J.P. Morgan: 2019 Economic Outlook - Joyce Chang

2019 Global Outlook

J. P. Morgan

January 2019

With the current US expansion destined to become the longest in post-war history and just shy of the longest uninterrupted expansion since 1860, an increasing number of end-of-cycle forces are converging, but only slowly. 

Economic challenges are rising, but the fundamental backdrop for the global economy remains healthy into 2019 with global GDP expected to rise at an above-potential pace of 2.9% for a third consecutive year. Falling profit margins, tightening resource use, and rising interest rates will eventually slow global growth, but these dynamics are building only gradually. A prime concern is the recent decline in global business sentiment as growth momentum has slowed, but we believe that a 2019 recession is unlikely and current risk premia look excessive. 2018 is closing the year with negative returns across almost every asset class, and 2019 performance should improve but still come in below average for fixed income, currencies, and commodities (FICC). We believe that central banks will deliver more tightening than markets currently expect with the highest number of DM and EM central banks tightening since 2006. Prospects for equity markets should fare better as fundamentals and technicals for US equities decoupled during 2018, reflecting extremely poor liquidity and deleveraging of crowded trades at the same time that headline geopolitical risk increased. Equity fundamentals have remained resilient, as far as earnings, investment spending, corporate balance sheets, and leverage are concerned, which is disconnected from current equity sentiment, valuation, and positioning. We believe that there is scope for convergence of fundamentals and equity prices and that equities can still deliver a period of significant outperformance versus fixed income before this cycle is finished. We are overweight Equities versus Credit as equity multiples are already below their long-term averages, and we remain overweight US versus Europe, staying overweight Tech as we believe the sentiment is now too bearish on the sector’s earnings prospects, while buybacks remain strong. Within FICC, we forecast a roughly equal distribution of positive- versus negative-return markets, with USD cash (+2.8%) expected to outperform most FICC markets. We recommend neutral EM cross-asset positions, neutral duration, and long gold, and we expect continued USD strength versus Asia. 

Global Economics Outlook

We expect the global economy to deliver a third consecutive year of above-trend growth in 2019, rising 2.9%, as the expansion proves resilient in the face of significant challenges. 

The immediate challenge is this year’s unsustainable dependence on a US demand engine. US policy supports are starting to fade, and we expect a slowing in US growth toward 2% over the coming quarters to be offset by a pickup in Japan and Europe as temporary drags fade. China stabilization at about a 6% pace is also expected and should promote stronger overall EM performance and greater regional balance. Of equal concern is the expansion’s vulnerability to numerous geopolitical threats. We look for resiliency from a fundamentally healthy backdrop that includes balanced household and corporate income growth and supportive policy stances. Notably, global real policy rates remain low despite Fed tightening, and the US and China are leading an unusual late-cycle global fiscal stimulus. Another year of above-potential global growth is expected to push core inflation higher in response to tight labor markets even as fading energy price inflation lowers headline readings. We believe central banks will deliver more tightening than markets currently anticipate, with four hikes from the Fed expected during 2019 as the US unemployment rate falls to 3.3% and core PCE inflation rises to 2.3%. For the ECB and BoJ, the upward trajectory of core inflation will eventually prompt the start of rate normalization. Risks to the 2019 global outlook are skewed to the downside given the failure of the Euro area to rebound as yet and the recent decline in global business sentiment, which raises the risk that geopolitical drags will outweigh fundamental supports for global capital expenditures. Despite this risk bias, a 2019 recession is unlikely as the macro channels that recession vulnerabilities build on—corporate profit margin compression and central banks moving to restrictive stances—are not yet evident. Bruce Kasman, David Hensley, and Joseph Lupton

US Economic Outlook: Monetary policy, which has been accommodating growth for the past decade, is gradually moving closer to a neutral posture. 

Fiscal policy will still be supporting economic activity next year, although less so than it did in 2018. Trade policy thus far has been only a minor nuisance, but we expect that tariffs will become a more noticeable drag on growth in 2019. In summary, monetary, fiscal, and trade policies all are turning somewhat less friendly for growth next year. We expect GDP growth to moderate from a boomy 3.1% (Q4/Q4) in 2018 to a closer-to-trend 1.9% in 2019. Fiscal, monetary, and trade policies all will become either less supportive or more restrictive. Labor markets should continue to tighten, keeping upward pressure on wages and prices. We see the Fed needing to exert modest restraint on growth, hiking four times to 3.25-3.50% by year-end. Michael Feroli

Emerging Markets Economic Outlook: EM growth of 4.4% in 2019 will be lower than the 4.8% seen in 2018, driven largely by a slowdown in China and intensifying external risks. 

