2018 review

Stock markets see records and corrections

• A generally weak year for equities. Stock markets made a strong start, but ended up below zero after two corrections. This meant negative returns for many investors, while volatility staged a comeback.
• US equities were clearly the strongest performers, chalking up several new records. The rally was not broadly supported, however, but driven primarily by a handful of tech stocks. This vulnerability became plain when sentiment towards the tech sector shifted, driving the share markets down towards zero.
• European markets had an even tougher time: a slowdown in economic growth and greater sensitivity to the trade war wiped 10–15% off share prices.
• All this means that equities are no longer expensive: US valuations are around their long-term average and those in Europe are even significantly lower.
• Increased volatility has caused investors to pivot towards more defensive sectors: primarily health care firms and utilities. Sharp movements in the oil price also stood out: an initial steep rise was followed by a slide that ended below the year’s starting level.

Economy: US increasing its lead over the rest of the world

• The American economy is running at full throttle, with high levels of consumer and producer confidence and very low unemployment.
• Less rosy picture for the euro area, which saw a clear slowdown in growth since the start of the year, albeit with some stabilisation at solid levels.
• China cooled down a little too: a limited slowdown in growth, but no hard landing.
• Corporate earnings rose sharply.
  • Excellent growth in the US in particular, with over 20% year-on-year, stimulated by President Trump’s tax cuts and the strong economy.
  • Earnings in the EMU rose by 6%.

A year of rising interest rates. Or was it?

• The variance in economic performance translates into different inflation patterns and central banks operating at two different speeds.
• The tight labour market in the US kindled core inflation to some extent, triggering four rate hikes by the Fed in 2018.
• There was nothing like that in the euro area, which is further behind in the economic cycle and experiencing low growth figures. Total inflation crept up towards 2%, but when the volatile oil price is stripped out, core inflation of just 1% remains. So no interest-rate hikes. But after years of crisis management, the ECB announced that its support purchases will end in December.
• The difference remains exceptionally large at the long end of the curve too, with the Transatlantic spread widening to 2.65%. The US ten-year rate rose steadily throughout 2018, while its German counterpart looks set to close the year lower, following an initial uptick.
• Fear also grew towards the end of the year that the economy might be past its best. This drove US bond yields down which, combined with a very active Fed, fuelled concerns about an inverted yield curve (short end higher than the long end). That’s something that gives investors the shivers. as an inverted yield curve is viewed as an excellent signal of imminent recession.

(Geo)political risks firmly to the fore

Brexit

• Bumpy ride with no clear destination. Months of negotiation resulted in a provisional withdrawal agreement. The divorce terms have been committed to paper but the deal still has to get through the UK parliament, which will be far from easy. It seems highly unlikely at this point that the deal will be able to command a majority first time around.

Trade war

• Whipped up frequently by President Trump and the source of considerable volatility. The provisional outcome has, however, been mixed. NAFTA has been replaced with USMA, for instance, and negotiations between the US and EMU continue. But the relationship between China and the US has deteriorated, with America raising tariffs on imports from China, which weakened the Chinese currency. A temporary ceasefire was agreed in the fourth quarter, but this remains the most prominent risk.

Europe

• The German-French axis has lost some of its shine now that Angela Merkel has announced her departure and President Macron’s popularity is waning. Meanwhile, the migration pact continues to drive Europe apart and the Italian question is putting pressure on the credibility of the already fragile currency union’s budgetary rules.

Currencies: strong dollar, weak EMs

• The strong economy, changes in monetary policy and higher interest rates have translated into an appreciating US dollar, which came out on top in a rather turbulent year, along with other safe havens like the yen and the Swiss franc.
• More striking, perhaps, is the performance of emerging market currencies. The Turkish lira fell particularly sharply, after markets lost all confidence in it. Countries with a high external debt, sluggish economy as well as political problems performed poorly. Aside from Turkey, that also means Brazil and Argentina.

2019 preview

No slowdown in the US

An inverted yield curve (risk-free return is higher at the short end than it is for longer maturities) is seen as a herald of economic recession. That’s not our view! Particularly not when we take fundamental data into account :

• (+) There is no over-spending in cyclical sectors: the share of purchases of consumer durables in the Gross Domestic Product (GDP) is lower than in the run-up to previous recessions.
• (+) There is also no high debt ratio among the families. With 70% of disposable income, this is below the long-term average.
• (+)From a net perspective, there are also more banks that are easing their lending conditions.
• = Inflation has accelerated due to the tight labor market.
• = The budget does not allow further stimulation.
• = New tax cuts are difficult due to the size of the budget deficit (> 5% of GDP) and changed ratios in Congress after the mid-term elections.

