After a strong start to the year, financial markets are now being driven by both hope and fear. Hope that the U.S. can reach bi-lateral trade deals with key trading partners (China, Europe, Japan, etc.) and fear that the global economy...
After a strong start to the year, financial markets are now being driven by both hope and fear. Hope that the U.S. can reach bi-lateral trade deals with key trading partners (China, Europe, Japan, etc.) and fear that the global economy may slow in the absence of such deals.
The global economy remains on solid footing, but faces downside risks. Citi’s economists are looking for global growth of about 2.9% year-on-year in both 2019 and 2020. However, global trade war simulations suggest that global growth could slow to a rate of 2.0% year-on-year in just 12-months’ time if trade tensions escalate on a broad scale. Under such a scenario, global growth forecasts for 2020 would be lowered dramatically.
We think that the bull market remains intact, but are recommending a more cautious stance over the near-term. While underweight U.S. stocks for now, Citi’s mid-year 2020 S&P 500 target of 3,000 still presents upside from today’s levels. Globally, Citi’s bear market checklists are signaling some caution, but are not yet worrisome. As such, Citi’s global equity strategy team thinks that global equities can return an additional 13% over the next two years.
A dramatic shift from the Federal Reserve helped to boost stocks in the first part of 2019. After once predicting three rate hikes in 2019, the Fed is now signaling that it may be willing to cut rates if the U.S. economy were to weaken due to trade tensions. However, monetary policy often operates with a significant lag and may not be sufficient to offset the immediate impact of tariffs. Our fixed income preferences remain geared towards U.S. Treasuries and short- and intermediate-duration corporate debt.
Global Economy: Still Expanding
However, trade tensions pose a significant risk to growth
Global growth (particularly outside of the United States) has been easing since early 2018. While there have been some signs of stabilization in both China and the European Union (EU) following fresh Chinese stimulus, rising trade tensions could pose a significant risk to global growth if trade tensions escalate further.
Citi’s economists continue to expect a U.S. – China trade deal, but the timing of such a deal is highly uncertain. With negotiations currently stalled, investors will be focused on the upcoming G-20 Summit in Japan on June 28 and 29. Not only is President Trump slated to meet with Chinese Premiere Xi Jinping, but the summit will occur shortly after the closing of the public comment period on the additional list of $300 billion of Chinese goods that could be targeted with a 25% tariff. As such, we will be watching the G-20 Summit very closely as a gauge of whether or not the additional tariffs will be levied (perhaps as early as July). If implemented, the tariffs would present a downside risk to Citi’s projections for global growth (see figure 1).
Even though our economists do not believe that we are on the verge of a global trade war just yet, economic simulations suggest that a full-blown trade war between the U.S., China, Mexico, Europe, and Japan could cause global growth to slow to about 2.0% year-on-year in about 12-months’ time. This would be the slowest rate of global growth since right after the Global Financial Crisis and would likely meet the definition of a global recession. Citi’s simulation is based on the following assumptions (which may or may not occur): 1) a 25% tariff on the remaining U.S. imports from China that are not currently subject to tariffs, 2) a 25% tariff on U.S. imports of autos and auto parts from both the European Union and Japan (with a reciprocal response), 3) a 5% tariff on all U.S. imports from Mexico (with a reciprocal response), 4) a 10% decline in global equities, and 5) a 1.4% drag on business investment spending over the next year due to increased business uncertainty. Under such a scenario, Citi’s economists believe that many economies would likely see a decline in growth in 2020 (see figure 2). (Although it should be noted that a 5% tariff against Mexico may be less likely after the U.S. and Mexico agreed to a tentative deal on immigration.)
There is a risk that the Fed does “too little, too late.”
If growth does weaken, we think that central banks are much more likely to act than they were in 2018. In terms of the U.S., Fed Chair Jerome Powell has already stated that the central bank will, “act as appropriate to sustain the expansion.” However, we do wonder about the Fed’s ability to address the issue in real-time. After all, the negative impact of increased input costs is likely to take hold much more quickly than monetary policy. With monetary policy often operating with a one year lag time, we worry that the Fed may react with “too little, too late.” That said, absent an escalation in trade tensions, our baseline view remains that global growth will remain relatively steady.
Global Stocks: Hope and Fear
After a strong start to the year, fears of a slowdown are rising
In 2018, global equity returns were exceptionally weak in a year that provided extremely strong corporate profits. In the U.S., the companies of the S&P 500 witnessed a 23% jump in earnings-per-share (EPS) and yet the index finished the year 6.5% lower (see the red circle in figure 3). Such a large disconnect between corporate earnings and share performance is unusual. We think this disconnect, along with a much more dovish Federal Reserve has led to the strong equity market returns year-to-date (the S&P 500 is up 15.2% at the time of this writing).
