Testing limits

Powerful structural trends are testing limits — and threaten to intersect with the near-term outlook and become market drivers. Rising inequality and a surge in populism have implications for taxes and regulation. Trade frictions and deglobalization are weighing on growth and boosting inflation. Interest rates are nearing lower bounds and crimping the effectiveness of monetary policy. And sustainability-related factors such as climate change are having real-world consequences, affecting asset prices as investors start to pay attention.

Growth should edge higher in 2020, limiting recession risks. This is a favorable backdrop for risk assets. But the dovish central bank pivot that drove markets in 2019 is largely behind us. Inflation risks look underappreciated, and the lull in US-China trade tensions could unwind. This leaves us with a modestly pro-risk stance for 2020.

• The 2020 macro environment marks a big shift from the dynamics of 2019, when an unusual late-cycle dovish turn by central banks helped offset the negative effect of rising trade tensions. The US dovish pivot looks to be over for now. Any meaningful support in the euro area will have to come from fiscal policy, and we do not see this in 2020. Emerging markets (EMs), however, still have room to provide monetary stimulus.
• This makes growth the key support of risk assets. Our base case is for a mild pickup supported by easy financial conditions, with a slight rise in US inflation pressures. We see China’s economy stabilizing, but little appetite for replays of the large-scale stimulus of the past. We see the growth uptick taking root in the first half of the year, led by global manufacturing activity and rate-sensitive sectors such as housing.
• The main risk to our outlook is a gradual change in the macro regime. One such risk: Growth flatlines as inflation rises. This might pressure the negative correlation between stock and bond returns over time, reducing the diversification properties of bonds.
• A deeper economic slowdown is another risk to consider. There has been a pause in the US-China trade conflict, but any material escalation of global trade disputes could undermine market sentiment and cut short the expected manufacturing and capex recovery that underlies our tactical views.
• We remain modestly overweight equity and credit due to the firming growth outlook and pricing that still looks reasonable against the macro backdrop. Yet we have made meaningful changes to our granular views. We see potential for a bounce in cyclical assets in our base case: We prefer Japanese and EM equities, as well as EM debt and high yield. We are cautious on US equities amid 2020 election uncertainties.
• Yields that are approaching lower bounds make government bonds less effective portfolio ballast, especially outside the US. This causes a rethink of portfolio resilience. We prefer US Treasuries to other core government bonds, both in 2020 and in strategic portfolios. We like short maturities in the near term and inflation-linked bonds as resilience against risks of regime shifts.