The first quarter of 2019 was quite consequential for financial markets as the sharp reassessment of U.S. monetary policy that started in Q4 2018 culminated with U.S. the Federal Reserve (Fed) moving from a neutral to a dovish stance. This abrupt U-turn for the Fed had a significant positive impact on risk assets as the threat of tighter U.S. financial conditions was replaced by expectations of easier financial conditions.

As one would expect, the markets that had been most negatively impacted by the threat of tighter U.S. financial conditions benefitted the most. U.S. equities rallied by more than 13% while U.S. high yield bonds returned nearly 7.5%. Other credit markets also performed well. Emerging markets, for example, returned nearly 7%. The performance of the U.S. dollar was mixed despite the dovish Fed, as the dollar rallied against major currencies such as the euro and Japanese yen, while falling against select EM currencies, such as the Russian ruble and Chinese renminbi. Interest rates in most developed countries fell, and so too did rates in most emerging market countries. 

Global growth in Q1 continued to move lower with greater participation by the U.S. in the overall weakness. European economic data have not shown any signs of stability, but we are starting to see a stabilization in the trajectory of growth in emerging markets. The weakness in global growth came primarily from trade, but there was evidence of a seepage effect as data on domestic business activity was weaker in a number of countries.

Developed Markets

In the United States, the economy slowed down from about a 3% growth toward its potential long-term rate, which we believe is just below 2%. This slowdown was expected given that the acceleration in growth was due to tax cuts and fiscal spending measures, and the effects of those are now waning.

The Eurozone economy unexpectedly slowed last year. One of the main reasons was a significant slowdown in global trade. The Eurozone is an export powerhouse and changes in global trade affect its growth momentum. Additionally, several idiosyncratic one-off factors contributed to a further loss of momentum. In Germany, the new fuel emissions standards interrupted automakers’ production cycle. In Italy, uncertainty about fiscal policy led to higher spreads for bonds and had a negative impact on business confidence. In France, public protests impaired investor confidence and hurt retail sales, but recent data suggest a recovery in confidence may be underway.

We believe these one-off factors are now behind us and domestic fundamentals in the Eurozone will continue to support growth. Labor market performance has been quite strong in the Eurozone even with the slowdown and that has led to income growth. Consumer confidence and domestically oriented sectors, such as services and construction, have been resilient.

Like the Eurozone, Japan also experienced a slowdown. Natural disasters in the third quarter and slowing export growth were contributors, but domestic demand has still been robust. The labor market is extremely tight in Japan. In response, wages are slowly but surely rising, labor participation is increasing, and companies are investing in machinery and software to address labor shortages.

While our baseline view is that conditions will support growth, we recognize a key risk for global economies is the slowdown in global trade and manufacturing. Policymakers have recognized these risks and are responding by providing support through monetary policy support and, in some cases, fiscal stimulus. One of the major stories of 2019 is a change in the monetary policy stance of developed market central banks. Following the Fed, several central banks removed their tightening biases and provided a boost to the global economy.

Looking forward, we expect global growth, in response to domestic resilience and supportive economic policies, will remain around its long-term historical average.

China and Asia Emerging Markets

As expected, the slowdown in China and emerging market Asia continued, however there are early signs of stabilization in recent data, especially from China. That suggests stimulus efforts have begun working. Nonetheless, we do expect the first quarter to remain mired in further data weaknesses. The slowdown in developed markets does not bode well for EM Asia and China’s stimulus measures are still in their early stages. Our baseline view calls for a stabilization in the second half of 2019 and remains consistent with our Q4 outlook. We consider a potential trade deal between China and U.S. as a key catalyst for stabilization, along with stimulus from China. Moreover, the support that comes from the easing of global financial conditions now that both the Fed and European Central Bank ECB have changed their tunes will provide further stability. In the broader EM Asian markets, we believe benign, demand-led inflation pressures will allow several central banks to take extended interest rate pauses and may even bring rate cuts from other central banks, such as those in India, Indonesia, Korea, Malaysia, Philippines, and Russia. Furthermore, some domestic economies — primarily those of India, Indonesia, and the Philippines — could be supported by election-linked fiscal spending.