In many ways, the backdrop has not changed that much since April…the Fed remains on pause, the U.S. labor market remains tight, and global growth still looks decent (though a bit shaky). However, the outlook for global trade has worsened materially. In early April, a U.S. official was quoted as saying that a U.S. – China trade deal was approximately 90% finished. By early May, President Trump had announced that the 10% tariff on $200 billion of Chinese goods would be lifted to 25%. In addition, the United States Trade Representative was tasked with preparing an additional $300 billion of Chinese goods to target. After a public comment period, those tariffs could be ready by late June / early July.
This change in stance led to a notable equity market sell-off with the MSCI All Country World Index (a proxy for both developed and emerging market stocks) falling by 6.2% in May. Although it should be noted that the index is still up year-to-date. In fact, most global asset classes are noticeably higher year-to-date (see figure 4).
We are cautious near-term, cautiously optimistic long-term
However, with the U.S. and China both on the offense (in terms of trade), this has created an environment where “hope and fear” are driving markets more than fundamentals. Hope that trade deals will be reached, hope that the Fed will act to sustain the economy, and hope that worst-case scenarios will be avoided. On the flipside, an increasing chorus of voices calling for a Fed rate cut tells us that there is fear in the market that growth may be set to slow.
We think that this environment warrants a cautious stance over the near-term. As such, Citi’s Private Bank recommends underweighting global stocks (including the U.S.) for the time being and adding to cash, U.S. Treasuries, and intermediate-duration investment grade corporate debt.
While cautious over the near-term, Citi still believes that the S&P 500 could reach 3,000 by mid-year 2020 on corporate earnings-per-share growth of 5% (see figure 7 in the Risks to the Outlook section). If accurate, this would imply about a 4%-5% return from today’s levels. Globally, our global equity strategist believe that global equities could return about 13% over the next two years.
Global Fixed Income: Impatient
The Fed may be patient, but the market is not.
After hiking interest rates nine in three years (from December 2015 to December 2018), the Federal Reserve signaled that it does not expect to raise rates any further in 2019. This pivot helped to ease fears that the central bank would make a policy mistake by hiking interest rates during a time that global growth appears to be cooling.
Currently, the market-implied probability of a rate cut by the Federal Reserve by January 2020 is 98.6% (see figure 5). This suggests that the bond market might be starting to price in a slower pace of economic growth due to the ongoing trade tensions. While Citi’s economists agree that tariffs could eventually weigh on U.S. growth (see again figure 2 on page 3), most of the economic impact will likely not be felt until 2020. This suggests to us, that there may still be time for policymakers to mitigate the impact.
Currently, we do not think that U.S. economic data warrant a cut (even after the May jobs report), but it is not difficult to imagine a scenario that leads to yet another pivot in policy stance from Fed Chair Jerome Powell. Particularly as the pace of inflation seems largely contained with core inflation likely to remain in the 1.5% - 1.6% range in coming months (below the Fed’s inflation target of 2.0%, see figure 6).
We see pockets of opportunity in fixed income
Even though market uncertainty about the Fed’s path remains elevated, Citi’s Private Bank sees opportunities in several areas of fixed income. In the U.S., the Global Investment Committee maintains overweights on short-, intermediate-, and long-duration U.S. Treasuries as well U.S. Treasury Inflation-Protected Securities (or TIPS). We also believe U.S. intermediate-duration investment grade corporate debt may outperform if equity markets exhibit the traditional seasonal weakness over the summer months. For U.S.-based investors, municipals with solid taxable-equivalent yields present an opportunity in longer-term maturities in some states.
Away from the U.S., preferences include emerging markets debt, which we see as offering value over U.S. high yield corporates. In Europe, the Committee maintains an underweight stance on investment grade corporate debt and a neutral stance on corporate high yield. In terms of European and Japanese sovereign bonds, the Committee remains deeply underweight due to extremely low (and in some cases negative) yields. Please see page 7 for additional views on fixed income.
Risks to the Outlook: Trade
Trade uncertainty is the foremost risk to the outlook
We feel like a broken record at this point, but trade is clearly the foremost risk to the market right now so we feel obligated to dedicate one more page to the subject. A question that we are often asked by clients is, “why are tariffs negative for stocks?” Therefore, we thought we would use this chance to address the subject.