We forecast China’s growth to slow to 6.2% in 2019 with the evolution of US-China trade tensions a key variable. Although we have penciled in an uneasy trade truce in 1H19 between China and the US, the impact on sentiment should be marginal, and we expect fiscal policy and tax cuts to take the driver’s seat. A significant shift in China’s monetary policy management is underway, reflected in the thinning of China’s balance of payments surplus, leading to a more active management of domestic liquidity and more active use of tax cuts. How China manages these underlying shifts amid a cyclical slowdown will bear watching given its material influence on the region. We are forecasting more activist fiscal policy in Asia, with China providing the largest impulse at 0.6% of GDP, followed by Korea (0.5%pts), the Philippines (0.5%pts), and Malaysia (0.5%pts). EM ex. China is projected to slow by only 0.1%pt to 3.2% as a subpar recovery in Latin America offsets the modest deceleration in EM Asia and EMEA EM. After a challenging 2H18 for many EM economies, it will likely result in a weak start to 2019. However, our forecast assumes a cyclical pickup starting in 2Q19 and briefly moves above potential at year-end. Risks to the 2019 growth outlook remain external. While downside risks to China from escalating US-China trade tensions will be offset partly by domestic policy support, a protracted trade war poses a serious risk to EM as much of EM growth relies on trade. EM Asia would be in the direct firing line, but the direct impact on overall EM growth should be modest. A potential deterioration in global business sentiment would have broader implications for EM.

EM monetary policy will spend 2019 balancing a still benign domestic environment with continued tightening in global financial conditions. 

Estimated open-economy Taylor-type monetary reaction functions for EM suggest that at end 2018, EMX (excluding Argentina, China, and Turkey) policy rates will likely be about 60bp behind where they should be. Much of this discrepancy is due to the large CAD economies (the high-yielders) lagging the rate hike cycle, although the CAS economies (low-yielders) were also behind the curve. In 2019, we forecast about 75bp of rate hike for EMX (more hikes among CAD versus CAS economies) such that by end 2019, interest rates are where they should be based on our estimated monetary reaction functions. While in some economies, mainly CE4, the rate hikes reflect overheating pressures, in the rest of EMX the tightening in global financial conditions is expected to drive much of the increases and is concentrated in 2H19 when the recovery has taken a stronger hold. Jahangir Aziz

Market and Volatility Outlook

We remain positive on equities and overweight equities versus bonds, given the disconnect between strong fundamentals and valuation/positioning, and on the view that the cycle is unlikely to end next year. 

A near-term recession appears unlikely given strong consumer spending, strong PMIs, and growing corporate profits. Additionally, we think fiscal measures will supplement monetary policy to extend the cycle, not just in the US but also around the world. Fiscal measures are needed to maintain the competitiveness of the corporate sector in an era of global trade protectionism (e.g., the recent corporate tax cut in Canada) and to address populist tension (e.g., in France). For 2019, we forecast continued EPS growth at a rate of ~8% and a price target of 3,100 on the S&P 500. Positive GDP and earnings are “reality,” which is currently starkly disconnected from negative equity sentiment, low valuation, and positioning. While higher volatility that comes with less monetary support warrants somewhat lower equity valuations, lower risk positioning, higher equity volatility, and higher credit spreads, we think that the current divergence is simply too large. To some extent, we trace the disconnect between negative sentiment and macroeconomic reality to the reinforcing feedback loop of increased focus on geopolitics both in the media and among investors and market participants.

We expect volatility to decline somewhat from current elevated levels, with a VIX median of ~15-16 next year (which may be realized as longer periods of 12-13 and one or two bouts of higher volatility like in Feb-Mar and Oct-Dec’18). 

What are the main market risks for 2019? While we think that the trade war with China will not escalate next year, there is still some residual risk coming from global trade frictions. Similarly, the market focus on monetary policy and interest rate hikes will persist, although we believe that the Fed recently outlined a more nuanced stance. We believe that equity markets can absorb one or two more hikes but could come under increasing pressure if the Fed rating cycle continues through next year. With higher interest rates, there are also rising structural risks, most prominently the decline of market liquidity. Given the outcome of US midterm elections, it is virtually certain that US political divisions will introduce gridlock and additional market volatility in 2019, as will political issues in Europe. Negotiations and frictions are part of populist theatrics that have become the norm, not the exception. Yet, we believe that these new age populists are unlikely to cause the magnitude of disruptions that we witnessed during the Global Financial Crisis. Marko Kolanovic and Bram Kaplan

Cross-Asset Fundamental Strategy Outlook 

2018 has delivered losses on almost every asset class and investing style, a sweep that has only occurred twice in the past 50 years—during the 1970s stagflation episodes and the Global Financial Crisis. 

