Key Investment Themes & 2019 Outlook

2019 Investment Outlook Summary:

2019 Economic Outlook

Global growth to be lower in 2019 but still healthy

• The global economy is projected to grow by 3.6% in 2019, lower than what has been seen in 2018. Beyond 2019, growth in emerging markets will do the heavy lifting once momentum stabilises next year.
• The US economy is expected to grow by 2.6% in 2019, slower than 2018’s expected 2.9% growth rate. Overall growth will be driven by corporate investment and domestic consumption, which is supported by the Trump Administration’s recent fiscal package. We view the Federal Reserve’s continued campaign of monetary tightening via rate hikes as increasingly factored in by market participants and various corporations.
• On the other side of the Atlantic, Europe’s economy is expected to grow 1.6% in 2019 supported by improvements in the domestic economy. Although the European Central Bank (ECB) is widely expected to begin normalising monetary policy, the trajectory and pace is relatively gradual, which allows for growth to sustain.
• Emerging markets (EM) are projected to grow by 4.9% in 2019, with the Chinese and Indian economies expected to grow at growth rates of 6.4% and 7.3% respectively. We see growth improving for the entire emerging market space beyond 2019.

Corporate earnings growth remain supported

• With the global economy expected to clock in positive growth albeit on a lower trajectory, the prospects of corporate earnings growth is supported in 2019.
• Corporate earnings are projected to grow by 8.5% in 2019 and by 9.2% in 2020, supported by improving metrics such as return on equity.

Trade dispute will not derail potential of Asian & Chinese equities

• Thus far, the current trade spat between the US and China have not led to significant deterioration in economic data – damage has been on business and investor confidence.
• A large part of the trade spat has been largely factored into current prices in financial markets as the Trump Administration’s plans to raise tariffs on Chinese goods have been well communicated.
• Based on an optimistic scenario of a proper resolution, we think that Asian markets will see a recovery of investor sentiment and an upward multiple rerating, which could result in a total return of at least 33% from current levels by end-2020 as growth improves along the way.
• Additionally, we would like to point out that markets are not prepared for the possibility of a resolution in issues between both the US and China at this juncture. If that occurs, we could see a significant improvement in investor and business confidence worldwide.

Investor sentiment has deteriorated – a big positive for risk assets

• We entered 2018 with high levels of investor confidence and rising asset prices, and since then, expectations have moderated lower and investor sentiment has soured given the sell-offs seen in recent months in both equity and fixed income markets.
• The reset in general investor sentiment levels is a boon for risk assets going into 2019 and adds fuel for a recovery particularly if the majority of market participants out there are not positioned for the recovery scenario.

Asia poised for returns of 20% to 33% over the next two years

• Although Asia’s growth momentum has moderated lower this year, overall momentum may stabilise by the end of 1H 19, which will enable a pick-up and a recovery in corporate earnings growth across the region.
• Equity market valuations have improved across Asia and we believe that a large portion of the known negatives out there are already factored into current prices, allowing investors an opportunity to take advantage of lower prices at the current juncture.
• We target a PE ratio of 13.5X for the MSCI Asia ex Japan index by end-2020, which translates to a total return of 33% from current levels. Under the pessimistic scenario of continued escalation in Sino-US trade disputes, potential upside will be at the lower end of the range.

Chart 1: MSCI Asia Ex Japan Index

China’s growth to stabilise moving forward

• In the near term, growth momentum has been slowing on the Chinese mainland, but we do not expect a further significant deterioration. GDP growth is expected to come in at 6.4% in 2019 and 6.2% in 2020.
• Although economic data are expected to slow over the next few months, the overall economy is transforming to a consumption and efficiency-led growth model, which is healthier than the previous investment-driven model. Moreover, policy-makers have undertaken a series of measures to ensure that growth does not fall off a cliff and have been prioritising support for the private sector.
• Near-term volatility in Chinese equity markets may persist, but beyond 2H 2019, a significant recovery could be underway.
• Given a targeted PE ratio of 12.0X for the HSML 100 Index, we expect the index to move toward the 12,000 level by end-2020, which translates to a potential upside of at least 50% even accounting for continued trade tensions.
• Any resolution in the Sino-US trade dispute would lead to even better performance as earnings growth prospects improve and investor sentiment recovers.

Southeast Asia will benefit from further deterioration in Sino-US trade tensions

• Corporations may readjust their operations across the region and countries in Southeast Asia will benefit from geographic proximity to China and as regional trade continues to increase (see ASEAN: Looking to Boom).
• Wages in countries such as Indonesia and Vietnam and the Philippines remain competitive and serves as an incentive for multinational corporations to base their operations in this region.
• Singapore is poised to benefit from this development as a regional hub for trade and services.