The stock market reflects many things at once (geopolitical tensions, fiscal policy, monetary policy, etc.), but it primarily reflects the success of individual companies. If a company’s future is bright and earnings are on the rise, the company’s stock will tend to rise along with its earnings. However, if a company’s earnings decline, then its stock tends to decline. This relationship can be seen in figure 7, with the S&P 500 index and profits moving in the same direction over time.
How does this relate to tariffs? The U.S. importer of a foreign good, not the producer of the good, generally pays the U.S tariffs (although in theory a foreign producer could pay a price by having to lower prices). This often translates into higher input costs and lowers a company’s profits. This is why the U.S. stock market often reacts negatively to the news of increased tariffs. Simply put, “tariffs” are essentially “equity taxes” because investors often need to ratchet down their earnings expectations as input costs could potentially rise for U.S. companies. Unfortunately, the impact of tariffs on corporate earnings is quite difficult to model.
In some cases, the U.S. importer may be able to find a domestic supplier (which would allow the company to avoid the tariff) or they may adjust their supply chains to other foreign producers. As figure 8 shows, these shifts can happen quite quickly with at least some U.S. importers already shifting the origin of their imports away from China and towards other Southeast Asian countries like Vietnam, Korea, and Taiwan.
If alternative, low-cost suppliers can be found (either domestic or foreign), then input costs may not rise much and higher profit margins might be maintained. However, this often takes time and in some cases may not be easy to accomplish (think of having moving a factory from one location to another). Likewise, the new supplier could also fall under the specter of tariffs (think of Mexico).
A full-blown trade war may hit profits more than growth
While many compare the proposed tariffs to the size of nominal U.S. GDP and suggest that, “they don’t matter,” the size of the tariffs should be viewed in the context of corporate profits. As an example, if all the tariff threats from the U.S. against China are carried out, the tariff collections from U.S. importers would equal approximately 10% of large-capitalization firm’s U.S. profits. That is why the stock market often reacts negatively to tariffs. It is the potential impact on profits, not necessarily the economy.
Citi Private Bank’s Asset Class Views
|Asset Class: Fixed Income||View||Investment Rationale|
|U.S. Large Cap||Underweight||The Global Investment Committee (GIC) is underweight U.S. stocks. We acknowledge that things can turn on a dime, but the negative impact of tariffs on corporate earnings may prove deeper-than-expected. We are also not convinced that a Fed rate cut can completely mitigate the impact of tariffs as monetary policy often operates with a significant lag.|
|European Large Cap||Neutral||The GIC has moved to a neutral stance on European (ex-UK) stocks. Even though valuations look reasonable, European exporters may be exposed to the ongoing U.S. – China trade tensions. As an example, exports account for about 47% of Germany’s total output.|
|Japan Large Cap||Underweight||The outlook remains uncertain as Prime Minister Abe’s decision on whether or not to postpone a tax hike in October depends on U.S. – China negotiations. Currently, Citi is looking for just 0.1% growth in 2020. There may be opportunities in certain sectors like robotics and automation.|
|Developed Market Small and Mid-Cap (SMID)||Underweight||Small-caps received a second wind from the cyclical rebound thus far this year, especially in Europe with double-digit returns. However, considering the late cycle economic environment, we would rather be allocated to higher quality large-cap names who may be more resilient down the road.|
|Emerging Asia||Overweight||We modestly reduced our overweight after strong performance at the start of the year. Although China’s economy seems to have passed the bottoming out stage, recent trade squabbles with the US have reignited concerns in markets. For longer-term investors, Asian markets are likely to continue to outperform.|
|Emerging EMEA||Underweight||Emerging EMEA equities have slightly outperformed broader EM equities thanks to a strong performance in Russian equities. However, due to lingering political risks we prefer to focus our EM exposure in other regions.|
|Emerging Latin America||Overweight||The GIC slightly reduced its overweight to the region by moving towards a neutral stance on Colombia. If trade tensions ease, a better outlook for Chinese growth could provide an incremental boost for the more China sensitive parts of Latin America.|
