Outlook 2019: Developed markets converge, emerging markets diverge

14/11/2018

• US to face moderate growth slowdown as stimulus effect wanes and Fed tightening is starting to be felt • Economic growth in Europe and Japan is starting to re-converge to US growth in 2019 • As growth in developed markets converges, we prefer emerging markets and European assets to US • Emerging markets face challenges from trade tariffs and normalising US monetary policy • Individual investors expect global growth to decelerate, according to a poll by NN Investment Partners • NN Investment Partners prefers credit risk instead of duration as monetary policy slowly returns to normal

The consolidation of global growth in 2018 showed divergence in regional growth, making the US outperforming the fading growth in Europe and Japan. In the new year, NN Investment Partners expects the Eurozone to emerge from its current soft patch as labour markets tighten and wage growth picks up. Convergence in developed market growth creates opportunities for emerging markets (EMs), particularly via trade with Europe. But foreign investment and capital flows to EMs are curbed by import tariffs and normalising monetary policy in the US.

Individual investors share the concerns about the effect of import tariffs and monetary policy normalization on the global economy. Investor sentiment research* by NN Investment Partners (NN IP) shows economic growth, US trade policy and inflation dynamics as the main concerns among 100 institutional investors. Just over half of the surveyed investors expect a deceleration of global economic growth momentum in 2019, with 28% expecting a consolidation.

Valentijn van Nieuwenhuijzen, Chief Investment Officer at NN Investment Partners: “Going into 2019 the US will indeed face a moderate growth slowdown as the effect of fiscal stimulus wanes and recent tightening by the Federal Reserve is starting to be felt. But Europe should emerge from its current soft patch as labour markets continue to tighten and wage growth is picking up. Steady business confidence, improved profit margins and a low investment-to-output ratio should boost capital expenditure and set the stage for a further pick up in credit growth. Bear in mind that there is still some slack left in Euroland, we see unreleased demand for capital goods and expect ECB policy won’t be tightening before September 2019. As a result, we forecast Europe to experience above trend growth for most of next year. Finally, Japan is also set for continued above trend growth because the monetary and fiscal policy mix deliberately aims to overheat the economy to pull inflation expectations higher. The economic developments in Europe and Japan are starting to re-converge to US growth into the new year, with the usual show stoppers such as central bank and labour market squeezes unlikely to spoil the party.

Emerging markets & US trade

While developed markets continue their consolidation path, the environment for EMs has become more challenging. The normalisation of monetary policy in developed markets leads to tighter financial conditions and eventually lower domestic demand growth in EMs. At the same time, US protectionism is affecting the globalisation trend, which was already flat before recent US trade tariffs were initiated. This should hurt foreign direct investment and export growth in EMs. Thirdly, Chinese growth is becoming less commodity-intensive and gradually declining to levels that are more compatible with its demographics and debt ratios. With China focusing more on household consumption than on fixed investment, it’s more difficult to predict when Chinese stimulus will kick in to offset the negative impact from US tariffs.

We expect further policy divergence in the emerging world between countries with institutional strength to continue reforming and the more interventionist, unorthodox economic policies. For that reason, we’ll keep a close eye at elections in Indonesia, India and Poland.

Tensions between the world’s two major economies will remain a chronic theme for markets. Tariffs introduce a micro inefficiencies and these will morph into macro-economic underperformance, which will be mostly visible in productivity. Before this point is reached we could well see negative effects on business and financial market sentiment. We expect trade tensions to stay confined to the China-US axis and continue to be a source of volatility in 2019.

Europe

Next year will mark the first decade following the start of the Greek debt crisis. The Eurozone is still stuck with half-finished fiscal and banking union institutions, which make it vulnerable to economic and political shocks. Strengthening these institutions is essential but difficult because of the different ideas and preferences across the member countries.
Brexit comes at a potentially very large economic cost stemming from a negative change in UK institutions governing international trade and finance. Meanwhile, the perceived benefit may prove to be elusive given the large economic and defense interdependencies with the European continent.