The simplest explanation for this pattern is inevitable mean reversion, since 2017’s risk-adjusted returns were two or three times their long-term average in most asset classes. A 2018 that delivered trivial gains, or even losses, would still leave the average of the past two years respectable. A more complete framework focuses on late-cycle dynamics involving leverage problems, macroeconomic imbalances, policy catalysts and shocks, momentum loss, and valuation problems. 

Although valuations have improved, many of these undercurrents will persist through 2019 and thus constrain returns. 

Hence, why 2019 projections show gains on 2018 but are still below average. Given better starting levels, and a no-recession assumption, the best performers in FICC could be US high yield and leveraged loans (+6%), US cash (+2.8%), and Gold (+15%). Worst could be Bunds (-5%), Euro high grade credit (-2%), and a Commodities index (-3%). Equities could return +2% (Japan) to +15% (US) on near-trend growth and stable to slightly higher multiples.

Portfolio strategy remains semi-cyclical into 2019, as it has been since mid to late 2018. The main cyclical exposure has come through a declining overweight of DM Equities versus Bonds and Credit; an OW of DM Cyclical versus Defensive equity sectors; and an OW of the Growth style within DM stocks. DM duration had been and remains neutral to short but always very tactical. Hedges have been through short DM Credit; long Energy assets (sometimes Oil futures, now just Energy Equities and US High Yield Energy Credit); tactical currency trades (short CNH versus basket, short AUD versus USD or JPY); and long Gold. EM exposure has been neutral overall since midyear, via OW of EM versus DM Equities, short EM duration and neutral FX and Credit. We think it is still too early for the great rotations from Equities into Bonds, from Cyclical into Defensive stocks, and from Growth into Value and Quality. Peak EPS growth and the J.P. Morgan recession risk model are two tools for timing these switches at some point in 2019. John Normand

Equities Outlook

US Equities Outlook: We expect the S&P 500 to reach 3,100 by the end of 2019, realizing a 15% price return, and we forecast EPS to reach US$178 (versus consensus of US$176.25) in December 2019, reflecting 8% growth. 

2018 was characterized by significant de-leveraging and unwinding of crowded trades. The market correction in February and 4Q18 have made the existing style dislocation that began in early 2018 even more pronounced, and the extreme valuation spread between inflated defensive and neglected cyclical stocks is starting to price in a recession-like scenario, even though the equity cycle remains intact and fundamentals healthy. With real GDP growth forecasted to average within the 2-3% range in 2019, equity multiples are not expected to de-rate as long as yields remain below 4%. 2019 should be another record year for gross buybacks (US$800bn) and dividends (US$500bn) on higher profits and cash repatriation. Our forecasts embed key assumptions on diminishing tariff-related risks, positive earnings growth, attractive valuations, and continued shrinkage of equity supply via buybacks. We incorporate three scenarios for trade (55% trade deal, 35% cease-fire, and 10% tariff escalation) implying a 90% probability of a resolution. Cyclicals, in particular Growth stocks, should lead style performance in 2019, while Defensive Low Vol/Quality style should lag given its bubble-like valuation and crowded positioning. We anticipate a rotation to Cyclicals from Defensives and favor sectors that could benefit from improvements in trade and softening Fed rhetoric(OW Technology, Discretionary, Industrials and Energy). Technology is our highest conviction OW on the back of attractive valuations, lower sensitivity to macro factors, and elevated buyback activity. Consumer discretionary should benefit from an expanding labor market and wage increases, with some upside from trade resolution. Industrials are the most direct way to play a trade resolution in 2019 and should be supported from a lower USD, while Energy should benefit from earnings growth potential and still cheap valuations. We recommend investors avoid defensives (UW Staples, Utilities, Real Estate, and Healthcare) given increasing crowding concerns, record-high relative valuation, and low probability of a near-term recession. We recommend a neutral position on Financials where the sector is seen to come under pressure from a flatter curve, slower loan growth, rising deposit costs, and higher provisions. Dubravko Lakos-Bujas / Bhupinder Singh / Narendra Singh / Kamal Tamboli / Arun Jain / Marko Kolanovic

Global Equities Outlook: As 2018 progressed, a number of consensus calls got unstuck, such as bullishness on EM, bearishness on USD, complacency over the Fed and over trade, as well as the belief in the synchronized global recovery. 

