998 1989

1957 1962 1953 1902 1906 1965 1949 1963 1961 1985

1941 1946 1939 1896 1899 1959 1944 1951 1943 1980

1940 1932 1934 1895 1892 1926 1909 1942 1925 1955 1995

1974 1903 1929 1914 1894 1889 1921 1905 1919 1924 1950 1975

1930 1890 1913 1887 1888 1881 1886 1901 1898 1922 1938 1945 1958

2008 1917 1920 1884 1910 1883 1882 1874 1878 1900 1891 1918 1936 1927 1928 1935 1954

1931 1937 1907 2002 1893 1876 1873 1877 1875 1871 1872 1897 1880 1885 1904 1915 1908 1879 19331873

-40

%-4

5%

-35

%-4

0%

-30

%-3

5%

-25

%-3

0%

-20

%-2

5%

-15

%-2

0%

-10

%-1

5%

-5%

-10

%

-0%

-5%

+0

%+

5%

+5

%+

10

%

+1

0%

+1

5%

+1

5%

+2

0%

+2

0%

+2

5%

+2

5%

+3

0%

+3

0%

+3

5%

+3

5%

+4

0%

+4

0%

+4

5%

+4

5%

+5

0%

+5

0%

+5

5%

S&P 500 total return (USD) 1871-2018

2018 – Not a good year, not a very bad year either


2018 until Nov 30


Moving into late cycle and higher realized volatility



The normal state for US equities is – Bull Market!

Will we see the longest equity bull market on record?


Still a long way to go before we are at “all time long” in the US


250%

102%

223%

86% 80%

126%

229%

582%

102%

305%

97

49

86

50 44

73

60

147

60

116

0

20

40

60

80

100

120

140

160

0%

100%

200%

300%

400%

500%

600%

700%

1921 1942 1949 1957 1962 1974 1982 1987 2002 2009

S&P 500, total return Duration, months

Return, S&P 500 Duration

(months)


Scenarios for the 10-year US treasury yield Scenarios for equities in 2019

• Expansion: economic expansion continues while wage and inflation pressures remain moderate and rates rise slowly. (5-10%)

• Melt-up: US hard data catch up to soft data, China stimulus results in overheating, the trade war eases, and the rest of the world accelerates (15-20%).

• 2019 recession: Inflation rises while economic activity moderates. Fed behind the curve, the curve flattens and equities turn mid-2019. (-30%).

Boom, bust or base scenario in 2019?

Source: Thomson Reuters / Nordea Source: Thomson Reuters / Nordea

65%

20%

15%


What are the expected hot topics for 2019?

“Peak growth”

Downside risks have risen for the global

economy during 2018, and earnings

growth is slowing next year. Lately,

investors have put more weight on that

everything is peaking, rather than still

solid levels. Risky assets performance in

2019 will of course depend on that

fundamentals stay solid, but also to a

large extent on market sentiment.

Inflation and monetary policy

A maturing cycle, the fear that Fed

always “tighten until something breaks”,

and the fact that we are moving from QE

to QT in the western part of the world,

put both inflation and monetary policy

front and center for investors in 2019.

Source: Thomson Reuters / Nordea Source: Thomson Reuters / Nordea Source: Thomson Reuters / Nordea

Trade war

The trade war has deeper roots than just

the trade deficit, which means that US

/China related conflicts most likely will

stick around next year. Being the worlds

two largest economies, markets are right

to be concerned. We are hoping for de-

escalation, but an escalation is more

likely.

9


Where are we in the business cycle?

Weak Moderate Strong Weak

improving improving slowing growth Slowing down

Credit growth Weak Rising High Negative

Easing Tightening begins Tightening / tight Easing

Low Moderate High Moderate

Bottoming Rising Rising falling

Yield curve Steep Flattening Flat / Inverted Steepening

Below avg. About avg. Above avg. Below avg.

rising Rising Rising Falling

Profits increasing Profits rising Profits increasing Profits falling

Debt and leverage declining Debt and leverage declining Debt and leverage rising Debt and leverage rising

Above avg. Below avg. Below avg. Above avg

Declining Stable Rising declining

Credit preferred Both Credit Equity preferred Neither Credit

over Equity and Equity over Credit nor Equity

2018 2017

Downturn

Fin

an

cia

l

Valuation

Fundamentals

Volatility

Credit vs. Equities

ExpansionPhases: Recovery

Eco

no

mic

Economic growth

Monetary policy

Inflation

Repair


Chinese stimulus will provide a boost

Where is the global economy headed?