Meanwhile, the Italian drama is one where the populists have correctly identified that it needs a prolonged period of strong real growth to reach pre-crisis inflation levels and to achieve debt sustainability. Too much austerity, as we experienced in the aftermath of the financial crises weighs heavily on real growth as it triggers more caution in the private sector. On the other hand, a lack of austerity can easily lead to a tightening of financial conditions and credit supply, a drop in confidence and eventually substantially lower real growth.
This would spur sovereign rating downgrades, increase borrowing costs and further push up the debt-to-GDP ratio. It complicates the relationship with other Eurozone countries and make the ECB much less willing to provide a conditional backstop for Italy’s sovereign debt. The only solution for Italy is to combine the right balance on fiscal spending with economic reforms to stimulate growth.

Ewout van Schaick, Head of Multi Asset at NN Investment Partners: “Some might perceive the economic environment worse than it really is, however corporate profit margins outside the financial sector are still performing well. But as we move into macro-economic consolidation, markets become more vulnerable to sentiment swings. We see improving sentiment as a catalyst for better equity performance. Of the investors surveyed by NN IP, about 55% prefer equity strategies in terms of risk versus return. We see stabilisation in the earnings of Japanese stocks and acceleration in Eurozone equities, providing better value than the relatively expensive US market. The search for yield will become less of a theme in equity investing as the normalisation of monetary policy leads to gradually rising bond yields. Investors may move from defensive stocks to cyclical companies. But risks to this scenario can be found in more aggressive central bank policy, an escalating trade war between the US and China and increased tensions and market stress on the Italian budget.

Fixed income

The widening of bond spreads improved the valuations in 2018, but they’re still not cheap. We expect spreads to remain stable in 2019 and the carry to offer some pick-up for total return investors. The US yield curve is likely to stay flat with the risk of a negative slope in the course of next year and we don’t expect a material reduction of the yield gap with other developed market countries. The gradual return to normal monetary policy and bond yields weighs on the return of all longer-duration fixed income investments. Therefore we prefer fixed income instruments that are more exposed to credit risk instead of duration. Short-duration emerging market debt is attractive as it may profit from higher rates and demand adjustment. We also favour senior bank loans and convertibles.’’

Responsible investing

NN IP expects demand for opportunities to invest according to environmental, social and governance criteria to continue to grow in 2019. Responsible investing is no longer a matter of conscience, according to the investor survey. Almost half (48%) of the investors now sees it as a way to help both risk and returns with only 13% stating sustainable investments are just about values. We believe that when it comes to responsible investing, financial returns and societal impact go hand in hand and do not necessarily has to cost return. In 2019, NN IP will make further progress in mapping our portfolio exposure to SDG’s and further improve our reporting standards on the impact of our portfolios.

* Risk on Risk off research, NN IP, 100 institutional investors, November 2018

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About the author

Valentijn van Nieuwenhuijzen

Valentijn van Nieuwenhuijzen

Chief Investment Officer of NN Investment Partners

Experience since 1998

Previous work experience: Valentijn has substantial experience working in financial markets and joined the firm in 1999. Prior to becoming Chief Investment Officer, Valentijn held the role of Chief Strategist and Head of Multi-Asset from 2013 to 2017 and from 2010 to 2013 he was Head of Strategy within Multi-Asset. He is a key spokesperson for the company and appears frequently at client events and in the media.

Education: MSc in Economics from the University of Amsterdam

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About the author

Ewout van Schaick

Ewout van Schaick

Head of Multi-Asset

Experience since 1997

Business Experience

2017- to date Ewout is Head of the Multi-Asset investments team and member of Management Team Investments. As investments team manager he is responsible for macroeconomic & investment strategy research and design, tactical asset allocation (TAA) and the management of Multi-Asset funds and mandates within NN Investment Partners. The Multi-Asset boutique manages a large range of multi asset funds and mandates, including both benchmarked and absolute return strategies.

2007-2017 As Head of the Multi-Asset Portfolios team, Ewout is responsible for day-to-day management of Multi-Asset and Absolute Return portfolios. Ewout has been involved in the development and introduction of new multi asset strategies like absolute return strategies, multi credit strategies and sustainable multi asset.

2002-2007 Portfolio manager at PGGM, the second largest pension fund in the Netherlands, responsible for managing a portfolio of external alpha strategies

1997-2002 Product Development Manager at ABN AMRO Asset Management. He also spent one year at the asset management unit of NIBC that was dedicated to specialized Fixed Income portfolios.

Qualifications

CFA

MSc in Economics from the University of Maastricht in 1997

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