Remember: Volatility Opens Up Other Investment Opportunities

If the end of 2018 showed us anything, it is that no gains are safe. Thus, advisors must continue to prepare their clients for continued volatility, according to analysts from BNP Paribas Asset Management and Northern Trust in their annual outlooks. That said, neither group believed the economy will fall into recession, at least in 2019.

“The global economy has lost some momentum, and we expect to see some further signs of this in the long term,” said BNP’s senior economist, Steve Friedman, in a webcast presentation. “But concerns about a recession in the near term either in the U.S. or more broadly are overdone.”

The three key reasons for this “relatively upbeat outlook” are: 1) Developed market central bank policy will remain accommodative. “We already are seeing the Federal Reserve pivot in a more dovish direction,” he said, 2) There has been progress made on trade issues between the United States and China. “While a full agreement appears far off, we believe that recent progress will allow the freeze on tariffs agreed to in Buenos Aires to be extended beyond March 1 to allow for more time for negotiations,” he added, and 3) They expect further monetary and fiscal policy easing by China, where Friedman sees growth above 6%.

Northern Trust’s 2019 outlook notes that “continued low inflation gives central banks an excuse to either take their foot off the brake or continue easy money policies. This has allowed us to take an opportunistic approach; earning positive returns is easier when companies don’t have to ‘fight the Fed’ or other central banks.”

One point BNP’s Friedman made was that the Federal Open Market Committee has “a very delicate balancing act,” adding that the bank must have learned from the “great inflation of the 1970s when persistently low unemployment rate led to very high inflation.”

He believes the Fed will err on the “side of caution taking policy only gradually into restricted territory.” He says that because inflation is “quite limited at present,” the Fed can be patient.

Even Northern Trust states that recent comments by the Fed chairman may mean the Fed “may finally appreciate the benign inflationary environment.”

China Syndrome

Both firms are optimistic about trade talks between the U.S. and China. Northern Trust states that “ongoing U.S.-China interactions are causing some volatility in the markets. However, instead of being swept under the rug, conflicts are being addressed by talking openly.”

Friedman sees China’s growth coming in at 6.5% or higher. “The fact remains that Chinese authorities remain committed to deleveraging and structural reforms and this will impose some constraints on easing measures going forward,” he said. They still expect tax cuts in China, and there are significant spending projects planned for 2019, especially in transportation and oil and gas.

Emerging Markets

Northern Trust urges caution on emerging markets unless the Fed quits raising rates or U.S.-China trade tensions end. “Should these risks subside,” it stated, “attractive valuations may argue for an increased allocations sometime in 2019.”

BNP was somewhat more upbeat. Bryan Carter, head of emerging markets fixed income, noted that “all credit spreads are likely to remain elevated. This is both good and bad. It means higher volatility, but it also means higher carry on an ongoing basis. Second, underlying growth here is maybe overdone and we think the market is too pessimistic. Volatility does not necessarily mean a slowdown in growth, and in fact, when we look at emerging markets we think this will be a year in which emerging markets do better than developed countries and the U.S. on a changed basis. Lastly, we believe the [Fed] will ease its rhetoric. It may even pause near term, and that historically has been a green light for investors when it comes to emerging debt.”

Quang Nguyen, head of global emerging market equities for BNP, also was upbeat, especially on the long term. He noted that “as a percentage of total global market cap, emerging markets only make up 25% despite contributing to almost 50% of global GDP.”

He said that there were opportunities for stock pickers, as “not only have valuations become more attractive, we also don’t see a huge correction in our earnings forecast despite the ever-present geopolitical noise, which we think will ensure volatility remains with us for the year.”

Small-Cap Equity

Small-cap equities ended 2018 in bear territory, noted Pam Woo, head of U.S. equities for BNP. She says that for 2019, “the greater fundamental challenge facing small-caps compared to large caps are 1) higher exposure to rising rates, 2) bigger downward revisions to margin expectations compared to post-crisis trends due to less pricing power and inability to absorb higher costs, and 3) fears of a recession.”

She did say that on a valuation basis, some small-cap stocks are “trading below their long-term averages versus large-caps and below parity.”

Woo said that BNP now “views the hunting ground more attractively than we did just six to 12 months ago. To be clear, numerous risks and headwinds remain, such as trade, Brexit, rates and recession. Nevertheless, with small-cap expectations lower, sentiment still negative and valuations at more attractive levels, we view the upside risks in small caps as more compelling at current levels, particularly compared to large-cap.”

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