|Asset Class: Fixed Income||View||Investment Rationale|
|U.S. Sovereign Bonds||Overweight||Treasury yields are likely to remain constrained by trade uncertainty and slowing global growth. The deepening yield curve inversion likely does imply rising recession risks, but probably not imminent. Stay overweight.|
|European Sovereign Bonds||Underweight||The GIC expects Eurozone yields to stay low, offering little value to fixed income investors. Likewise, the ECB is likely to remain dovish to contend with weak macro and deflationary concerns. Italy’s fiscal issues may also act as an overhang.|
|Emerging Market (EM) Sovereign Bonds||Overweight||U.S. dollar-denominated emerging market debt still offers some of the best relative value in global fixed income. The GIC’s prefers Latin America and Asia. We are less enthusiastic on local currency-denominated bonds as yields have already fallen to lowest levels since 2016 and are unlikely to move much lower.|
|Corporate Investment Grade||Overweight||In the U.S., we continue to favor duration extension strategies and find the best value to be in 5-7 year maturities. Tactically, our fixed income team favors defensive sectors. In Europe, we think that wider spreads and higher yields still do not present an attractive opportunity.|
|Corporate High Yield||Neutral||In the U.S., we think that tight spreads may be susceptible to rising trade concerns and broader risk aversion; this leaves us favoring loans over bonds. In Europe, spreads have tightened, but growth concerns remain. As a result, we recommend moving up in quality.|
Forecasts, Indicators, and Returns
|Region||GDP Growth||CPI Inflation||10-Year Yields||Exchange Rate vs. USD|
|Global: Based on PPP Weights||3.7||3.4||3.6||3.2||3.2||3.1||N/A||N/A||N/A||N/A||N/A||N/A|
|Early Returns (%)||Valuations||Dvd Yield|
|Equity Index||Level||2014||2015||2016||2017||2018||Month to Date||Quarter to Date||Year to Date||Price to Earnings||12-Month Forward P/E Ratio||Current (%)|
|Fixed Income Returns (%)||Other Key Rates|
|Bond Index||Yield to Maturity||2013||2014||2015||2016||2017||Month to Date||Quarter to Date||Year to Date||Instrument||%|
|Global||1.67||7.9||0.9||3.3||2.1||0.5||1.4||1.4||4.1||10 Year U.S.||2.12|
|U.S.||2.70||5.9||0.5||2.7||3.6||0.0||1.8||1.8||4.8||Treasury 30 Year U.S.||2.57|
|Europe||0.42||11.2||1.1||3.3||0.5||0.5||0.9||0.9||3.4||Treasury 1 Year CD Rate||1.46|
|EM Sovereign||5.51||7.1||0.6||9.6||9.8||-4.1||0.5||0.7||6.8||30 Year Fixed Mortgage||4.03|
|U.S. High Yield||7.00||1.8||-5.6||17.8||7.0||-2.1||-1.3||0.0||7.3||Prime Rate||5.50|
|Region / Index||Year-to-Date Return|
|United States (S&P 500)||9.8%|
|U.S. High Yield||7.3%|
|EM Government Bond||6.8%|
|Euro (Euro STOXX 50)||6.5%|
|U.S. Investment Grade||4.8%|
|Euro Investment Grade||3.4%|
|Emerging Markets (MSCI)||3.3%|
|Economic Sectors||Year-to-Date Return|
- The Citi Emerging Market Sovereign Bond Index (ESBI)
- includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee and Eurodollar markets, excluding loans. It is composed of debt in Africa, Asia, Europe and Latin America. We classify an emerging market as a sovereign with a maximum foreign debt rating of BBB+/Baa1 by S&P or Moody's. Defaulted issues are excluded.
- The Citi U.S. Broad Investment-Grade Bond Index (USBIG)
- racks the performance of US Dollar-denominated bonds issued in the US investment-grade bond market. Introduced in 1985, the index includes US Treasury, government sponsored, collateralized, and corporate debt providing a reliable representation of the US investment-grade bond market. Sub-indices are available in any combination of asset class, maturity, and rating.
- The Citi World Broad Investment Grade Bond index
- is weighted by market capitalization and includes fixed rate Treasury, government sponsored, mortgage, asset backed, and investment grade (BBB–/Baa3) issues with a maturity of one year or longer and a minimum amount outstanding of $1 billion for Treasuries, $5 billion for mortgages, and $200 million for credit, asset-backed and government-sponsored issues.
- Corporate High Yield
- is measured against the Citigroup US High Yield Market Index, which includes all issues rated between CCC and BB+. The minimum issue size is $50 million. All issues are individually trader priced monthly.
- Corporate Investment Grade
- is measured against the Citi World Broad Investment Grade Index (WBIG) – Corporate, a subsector of the WBIG. This index includes fixed rate global investment grade corporate debt within the finance, industrial and utility sectors, denominated in the domestic currency. The index is rebalanced monthly.