Earnings growth: both feet back firmly on solid ground

• While the sky was the limit in 2018, especially in the US, 2019 will be more of a normal year with worldwide earnings growth around 10%:
  • Robust economic growth, above trend in the euro area
  • The lower oil price will boost consumer spending o But the stimulus provided by tax cuts will disappear in the US...
  •  ... where very high profit margins will also come under pressure from higher import prices and pay increases.
  • Margins could still rise further in the euro area, while the lower euro could provide support.

Neither bulls nor bears but... bunnies

• It won’t be a bull market at any rate. The stock market cycle will enter its eleventh year, with profit margins in the US in particular at very high levels.
• But it won’t be a bear market either: we only see those in economic recessions, which is not the scenario for 2019.
• So a bunny market it is! Hopping about without any obvious direction.
• We nevertheless see upside potential for shares, so this will be a rabbit with little horns! In other words, economic and earnings growth will remain robust, with valuations on the low side. Certainly in Europe, where TINA (There Is No Alterantive) is still firmly present.

Welcome back volatility (here to stay)!

• The low volatility trend seen in recent years came to an abrupt end in 2018. A return to higher levels was always on the cards, however, when the biggest central bank began to scale back its policy of stimulation.
• Spreads on corporate bonds also diverged further, but most of all it was the turbulence of the emerging markets (and their currencies) that stood out.
• We expect a higher degree of volatility to persist in the years ahead too: this wasn’t just a one-off spike!
• What will keep investors awake at night in 2019?
  • Weaker economic growth figures and a late-cyclical US.
  • General tightening of monetary policy: support purchases will end and accelerating core inflation will incline central bankers to raise their key rates.
  • Fear of ‘peak earnings’: lower economic growth and rising costs (labour, energy) will weigh on profit margins.
  • Not to mention the many political risks...

It’s the politics, stupid!

Europe is looking at another busy political agenda in 2019.

Brexit – the deadline is looming!

• The first step is a vote on the EU-UK deal on the transition period to 2020, including the ‘backstop’ arrangement for the Irish land border.
• If the UK parliament votes against the deal, there could be crisis negotiations in the first quarter.
• 29 March: UK actually leaves the EU and negotiations begin on a new trade treaty.
• End of 2020: completion of trade treaty negotiations between the UK and EU, or an extension of the transition period.
• Many outcomes possible, but at KBC AM we assume the negotiated solution (via adapted deal or 'lastminute solution') with a temporary negative economic and market impact.

Italy

• On a collision course with Europe since accession of new government over the budget and migration.
• All the same, there’ll be no ‘euroviderci’! Italian citizens and business remain moderately positive towards the euro.
• Conflict will probably stay on the back-burner until after the European elections and Italy will also remain the poor relation after that.

European elections

• The first European elections without the UK will be held in May 2019.
• Possibly a good indicator of the success enjoyed by populist parties. Although the polls do look positive for the traditional parties, which are managing to stem their losses. Europe is a favourite scapegoat for many, but at the end of the day there is no appetite virtually anywhere for quitting the monetary union.

ECB to raise key rate

• The ECB will most likely lift its key rate in September, just before Mario Draghi departs, from -0.4 to... -0.2.
• Merely a first, tentative step towards normalisation, assuming that:
  • The dip in euro area growth proves only temporary
  • Preliminary tightening in the labour market pushes up core inflation
• Support purchases coming to an end: from a loose to a tightening monetary policy.
• · So expect rising long interest rates, which ought to support the euro

Investment still pays!

• Looking ahead, we see a climate in which bond investors, certainly, are facing some difficult years. It will be up to shares first and foremost to deliver growth in investment portfolios.
• The traditional savings account might seem attractive in uncertain times, but it still pays to invest! Forecast returns are higher than they are for saving also for defensive investors.
• What’s more, investing is still the answer to inflation! 

Is there still any point in bonds?

• Bonds are very expensive right now because of the low coupons on new issues. What’s more, the value of these investments is under pressure due to the anticipated rise in interest rates and lower demand now that the central banks are gradually closing off the monetary tap.
• Bonds are not currently attractive, which means we are investing substantially below the norm, while limiting the interest-rate risk by investing in short maturities.
• But bonds from the safe core countries in the euro area do play an important stabilising role in the portfolio. Price fluctuations are limited and they form a buffer in a portfolio with shares in the event of stock market turbulence. Riskier bonds and junk loans don’t offer any stabilisation.

 
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