July 5, 2019
Bond and equity markets have had a good first half of the year, boosted by dovish monetary policy from the world’s central banks, with the S&P 500 hitting another fresh record high. Following the June 2019 G-20 summit, where a U.S.-China trade truce was agreed for the time being, asset prices should be supported for the remainder of the year. Low single-digit returns are expected across most asset classes, as the global economy slips slowly into sub-trend growth and valuations are less attractive. In this report, the J.P. Morgan Research team explores how investors should be positioned for the second half of 2019 as central bank easing becomes more synchronized.
The dovish shift in global monetary policy continues to deepen, with macroeconomic policy support coming from the Federal Reserve’s (Fed) pivot and China’s fiscal easing. The Trump administration’s willingness to actively use trade barriers as a tool of broader foreign policy remains a key risk to monitor, despite the agreement to a second truce between the U.S. and China on trade negotiations. The business sector response to this assault, rather than the direct impact of higher tariffs, poses the greatest threat to global growth.
“We have consequently downgraded global growth forecasts further. At the center of this storm, we have lowered GDP growth for the U.S. and China by an annualized 0.5 percentage points for the remaining quarters of 2019 and recently reduced second quarter U.S. GDP growth to 1.25%,” said J.P. Morgan Chief Economist, Bruce Kasman.
Similar drags on growth are set to follow in other parts of the global economy and the central bank policy reaction is expected to be straightforward. China is committed to maintaining 6% growth and will respond to any slowing with further easing. In the U.S., the Federal Open Market Committee (FOMC) is ready to respond to slowing GDP and job growth, with J.P. Morgan’s Economic Research team now forecasting two rate cuts later this year—one in July and another in September. A large number of central banks will likely follow suit, including the European Central Bank (ECB), Bank of Japan (BoJ) and 13 emerging market (EM) central banks.
“These additional policy supports, alongside healthy private sector fundamentals, underlie our view that the latest shocks won’t tip the global economy into recession. However, even a healthy expansion can be thrown off course if buffeted by a large enough shock. For the U.S., recession risks for the next twelve months have consequently risen—from roughly 25% last fall (September 2018) to around 45% currently,” said Kasman.
The annual pace of global GDP growth in 2019 is now forecast at 2.7%, with the U.S. and euro area expected to come in at 2.4% and 1.2% over the same period respectively, according to J.P. Morgan estimates.
In total, J.P. Morgan now expects six developed market (DM) and 13 EM central banks to ease in the latter half of the year. Policy rates are estimated to decline by a GDP-weighted average of 29 basis points (bps) for DM central banks and 31 bps for EM central banks.
This central bank dovishness, along with low positioning should support global equities through the global slowdown, but trade uncertainty remains the single largest source of downside risk. Existing tariffs are already pressuring profits, but this has been offset partially by the impact of the Tax Act so far. Companies will likely address this tariff impact in the upcoming reporting season with lower growth estimates. J.P. Morgan forecasts 2020 earnings per share (EPS) of $178 compared to a consensus of $186.
“We believe additional round of tariffs would increase the risk of pushing the U.S. business and profit cycle into an outright contraction. Had the phase three tariffs materialized, we estimated the first-order impact to be an additional hit of around $4 (cumulatively around $9) to S&P 500 EPS over one year,” said J.P. Morgan Head of U.S. Equity Strategy, Dubravko Lakos-Bujas.
J.P. Morgan Research maintains its positive stance on equities and keeps its trade probability-weighted S&P 500 price-target at 3,000, given the base case view that trading tensions do not escalate into a standoff. However, if trade talks fully collapse and phase three tariffs are implemented without any indication of rollback, the S&P 500 could decline closer to 2,500, triggering both the “Trump Put” and “Fed Put.” In a more positive scenario of a trade deal and tariff rollback, earnings should see positive revisions with the S&P 500 reaching around 3,200. Regionally, J.P. Morgan Research maintains its preference for the U.S. versus Europe, despite a large 15% outperformance over the last year. In Asia, J.P. Morgan Research recently moved overweight Japan equities.
“We have been cautious on Japan for a while, but have recently upgraded the country to overweight as the region has lagged and positioning in Japan is very light. While we believe Chinese policy stimulus will be effective, we are neutral emerging versus developed markets going into the second half, given unexciting valuations and continuing trade concerns,” said Head of Global and European Equity Strategy at J.P. Morgan, Mislav Matejka.
Four key macro and policy themes are set to influence markets at different speeds for the second half of the year and into 2020:
1. President Trump’s unfinished trade, technology and budget wars
2. Fed rate cuts as part of both standard risk management and once-in-a-generation regime change
3. Broader “Japanization” – an extended period of stagnant growth, subdued inflation and ultra-low interest rates – across regions
4. Late-cycle dynamics swayed more by geopolitics than by a restrictive Fed
“As easing from both China and the Fed can probably offset the impact of current tariffs and prevent a 2019 recession, asset allocation remains cyclical. We are looking at this mainly through a preference for equities versus fixed income at the moment,” said Head of Cross-Asset Fundamental Strategy, John Normand.