As we enter 2019, we think one should be contrarian to prevailing consensus views. We do not believe a downturn is inevitable over the next one to two years and think equities can still deliver a period of significant outperformance versus fixed income before this cycle is finished. We believe earnings will grow in 2019, not too far away from consensus projections of 8-10%, and that bond yields should move higher. Many see higher yields hurting P/Es, but equity multiples are already below their long-term averages, with MSCI World trading at 14.5x forward P/E, outright 7% lower than 30-year typical.

At a regional level, we started 2018 with a non-consensus cautious view on the EM, and we believe one should be bullish EM equities for next year. 

EM equities have de-rated significantly and are currently trading even cheaper than at the low point in 2015-16, when the Chinese economy appeared much worse. Potentially, a dovish turn by the Fed would be supportive for EM equities. Within DM, we remain OW US versus Europe, despite an already significant US outperformance. US equities remain underpinned by strong earnings delivery and record levels of buybacks. Eurozone is unlikely to bounce back until Italian political stress eases. We are Neutral on Japan as Japanese valuations look appealing, but elevated positioning and potentially weaker domestic growth present challenges for next year. We stay UW UK as even if/when the Brexit deal is signed off, the resulting strength of the GBP might take away the upside from equities.

Sector wise, Cyclicals underperformance has been extreme, with the group now trading cheap and opening a gap with bond yields. 

We find Mining stocks to be particularly attractive and upgrade Energy to OW following the sector’s recent underperformance, while booking profits on our OW in Utilities. We remain unexcited by European Banks but think US Banks could start performing better. We stay OW Tech as we believe the sentiment is now too bearish on the sector’s earnings prospects, and buybacks remain strong. Mislav Matejka

Emerging Markets Equities Outlook: We set MSCI EM target at 1,100 for year-end 2019 (11% upside) driven by earnings growth and no valuation multiple expansion. 

The bull/bear case range is 1,250/900. Projected returns for EM equities might resonate well versus fixed income/cash returns and appear competitive versus other equity markets. EM equities trade at a big discount compared to DM (27% on forward P/E) and offer potential double-digit growth, and global equity investors hold 2pt less in EM equities than the 10-year average (7.0% versus 9.2% of global mutual funds AUM). 

We recommend OW positions on Brazil, Chile, Indonesia, Russia, EM Healthcare, Industrials, and Materials, and UW on South Africa, Malaysia, Colombia, Peru, EM Utilities, Consumer Staples, and Telecom. 

Greater macro uncertainty promotes local idiosyncratic factors, thus we recommend investors blend their investment portfolio: valuation cushion (Russia), earnings resilience (Indonesia), and reward for good policy-making (Brazil and Chile). EM GDP growth of 4.4% in 2019E will be lower than the 4.8% seen in 2018E, driven largely by a slowdown in China and intensifying external risks. US-China trade war is a wild card. 

We present frameworks for tactical portfolio rebalancing. 

There are too many pivot points ahead that can significantly affect EM equities, such as the aging US economic cycle and uncertainties around the 2019 EM election calendar after a heavy 2018 election year that brought in many new governments. The bull case for EM equities is the scenario that EM is able to reestablish the EPS growth premium to DM, improvement on US-China trade negotiations, the peaking of the USD and the Chinese government promoting domestic growth stability. The bear case for EM equities is the one that geopolitical uncertainty continues to weigh on markets via lower growth and higher risk premium, US sanctions (such as Iran and Russia), US trade rebalancing, and European integration (Brexit execution and Italy’s fiscal choices). Pedro Martins Junior

Rates Outlook

US Rates Outlook: The end is not near, but we expect the markets to behave like the end of the cycle is at hand. 

We look for the Fed to continue with normalization and for the Treasury curve to bearishly flatten and eventually invert in 2H19. Cash and short duration should provide strong risk-adjusted returns. We look for 2- and 10-year treasury yields to reach 3.70% and 3.60%, respectively, in 4Q19. TIPS breakevens should widen modestly. In swaps, FRA/OIS should be biased narrower; overweight Treasuries versus OIS. In rate volatility, we have a bearish and tail-curve-steepening bias in gamma. Credit is somewhat concerning but likely to outperform rates. In MBS, valuations appear attractive: we are overweight MBS versus Treasuries. Alex Roever

Treasuries Outlook: It’s no question we are in the late innings of the current expansion, but we are not yet at the end of the cycle. 