Global growth set to decelerate somewhat


• Up, but at a slower pace than in 2018. However, the slowdown is likely to remain limited in 2019, and the economy is set to keep growing above potential.

• Major risks stem from a slowdown in the US as fiscal stimulus wanes and monetary tightening kicks in. Also, the loss of momentum in Europe is worrying.

• The momentum in China has weakened, but policy easing will eventually stabilise growth. Put together, the macro backdrop is ok but with risks.


Earnings growth will still be supportive for equity performance

Will earnings continue to grow in 2019?


Earnings growth will normalize in 2019


• Earnings expectations for 2018 will be met, but the more important question is if earnings will continue to grow in 2019. We think so, but at a lower rate.

• Top-line growth will continue to get support from improving consumption and investments, though margin pressure might start to take its toll on earnings.

• 16% earnings growth this year surprised investors positively, but has not led to price performance. Skepticism characterizes investors outlook for 2019.


Wage growth and financing cost should take its toll

Will profit margins collapse due to higher wages, financing and other input cost?


Margins normally correct in recessions, or due to external shocks


• Estimates point to further growth in already high margins next year. That sounds too good to be true, but we seldom see compression outside recessions.

• We expect that higher wage growth, financing costs, and a stronger USD in 2018 will take their toll on margins.

• However, both top line growth and pricing power have surprised to the upside and this could continue in 2019, keeping margins high.


The end is nigh: Markets are eyeing the end of the Fed cycle Interest rates decoupled from economic reality

• Monetary factors remain a key risk to the bull run in equities, as a late cycle environment implies monetary tightening.

• In 2017 rates decoupled from weaker economic growth, and something has to give.

• Bad news should be good news: moderating growth limit the upside to core interest rates from here.

How high can yields go?


Expect convergence in

2019


Economy: Higher rates beginning to dent parts of the economy Markets: Short term lifts in the real rate hurt equities short term

• Have rates moved too far already? Both the Feb. and Oct. correction was pre-empted by rapidly rising real rates.

• This, together with the recent weakness in US housing suggests that both financial markets and the economy are starting to react to higher rates…

• …indicating that core rates are close to the pain threshold aka. neutral rate. In our view, a self-correcting mechanism should keep a lid on yields.

Are we close to the pain threshold in yields?



The USD has appreciated against all currencies this year Stretched positioning will temper further appreciation pressure

Will the dollar contribute to financial headwinds in 2019?


• The stronger dollar has boosted European investors’ returns from US-dollar based equity investments, but we don’t expect this to continue in 2019.

• We expect USD to stabilize and weaken due to valuation, changes in liquidity and positioning. Short term though, risk-off sentiment points the other way.

• Going forward a weaker dollar will also serve to ease the recent stress in Emerging Markets currencies, in the backdrop of a solid global growth picture.


Oil has also experienced a wild ride YTD, but what about 2019? The usual suspects apply when it comes to (geo)politics

Will geopolitics matter next year?


• The short answer is yes. However, our usual caveat applies: while affecting markets short term, the lasting effects are usually far smaller.

• Most concerning is the trade war, which could cause more lasting effects, and also the result of of Brexit. Italy and North Korea could pop up as well.

• Oil and the machinations around this central commodity spans both geopolitics, the global economy and is thus a constant companion to the market.


Will equities continue to derate?

Its not abnormal that equites derate in FED hiking cycles


Equities are priced below long-term average

• Global equities have derated close to 20% since January 2018; due to extremely strong earnings growth and muted equity price development.

• Weaker cyclical outlook and higher bond yields are among the reasons for this derating.

• The derating can continue, but then equites would start to price in an economic recession, and we do not think a recession is likely next year.


