What a start to the year that was.

By the end of February 2019, global equity markets had risen about 10%. That performance was meaningful in magnitude and broad-based in its participation, making the 4Q18 sell-off a distant memory.

As we discussed at the end of 2018, risk assets seemed to have approached oversold conditions, even after accounting for the deceleration in global growth, increasing the likelihood of a near-term stabilization or rebound. However, while financial markets have experienced a solid start in 2019, economic activity around the world has deteriorated further.

To date, weakness has been particularly pronounced in global manufacturing, with several large economies ̶ China, Germany, Italy, South Korea, and others ̶ posting contractionary readings in recent Purchasing Managers Index (PMI) surveys,1 primarily due to weak external demand and global trade headwinds. Moreover, analysis of industrial new orders versus inventory levels across major global economies suggests continuing weakness in the next few months. Outside the industrial sector, measures of consumer sentiment and housing activity show continuing weakness in the United States, Eurozone, and China.

Business Cycle Slowing in Developed Markets

Overall, our macro regime framework shows that both the United States and developed markets are in a slowdown phase of the business cycle (i.e., growth above trend and decelerating), while China and the rest of the emerging markets are in a contraction phase (i.e., growth below trend and decelerating). Exhibit 1

Exhibit 1: Global Growth is Decelerating

In the United States, recent bank lending surveys point to a marginal tightening in lending standards, the first in three years, suggesting some modest reduction in credit availability. This is not unusual, given past interest rate increases, the steady flattening in the yield curve, and cumulative credit growth. Exhibit 2

Exhibit 2: Lending Standards Follow the Leverage Cycle

Based on our credit cycle framework, we expect credit spreads to remain volatile, with limited upside potential for credit assets versus government bonds in risk-adjusted terms.

We find it interesting that while the cyclical backdrop is certainly deteriorating, there are no late-cycle inflationary pressures, domestically or globally. As a result, all major central banks around the world have already acknowledged the current slowdown and explicitly adopted a more dovish stance, scaling back their projections for higher interest rates. This is an important feature of the current cycle compared with historical precedents, when central banks have often tightened policy into restrictive territory because of rising inflationary pressure despite a slowing economy. Today, the absence of progressively restrictive monetary conditions can help reduce downside risks to economic growth and asset prices on the margin.

Long-Term Perspective

From a long-term perspective, our capital markets expectations suggest that over the next five years global equities are likely to do well, on average, with potential for outperformance in international and emerging markets over U.S. equities. However, from a dynamic asset allocation standpoint, the current divergence between strong financial market performance and deteriorating economic activity warrants cautiousness in the medium term.

As we have discussed in the past, our research indicates that in a global slowdown regime, investors have historically received limited compensation for bearing incremental risks in a global multi-asset portfolio. As a result, we have moved back to an underweight position in global equities, and an overweight position in developed markets duration.

Within global equities, we continue to express our underweight primarily through international equities, where we see the weakest cyclical dynamics; in addition, we have neutralized our previous overweight to emerging markets due to renewed deterioration in economic data. In the U.S., we maintain overweight exposure to master limited partnerships, and favor low-volatility and quality factor exposures in large-cap equities.

Within fixed income, we hold a duration overweight and continue to favor alternative income-generating assets, such as event-linked bonds, at the expense of investment-grade credit. Our overall exposure to foreign exchange risk is close to neutral. While the U.S. dollar is expensive across all our valuation metrics, the weakening growth environment in international markets is a deterrent to capital outflows from the U.S. at this stage.

  1. ^Source: Purchasing Managers Index (PMI) surveys, Jan. 2019. China, Germany, Italy, South Korea, and many other countries posted PMI readings below 50. Readings below 50 indicate declining manufacturing activity.