In the year ahead, the Fed’s continuing normalization campaign should be the main lever to drive two-year yields higher. Markets are pricing in less than two hikes between now and year-end 2019, while we expect five over the same period. If our forecast is realized, this leaves significant scope for front-end yields to move higher and the curve to flatten. Longer out the curve, the combination of higher real policy rates and continued Fed balance sheet normalization should contribute to higher yields. At the long end, we find that budget deficit expectations have become a significant driver of curve shape, but even after adjusting for increased deficits, the curve appears steep. We project the curve will invert in 2H19. 

We project the deficit will widen to US$900bn in FY19, and when accompanied with increased SOMA redemptions, Treasury’s funding needs will only continue to increase in the near future. 

Given the combination of these factors, we project net issuance of Treasury to the public to total US$1.268tn in 2019, with US$1.115tn of this coming in coupons. However, given the large increase in auction sizes this year, Treasury has created substantial borrowing capacity, and there will be little need for further increases in auction sizes next year. Accordingly, our issuance forecast for 2019 incorporates only modest increases coming in TIPS, while we see nominal sizes holding unchanged.

The demand picture in 2019 remains challenging. 

We expect foreign demand to remain relatively weak: FX reserves are set to contract further, and valuations look expensive for foreign-funded investors. Accordingly, foreign purchases, which had been a tailwind for Treasury valuations for much of the past two decades, are becoming a modest headwind. We see increased demand from banks: accelerating reserve draining and more attractive valuations suggest buying from depository institutions is set to increase sharply. Finally, pension and insurance demand should remain robust as higher yields and wider credit spreads will make long-duration fixed income more attractive. While demand should be sufficient to meet supply, we think it will require somewhat higher yields. Jay Barry, Kimberly Harano, Phoebe White, Luke Chang, and Natalie Matejkova

European Rates Outlook: We are bearish on European rates with relative stronger conviction in Scandinavia and the UK (conditional on approval of the Withdrawal Agreement) versus the Euro area, where we expect a larger repricing in 2H19. 

Global growth is expected to become more synchronized in 2019 with less US exceptionalism. Tight labor markets warrant a pickup in inflation, although the uplift in Euro area core inflation is likely to be slow, reaching 1.4% in 4Q19. We expect further policy rate normalization, with the BoE hiking twice if the Brexit deal is eventually ratified and the ECB to lift off policy rates in 2H19, while the Riksbank will start and the Norges Bank will continue their tightening cycle. Risks are skewed toward lower yields, coming from a macro slowdown in the US, political risk (Brexit and Italy), or a slow inflation normalization, while the bearish duration risk will come mostly from a US/China trade deal. In the Euro area, we forecast higher intermediate yields and initially steeper curves in 1H19, which we see eventually turning into a bear flattening in 2H19 as we approach the lift-off in the deposit rate. We recommend short 30-year Germany and money market steepeners, while initiating conditional bear flattener with longer dated options. Italy will continue to be the main driver of intra-EMU spreads. Directional risk on intra-EMU spreads should be tactical; play the range with duration-hedged Italy credit curve steepeners. A more market-friendly Italian government in 2H19 is likely, and we plan to shift to intra-EMU tighteners. Portugal and Ireland are our best picks. In the UK, we expect an increasingly fraught and chaotic political backdrop over the coming weeks, but look for higher gilt yields and a flatter curve under a managed transition in March 2019. Assuming Theresa May remains the Conservative Party leader, we take a bearish approach to UK rates. We recommend short at the front end cross-market versus EUR and shorts in intermediate inflation swaps. In Sweden and Norway, we recommend short duration in 10-year and money market steepener. We forecast 2-year German yields at ‑15bp by year-end and 10-year Bund at 100bp, and 2-year and 10-year gilts at 135bp and 190bp, respectively. Fabio Bassi

Securitized Products Outlook 

Going into 2019, we recommend a modest overweight in agency mortgage-backed securities (MBS). 