The US economy is late in its business cycle; but not expecting a recession

• A slew of economic data suggests the business cycle is in its later stages in the US, but we are not expecting an outright recession for the US economy.
• Although economic data so far has been robust, with unemployment at cycle-lows and business investment progressing, economic benefits flowing from the Trump Administration’s fiscal package are expected to gradually decline in 2019 and beyond.
• A combination of wage pressures, slower growth and tightening monetary policy could start to impact top-line growth and pressure profit margins of corporations; companies that will do better at this stage of the cycle are those with resilient business models that are able to pass on higher costs to consumers or to protect their margins.
• In terms of the credit cycle, it is somewhere in its later stages in the US as well. With debt-servicing costs rising, any deterioration in the domestic macroeconomic environment could see a rise in credit rating downgrades and defaults in the US high yield debt market.

Be wary of betting on further USD appreciation

• While the US Dollar weakened broadly throughout 2017, it has made a comeback this year as growth differentials between the US economy and the rest of the world widened. Subsequently, the US Dollar Index has risen by 4.9% year-to-date (as of 22 November 2018) – against the SGD, the USD has appreciated 2.7%.
• We would caution against betting on further Dollar appreciation as other major developed central banks are expected to begin their respective monetary policy normalisations, which once commenced, could cause their currencies to gradually start strengthening relative to the USD.
• Additionally, investor sentiment on the greenback has completely reversed from being bearish to an outright consensus ‘buy’, which adds fuel to any potential depreciation should the USD start to weaken broadly moving forward.

Active Management is back in vogue

• With the Western developed countries at the middle-to-late stages of their business cycles and cross-asset volatility expected to rise, we reiterate that investors should not underestimate the value that active management could bring.
• Active managers can overweight relatively attractive areas and avoid or underweight segments that are unattractive. With equity valuation multiples expected to reset lower for markets that are richly-valued, and with credit selection and flexible positioning warranted for global fixed income markets, active managers are indeed apt for the current market environment moving forward.
• Effective actively-managed strategies are likely to outperform indexed based strategies in the year ahead.

What should investors do?
Table 1: Equity Market Valuations

Overweight Equities vis-à-vis fixed income

• Both fixed income and equity markets worldwide have seen a general improvement in valuations on aggregate. Consequently, pockets of value and opportunities across market segments have appeared.
• Relative to fixed income markets, equity markets remain more attractive as earnings yields are higher than where we expect fixed income markets to trade at in 2019 and beyond.
• We remain overweight equities vis-à-vis fixed income for our asset allocation in 2019.

Remain overweight Asia ex Japan in equity allocation

• As mentioned above, the reset in investor sentiment and valuation multiples in emerging market and Asian equities is a big positive for the asset class.
• Investors should remain overweight Asia ex Japan and use any further market weakness over the next few months as buying opportunities to prepare for an eventual recovery, which we believe could take place by the start of 2H 2019.
• A stabilisation of growth on the Chinese mainland and pickup in India as well as Southeast Asia could allow a structural upward rerating in valuation multiples.
• Unfortunately, the western developed markets continue to trade at levels suggesting that they are fairly-valued. Nevertheless, investors should still have exposure to them for diversification purposes; albeit an underweight in their equity allocations.
• The FSMI Asia ex Japan Equity Index, which represents the average performance of Asia ex Japan equity funds on the platform, is set to attain new-highs by end-2020.

Chart 2: FSMI – Asia ex Japan Equity Index

Emerging market debt starting to look interesting

• Yields of hard-currency denominated emerging market bonds have risen from 5.4% at the end of 2017 to 7.1% as of the end of November 2018, with spreads widening in the process as well.
• In particular, Asian non-investment grade bonds have seen even wider increases in both overall yields and spreads year-to-date. The segment is currently offering yields north of 9.0%, with Asian high yield bond funds also offering gross yields of 9.0% and above.
• Over the near-term, emerging market debt could still see volatility and price declines, but we believe that over the next two years, credit spreads could compress as economic growth in the region stabilises and improves.
• Barring any unexpected rise in defaults over the next two years or any significant adverse developments, investors are well compensated for risks with the current valuation levels as they have improved from where they were a year ago.

Chart 3: YTMs On Safer Bond Segments

Chart 4: YTMs On Riskier Bond Segments

Still favouring short duration bonds

• Although yields of G7 sovereign bonds have risen, they are still not particularly attractive due to their long duration exposure and are vulnerable should interest rates rise more or quicker than expected.
• As yields rise along the short-end of the yield curve (particularly in the US), they are increasingly attractive for the fixed income allocation within a portfolio. We continue to favour short duration bonds for their ‘sweet spot’ of offering decent yields as well as the potential for capital preservation due to their relatively lower interest rate risks.
• Riskier segments of the global bond markets like high yield segments are starting to trade at better valuation levels as compared to a year ago. Within the high yield space however, we prefer emerging market and Asian non-investment grade debt over their US counterparts, as the US economy is late in the credit cycle and valuations of the former are relatively more attractive.

The Research Team is part of iFAST Financial Pte Ltd.