Central bank policy has eroded most carry in bonds – the yield of the bond minus the financing or the cost of owning a bond – which means income-seeking investors have no choice but to own assets with returns that are much more cyclical than they might prefer.
“We hold equities versus credit rather than bonds to reduce risk to the global business cycle and we hold no net exposure to emerging markets,” added Normand.
Traditionally, low growth and inflationary environments tend to be negative for commodities. The Organization of the Petroleum Exporting Countries (OPEC+), the oil producer group that pumps more than half of the world’s crude along with its allies, has resolutely adhered to its commitment to help balance markets since the end of 2016. J.P. Morgan Research expects this commitment to remain in the current fragile market as suggested by discussions between the Saudi and Russian leaders at the June 2019 G-20 summit.
“As long as demand does not crater, heightened geopolitical risks and OPEC+ cuts should still be enough for oil to provide positive returns for the latter part of this year,” said J.P. Morgan Head of Oil Market Research and Strategy, Abhishek Deshpande. The July OPEC summit, along with Iran tensions, should keep Brent in the $60 per barrel range. U.S. natural gas, on the other hand, looks more vulnerable, as it gradually shifts from supply-driven to supply-demand dynamics, given the growing links to economies abroad.
In metals, “safe haven” precious metals have historically held up best in low growth environments, while demand-driven base metals face the highest risks to the downside.
Current Fed policy should support the gold price above $1,400 per ounce. At current spot levels, base metal prices are still too rich versus global growth — a valuation gap that should further close if growth does not recover, according to J.P. Morgan estimates. Similar to oil, supply-sensitive agriculture products still have upside potential for the second half. All in all, bullish second half forecasts for oil, agriculture and precious metals should push broader commodities indices around 6-9% higher over the balance of the year.
U.S. rates markets are pricing in a more dovish path for the Fed than J.P. Morgan current forecasts, which could lead to the market continuing to price an aggressive path in the second half of the year. The FOMC has less room to ease than in past cycles and Fed Chair Jerome Powell has indicated a willingness to act more aggressively because of this binding constraint. The Committee is also very focused on keeping inflation expectations anchored.
“We see further room for yields to decline over the balance of the year and we forecast a decline in 2-year and 10-year Treasury yields to 1.40% and 1.75%, respectively, by year-end,” said J.P. Morgan Head of USD Government Bond Strategy, Jay Barry.
The second half of 2019 will also bring synchronized easing across DM central banks, with the ECB and the BoJ following the expected Fed rate cuts.
Elsewhere in Europe, the Bank of England and Scandinavian central banks are on hold. The universe of negative-yielding bonds has increased to 27% of the Global Aggregate Bond Index (GABI), up nearly 10 percentage points from October 2018. Geopolitical risks and Brexit will remain in the spotlight, with a late focus on Italy because of expected general elections and a demanding 2020 budget. In the Euro area a 10 bps cut in the deposit rate is expected in September without tiering, but Euro area rates will be mostly driven by the market pricing an increasing probability of further easing.
In foreign exchange markets, recent global macro developments are constructive for safe reserve currencies and negative for lower yielding high-beta currencies. But overall it is a muddied picture for the broad dollar index. Historically, the USD does well on a broad trade-weighted basis whenever global growth is weak or weakening, irrespective of whether the U.S. economy itself is decelerating, the Fed cuts rates or indeed there is even recession.
The dollar is not expected to appreciate against all currencies as the Fed lowers rates, with other safe-haven currencies likely to outperform in an anti-cyclical easing phase.
“This club of alternative safe-havens [that could outperform the USD] is exclusive and membership is probably confined to the Japanese yen and the Swiss franc,” said J.P. Morgan Head of Global FX Strategy, Paul Meggyesi.
The Swiss franc is usually the single best performer in a Fed easing cycle whereas the yen’s track record is much patchier. Both currencies together with the dollar are historically very effective hedges to either a U.S. recession or a sharp global downturn.
Since the breakdown of U.S.-China trade talks in early May resulting in tariff increases, the macro outlook has been in flux with growth forecasts lowered. J.P. Morgan Research forecasts broadly stable emerging market (EM) GDP growth of 4.5% in the second half of the year, but this view is overshadowed by heightened uncertainty and significant downside risks.
Given the risks to the growth outlook along with dovish revisions to developed market (DM) policy rates, policy easing across EM is now expected.
“The tension between weaker growth and a reactive Fed keeps us defensive, but not overly bearish EM fixed income in in the second half of the year,” said J.P. Morgan Head of Currencies, Commodities and Emerging Markets, Luis Oganes.
“We do not assume a repeat of EM equities sell-off seen earlier this year — the support arsenal is there if things get worse. Additional policy supports like further China easing and Fed rate cuts could break negative feedback loops,” added J.P. Morgan Chief Emerging Markets Equity Strategist, Pedro Martins Junior.
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