Quantitative easing (QE) caused credit spreads to tighten by multiples more than mortgages, and the reverse could be true as the unwind continues. MBS spreads have reached their pre-QE equilibrium levels after widening 15-20bp over the course of 2018. On the prepayment front, S-curves are the flattest they have been in the post-crisis era, partly due to cash-outs boosting baseline speeds. In non-agency residential mortgage-backed securities, investors were yet again rewarded for being long credit and spread duration. We expect a similar result in 2019 as fundamental mortgage credit performance and underwriting remain strong and home price growth should moderate to 3.3% in 2019. In asset-backed security (ABS), we recommend sticking with the top-tier and most liquid issuers given the spread tiering compression observed this year. In commercial mortgage-backed security (CMBS), we continue to prefer more seasoned opportunities in the conduit CMBS space, and given our rate forecast, we also have a preference for floating rate obligations. Matthew Jozoff, Alexander Kraus and Nicholas Maciunas

Emerging Markets Outlook

2019 is shaping up to be another challenging year for Emerging Markets. After the outperformance of EM assets in 1Q18, this year saw an abrupt underperformance from April onward, leaving EM local markets at a -7.4% return YTD, EM sovereigns at -5.5%, and EM corporates at -2.1% as of end-Nov 2018. The initial catalyst for this weakening in performance was a stronger USD as Fed hikes became priced in and US growth began to outperform against disappointments in the Euro area and Japan starting in 2Q. This in turn led to EM currency weakness, prompting higher EM rates as a policy response and eventually full-blown currency crises in Argentina and Turkey, with weakening in many other EM countries as portfolio inflows stopped and confidence eroded. The downgrades in EM growth compared to US growth helped pressure EM assets. With a global liquidity outlook that sees the Fed hiking another five times until the end of 2019 and G4 central bank balance sheets going into outright contraction in 2019, EM fixed income is forecast to weaken as the year progresses. This should also pose challenges for EM portfolio flows. Given a weaker starting point from 2018 and a potential reprieve at the start of 2019, we see full-year EM fixed income returns in the low single digits and underperforming USD cash, with local markets returns of +1.1%, EM sovereign returns of +0.2% on 50bp of spread widening to 425bp by end 2019, and EM corporate returns of +1.5% on 50bp of spread widening to 375bp by end 2019. Our EM fixed income recommendations going into 2019 are MW EM FX, EM sovereigns, and corporates and small UW rates as a low-yield UW duration view. We had cut UW EM positions in early November’s weakness, leaving us more neutral as we see a reprieve in the next few months with global growth forecast to rotate, EM spreads at year wides, and upcoming US-China talks a wild card. Luis Oganes and Jonny Goulden

FX Outlook 

A fading US cycle should lead to narrow retracement of dollar strength versus some reserve currencies in the 2H19 but will be little relief for high-beta FX, which will remain vulnerable to global end-of-cycle concerns and the shift from quantitative easing to quantitative tightening—this leaves the USD index 0.5% stronger on net by end-2019. 

The most notable phenomenon of this past year was unexpected US cyclical exceptionalism, which helped propel an 8.9% resurgent bounce in the broad dollar from February lows. One major change we expect for 2019 is for the US cycle to fade, with US GDP growth expected to fall below 2% and below the Eurozone growth rates by 3Q19. This helps drive some retracement in the USD versus EUR, European currencies, and some of the other majors, but it does not restart broad-based secular weakness. This is because the other key differentiating factor for FX next year could be the move by the Fed into outright restrictive territory overlaid with the symbolic reversal of the decade-long tailwind of expanding central bank balance sheets. Whereas the dollar could eventually slip versus reserve currencies, due to a narrowing in this year’s artificially wide growth gaps (dollar -3.4% on a narrow DXY basis), USD could make further headway against deficit currencies as the era of QE gives way to QT (dollar on net still 0.5% stronger on a broad TWI basis). Paul Meggyesi and Daniel Hui

Commodities Outlook 

The global macro environment is not going to get any easier for commodities in 2019. 

The biggest change we expect in 2019 will be the fading of US economic exceptionalism. Meanwhile, EM growth will be lower in 2019 versus 2018, driven largely by a slowdown in China and intensifying external risks. End-of-cycle market dynamics are more like a step change in risk markets and could overwhelm as 2019 progresses, supporting precious metals but pushing oil and industrial metals lower. We stay neutral in oil and metals, but in agricultural commodities, we stay long Sugar May ’19 futures, stay long Wheat March ’19 540-600 call spread with a short Wheat March ’19 520 put, long Corn March ’19 and long the agriculture complex via an index. Abhishek Deshpande, Natasha Kaneva, Gregory Shearer, and Tracey Allen

Oil Outlook: In oil and oil products, navigating markets has become challenging due to US foreign policies concerning OPEC+ members along with rising geopolitical uncertainties. 