…which in itself is very volatile Get used to higher volatility and more swings in sentiment…

Where is sentiment heading?


• Sentiment is in itself a fickle indicator, and will most likely shift from bullish to bearish, and vice versa, several times during next year.

• With volatility moving higher as the cycle matures, we expect the swings in sentiment to increase as well. Prepare for a more bumpy ride during 2019.

• Currently, sentiment is beaten down and markets are still reluctant as risk-off is dominating. Should good news appear, there’s thus room for improvement.


Which risk factors to look out for in a late cycle environment?

Risk 2: The missing HY link an a late cycle playbook


Risk 1: Further deterioration of the growth/inflation trade-off


• Although the market is pricing the end of the Fed cycle, a Fed policy error is still ranking high in the list of classic late cycle risks.

• A further deterioration of the growth inflation trade-off would leave the Fed with no choice but to move policy rates above the pain threshold.

• Wider HY spreads are a classic late-cycle phenomenon. Significant spread widening would mean more tightening, adding to the list of monetary worries.


Is the credit cycle about to end?

Lower oil price has increased the pressure for spread widening


Big differences in yield levels

• The credit cycle still has legs to run, but credit environment is turning more challenging as financing conditions tighten and the global economy moderates.

• For that reason, we downgrade high-yield bonds to underweight in our recommendations and increase government bonds to overweight.

• Bond market returns have been modest this year, and we expect that to continue.



Emerging Markets have taken the lead in earnings

Where is the best value in equity regions?


US equities have been the strongest this year

• We find the best value in Emerging Markets. The region has the strongest earnings outlook and the lowest valuation.

• Europe remains underweight with lagging earnings and continued political risks, although the latter may turn into positives from time to time.

• In the US, fundamentals are healthy but positioning is growing worrisome, and earnings are normalising, which is why we prefer neutral.


We favour IT over CS, but neutralize other bets as risks has increased

What are the best candidates from a sector perspective?

Defensives in the lead during the selloff


• We recommend overweight in IT, which benefit from both cyclical and structural factors.

• We neutralize underweights in some defensive sectors by reducing the IT overweight and lower Energy and Materials to neutral.

• With the changing sector setup, we introduce Communication Services and Real Estate at neutral weight.

Sector Recommendation Relative weight

Industrials Neutral -

Consumer Discretionary Neutral -

Consumer Staples Underweight -2%

Health Care Neutral -

Financials Neutral -

IT Overweight +2%

Communication Services Neutral -

Utilities Neutral -

Energy Neutral -

Materials Neutral -

Real Estate Neutral -


Nordea Global Asset Allocation Strategy Contributors

Strategists

Sebastian Källman

Strategist

[email protected]

Sweden

Ville Korhonen

Fixed Income Strategist

[email protected]

Finland

+358 50 581 8261

Espen R. Werenskjold

Senior Strategist

[email protected]

Norway

+47 91 36 51 91

Assistants

Victor Karlshoj Julegaard

Assistant/Student

[email protected]

Denmark

+45 5547 7088

Mick Biehl

Assistant/Student

[email protected]

Denmark

+45 5547 5935

Amelia Marie Asp

Assistant/Student

[email protected]

+45 5547 2195

Frederik Saul

Assistant/Student

[email protected]

+45 60126102

Global Investment Strategy

Committee (GISC)

Leif-Rune Husebye Rein

Chief Investment Strategist

[email protected]

+47 95 86 92 05

Michael Livijn


[email protected]

+46 8 579 42 619

Antti Saari


[email protected]

+358 95 300 7019

Andreas Østerheden

Senior Strategist

[email protected]

Denmark

+45 5547 3349

Sigrid Wilter Slørstad

Senior Strategist

[email protected]

Norway

+47 90 94 40 57

mailto:[email protected]


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generic investment proposals. The advice includes allocation of the customers’ assets as well as concrete investments in national, Nordic and international

equities and bonds and in similar securities. To provide the best possible advice we have gathered all our competences within analysis and strategy in one

unit - Nordea Investment Center (hereafter “IC”).

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