Latin America

The emerging market economies of Latin America are still seeing sluggish growth. As a result, we are cutting our 2019 growth forecast for the region. The disappointing slowdown comes from its larger economies, where we now see traction coming later. Still, the region’s currencies have been relatively well behaved. Almost everywhere, inflation is at low or at least comfortable levels. Even while moderating our expectations, we continue to see a growth recovery in Latin America for all countries, except Mexico, where the U.S. slowdown, combined with uncertainties over domestic policy, will likely reduce growth in 2019. In our opinion, the new administration of President Andrés Manuel López Obrador could deliver truly historical changes, and the economy – with low debt levels – is at a good starting point for future growth. Argentina, with its lower growth and higher inflation, is the one key exception to our overall outlook for the region. We see an economic recovery on the margin, and there is a background for a stabilization of macroeconomic conditions that could persist past the October presidential election. In Brazil, economic activity has been impaired by delays in the approval process for pension reforms. This delay has undermined the potential benefits of a more benign environment generated by positive changes in credit conditions and fiscal policy. We think traction for the economy will come later because we do expect a robust pension reform will be approved and higher growth will materialize as a result. We are cutting this year’s growth rate to 2%, but we do believe a growth rate of 4% could be achieved next year in Brazil. While outright interest rate cuts in the region are unlikely, beyond the three countries noted above, the recent guidance provided by the Fed gives Latin American central banks room to wait before removing their monetary stimulus. We are now looking for lower growth in Brazil and Mexico, and lower inflation in Mexico, Chile, and Colombia. In this context, we think Mexico’s central bank will ease monetary conditions, and Argentina’s may do likewise as the country’s economy stabilizes. The central banks of Chile and Colombia may go more gradual with their tightening cycles, while the Brazilian central bank may just want to wait to determine its own path.

Outlook

In a continuation of our views from Q4 2018, we still see global growth momentum slowing in Q2 2019, but at a declining rate. For the investible world, growth slowed to below 2.8% in Q1 2019, and while near-term challenges remain, we are seeing signs of stability in EM countries. As we had expected, China appears to have provided some stimulus that should peak in Q2 and Q3. That should allow global growth to be stable and in a range around the current level for the full year. The current underpinnings of growth remain solid, although the fundamentals have been deteriorating. The domestic drivers of growth, which had been stable, in almost every region, have shown signs of weakness evident in some slowing in consumption. However, trade, particularly in developed countries, remains the greatest current impediment for global growth. In Europe, we continue to expect the headwinds will diminish, with looser fiscal policy in Germany and France providing some additional momentum.

While growth is weaker globally, it is still very much in the sweet spot of being at its potential or slightly below it – conditions that provide strong support for risk assets. The impact of policy, both monetary and fiscal, is expected to be positive for assets in this environment. We expect that monetary policy around the globe in 2019 will be far more supportive than it was in 2018. We continue to believe that the Fed will be on hold for an extended period. While the next move is some time away, the bar for raising interest rates in the U.S. is much higher than it is for easing as the Fed potentially moves to an average inflation targeting regime. Similarly, the European Central Bank announced additional monetary policy stimulus in Q1 and stands ready to add to its measures if growth does not stabilize. In this environment, there is some room opening up for emerging market central banks to provide monetary stimulus. EM central banks have no further need to tighten monetary policy, and a number of countries, particularly those in Asia, have the ability to reduce rates. Real policy rates in emerging market countries remain high with room to fall. The high real interest rates also highlight the fact that inflation remains muted globally, and there is little near-term risk of it accelerating in a meaningful way.

Portfolio Implications

The shift in economics and policy environment is allowing us to keep our portfolio fairly stable. We continue to believe that the U.S. dollar will resume its decline, with that decline possibly accelerating in the second half of 2019 as the global growth differential to the U.S. widens. Our expectations from Q4 have not changed. We continue to think that the medium-term trend for the dollar is lower, continuing the decline that started in 2015, and only interrupted in 2018 because of the large fiscal stimulus in the U.S. With the expected slowdown in U.S. growth to below 2%, we think the weaker U.S. dollar cycle can resume correcting for the overvaluation of the currency. EM currencies will benefit from carry, while DM currencies could benefit from a change in valuations. In our portfolios, we are favoring carry from currencies and while we have a significant underweight in the euro, we have added to our exposures in the Brazilian real, Indian rupee, Indonesian rupiah, and South African rand. We also remain invested in the Norwegian krone, Swedish Krone, and Polish zloty, but have decreased our exposures to these three currencies. 

We continue to favor emerging market interest rates over developed market interest rates. Real yields in emerging markets remain close to decade highs, when compared to a combination of developed market yields. For those countries where the central banks have raised rates, we see value in the short-term rates. In the countries where the central banks have not fully tightened, we see value in long-term bonds, particularly in countries where the yield curves are very steep.

Given the strong performance in credit in Q1, we have modestly reduced our emerging market sovereign credit exposure as certain credit positions appeared to be fully valued. We continue to believe that European high yield and subordinated debt from financial corporations offer significant opportunities for excess return over our investment horizon, as do select emerging market high-yielding corporate bonds.