OPEC+ has acted decisively with a combined supply cut of 1.2mbd on average initially for the first six months of 2019 as oversupply was particularly skewed in the first half of the year due to seasonality. This is likely to prevent a further drop in oil prices especially as the impact of US sanctions on Iran will be felt by end of April next year, which is when the next OPEC+ meeting is scheduled and may once again need to revisit its decision on production cuts. We forecast average 2019 Brent price at $73/bbl and 2020 at $64/bbl. Given the OPEC+ decision was in line with our expectations, our risk bias for the rest of 2018 and 2019 relative to our base case for oil prices is now neutral. In terms of remaining market fundamentals, we expect oil demand growth to remain firm in the next couple of quarters as our economists forecast a turnaround in manufacturing PMI and industrial production. Equally on the supply side, we expect a brief slowdown in North American supply growth in the next few months, which should help with a limited recovery in oil prices. However, this recovery is unlikely to last as structural demand should slow in 2019-20 based on our economists’ projection for GDP, and low-cost non-OPEC supply growth should put a cap on oil prices in the absence of any large-scale geopolitical disruption. Moreover, we expect North American oil infrastructure development, IMO2020, and OPEC-US oil policy to impact oil and oil product prices, as well as crude differentials, as we move along 2019. Abhishek Deshpande

US Natural Gas Outlook: We see the US natural gas market experiencing its tightest balance in recent history during 2019 despite extraordinary production growth. 

Winter weather will likely drive prices formation, and we forecast US natural gas close to US$3.05/MMBtu in 2019. Shikha Chaturvedi

Metals Outlook: For the rest of this year and through 1H19, industrial metals prices should climb higher to catch up with spot physical conditions that are much stronger than the price action seen over the last four months. 

We maintain this bullish bias on base metals throughout 1H19, as we have pushed forward the impact of Chinese policy support by one quarter and have adjusted our first half, top-down demand assumptions for China higher to now incorporate a fiscal-easing-driven boost on Chinese metals elasticities in 1H19. As we progress later into 2019 and 2020, we see base metals prices coming under increasing pressure as the macro cycle begin to roll over, sending physical balances into surplus. On precious metals, we maintain our neutral view on gold through 1H19 and retain our bullish bias over 2H19 and 2020 and still see prices rising above US$1,400/oz as the development of an inverted yield curve in the US likely attracts renewed investor interest in gold. Natasha Kaneva and Gregory Shearer

Agriculture Outlook: Agricultural commodities market participants have adjusted to the “new normal” of a persistent US-China trade war. 

Investor risk appetite has waned due to heightened political uncertainty and a weaker growth outlook through 2019. However, constructive grain and soft commodity fundamentals are returning to the fore, and the risk profile for agri commodity prices is skewed to the upside at least through 1H19. Any improvement in the US-China trade relationship is a materially bullish risk factor for agri markets. Tracey Allen

Credit Outlook 

Global Credit Markets Outlook: The current market zeitgeist seems to be that credit markets are the weak link in the global risk markets chain and are set to break down and destroy value in a way not seen since the dark days of 2008 through early 2009. 

In particular, the three consensus views seem to have become even more entrenched now. They are: 1) that spreads are set to widen; 2) that BBBs are a problem; and 3) US High Yield is the most expensive part of the global credit complex. Spreads have widened materially over the past month against the backdrop of broad weakness in global risk markets. As such, from forecasting spreads anywhere between 5-20% wider at the point of initial publication, our year-end forecasts now imply much more modest widening from current levels or even ending 2019 close to where they are today. Built into these forecasts are views that some of this year’s trends will endure into 2019; that is, more High Yield-High Grade compression in the US, more decompression in Europe, and more Emerging Market underperformance versus Developed Markets. While the overall profile of our forecasts hardly suggests a return to the dark days of 2008-2009, they also suggest that there’s not much of an incentive to engage the asset class either. Based on our calculations, returns across global credit markets will range from small negative single digits to small positive single digits. This does not seem especially attractive relative to the return on cash, money market instruments, or other short-duration instruments. Stephen Dulake

US High Grade Credit Outlook: We forecast year-end 2019 High Grade bond spreads at 170bp. 

Drivers of wider spreads next year include a gradually slowing economy with the potential for less revenue growth and margin pressure, the flattening UST curve, which both hurts bank earnings and foreign demand for USD assets, less supportive monetary policy globally, and increasing market focus on the growth of corporate leverage and BBB rated credits. Offsetting this, we expect less bond supply, less M&A, and more attractive bond yields over the year. Also, a focus on deleveraging and balance sheet repair by High Grade issuers may be evident in 2019. 

Our UST forecasts combined with our spread forecasts lead to a total return forecast of 0.2% and excess return forecast of 0.0% next year. 

For the High Grade bond supply forecast: we expect 2019 supply of US$1.05tr, down 10% from the estimated US$1.16tr in 2018. Bond maturities are US$37bn higher in 2019 versus 2018; therefore, our forecast implies net bond supply of US$353bn, down by ~US$150bn (30%) y/y. We expect less M&A, continued light supply from corporates that have significant “overseas” cash, and higher yields overall to slow issuance. For Relative value, we expect the BBB-A rated spread relationship to widen by 22bp to 80bp and BBBs to also underperform BBs by 22bp. Further, we expect the High Grade 10s30s spread curve to steepen by 2bp to 40bp, and Financials to trade 5bp through non-Financials from 2bp wider today. Our sector recommendations are Overweight US and European Banks, Pipelines, Healthcare, Telecoms, and Cable/Satellite and Underweight Technology, Manufacturing, Medical Devices, Australian, and Canadian Banks. Eric Beinstein

US High Yield Credit Outlook: Despite expectations for a continued supportive fundamental and technical backdrop, we are a little less constructive toward high yield heading into 2019 given a forecast for a continued steady rise in short-term interest rates. In particular, our economists forecast four Fed rate hikes in 2019. Meanwhile, our rates strategists also forecast the resumption of a bearish flattening trend with the US Treasury curve inverting between 3Q and 4Q19. As such, we expect late-cycle dynamics to drive elevated volatility in rates and equities, which would negatively influence sentiment in high yield. Furthermore, a 3.50% Fed Funds rate by year-end 2019 will likely crowd out demand for high yield credit and other risky asset classes. Even so, we continue to expect two more years of below-average default activity (1.5% 2019, 2.0% 2020) given balance sheet strength, few candidates, and a highly accessible capital market for loans. And our colleagues’ relatively benign forecasts for the global economy, 10-year US Treasury yields (3.60% YE19), and stock prices suggest high yield bonds can manage to once again outperform the majority of fixed income. We are forecasting high yield bond spreads of 450bp by year-end 2019, absorbing 15bp of the expected 75bp rise in five-year Treasury yields and leading the YTW to increase 55bp to 8.00%. Peter Acciavatti

European Credit Outlook: While valuations in the European credit market are significantly better than where they started the year, it is still difficult to find buyers at current levels. 

For one, we are still coming to terms with the approaching end to central bank purchases, which have been a major source of marginal demand over the past two and a half years. High yield is especially suffering from the reversal of the “search for yield,” with both insurers and investment grade tourists becoming less active in the space. Further, both investment grade and high yield retail funds have also seen heavy outflow of 7-8% of assets under management this year. To make matters worse, we are also looking for an increase in net supply next year, driven primarily by heavy bank senior unsecured issuance. We are also seeing increased focus on single-name risk, with the BBB space having grown by more than five times from €190bn in 2009 to €960bn today. Similarly, in high yield, we have seen corporate fundamentals drift lower and sharp price declines for a growing number of bonds. We are forecasting spreads of 160bp in investment grade and 500bp in high yield. Saul Doctor, Daniel Lamy and Matthew Bailey

EM Credit Outlook: We expect the continued rise in rates and a number of macro headwinds to result in a challenging environment for EM corporates in 2019 and forecast 50bp spread widening in the CEMBI Broad to 375bp with +1.5% returns for the year. 

The tightening in global liquidity and macro headwinds make it challenging for spreads to compress, which is also reflected in our expectations for spreads to widen across most major credit asset classes. We head into 2019 with a Neutral stance and defensive bias, overall favoring investment grade, but recommending specific high yield segments or countries where valuations have adjusted or positive momentum exists. We keep a small Overweight bias in Asia focusing on BBB and BB, corporate hybrids, and select China High Yield property credits. Within CEEMEA, we are Overweight Middle East through GCC investment grade credits, but Underweight EM Europe due to the still cautious view on Turkey banks and reduction in Ukraine corporates. For Latin America, we are overall Neutral as we look for the short-term positive momentum in Brazil to remain in place for now, but we see limited value in the rest of the region. Despite the micro level trends looking more favorable, the resilience of the asset class is likely to be tested on both the fundamental and technical side by the macro headwinds. We are of the view that EM corporates can hold up better against the macro headwinds given the conservative behavior in recent years of focusing on deleveraging while limiting capex/M&A activities, which put them in a stronger starting position. Yang-Myung Hong