- Developed Market Large Cap Equities
- are measured against the MSCI World Large Cap Index. This is a free-float adjusted, market-capitalization weighted index designed to measure the equity market performance of the large cap stocks in 23 developed markets. Large cap is defined as stocks representing roughly 70% of each market’s capitalization.
- Developed Market Small- and Mid-Cap Equities
- are measured against the MSCI World Small Cap Index, a capitalization-weighted index that measures small cap stock performance in 23 developed equity markets.
- Developed Sovereign
- is measured against the Citi World Government Bond Index (WGBI), which consists of the major global investment grade government bond markets and is composed of sovereign debt, denominated in the domestic currency. To join the WGBI, the market must satisfy size, credit and barriers-to-entry requirements. In order to ensure that the WGBI remains an investment grade benchmark, a minimum credit quality of BBB–/Baa3 by either S&P or Moody's is imposed. The index is rebalanced monthly.
- Dow Jones Industrial Average (DJIA)
- is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
- Emerging Markets Equities
- are measured against the MSCI Emerging Markets Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure equity market performance of 22 emerging markets.
- Emerging Sovereign
- is measured against the Citi Emerging Market Sovereign Bond Index (ESBI). This index includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee and Eurodollar markets, excluding loans. It is composed of debt in Africa, Asia, Europe and Latin America. We classify an emerging market as a sovereign with a maximum foreign debt rating of BBB+/Baa1 by S&P or Moody's. Defaulted issues are excluded.
- The Euro Broad Investment-Grade Bond Index (EuroBIG)
- is a multi-asset benchmark for investment-grade, Euro-denominated fixed income bonds. Introduced in 1999, the EuroBIG includes government, government-sponsored, collateralized, and corporate debt.
- Europe Ex UK Equities
- are measured against the MSCI Europe ex UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure the performance of large cap stocks in each of Europe’s developed markets, excluding the United Kingdom.
- The EURO STOXX 50 Index
- covers 50 blue-chip stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
- Fed Funds Rate
- is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. Reserves are excess balances held at the Federal Reserve to maintain reserve requirements. The fed funds rate is one of the most important interest rates in the U.S. economy since it affects monetary and financial conditions, which in turn have a bearing on critical aspects of the broad economy including employment, growth, and inflation. The Federal Open Market Committee (FOMC) that meets eight times a year, sets the fed funds rate, and uses open market operations to influence the supply of money to meet the target rate.
- Global Bonds
- are measured against the Citigroup Broad Investment Grade Bond. The index is weighted by market capitalization and includes fixed rate Treasury, government sponsored, mortgage, asset backed, and investment grade (BBB–/Baa3) issues with a maturity of one year or longer and a minimum amount outstanding of $1 billion for Treasuries, $5 billion for mortgages, and $200 million for credit, asset-backed and government-sponsored issues.
- Global Equities
- are measured against the MSCI All Country World Index, which represents 48 developed and emerging equity markets. Index components are weighted by market capitalization.
- Gross Domestic Product
- is the total value of goods produced and services provided in a country during one year.
- The High-Yield Market Index
- is a US Dollar-denominated index which measures the performance of high-yield debt issued by corporations domiciled in the US or Canada. Recognized as a broad measure of the North American high-yield market, the index includes cash-pay, deferred-interest securities, and debt issued under Rule 144A in unregistered form. Sub-indices are available in any combination of industry sector, maturity, and rating.
- Leading Economic Indicators
- are measurable economic factors that change before the economy starts to follow a particular pattern or trend. Leading indicators are used to predict changes in the economy, but they are not always accurate.
- MSCI All Country World Index
- captures all sources of equity returns in 23 developed and 23 emerging markets.
- MSCI Emerging Markets Index
- reflects performance of large and mid-cap stocks in roughly 20 emerging markets.
- MSCI Japan Large Cap Index
- is a free-float-adjusted market-capitalization-weighted index designed to measure large-cap stock performance in Japan.
- The NASDAQ
- is a composite index is a market-capitalization weighted index of more than 3,000 common equities listed on the Nasdaq stock exchange.
- The Nikkei 225
- is Japan’s leading index. It is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo stock exchange.
- Price-to-Earnings Ratio (P/E ratio)
- is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple. The P/E ratio can be calculated as: Market Value per Share / Earnings per Share.
- S&P 500 Index
- is a capitalization-weighted index, which includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large cap segment of the market, with over 80% coverage of US equities, it is also an ideal proxy for the total market.
- The Unemployment Rate
- is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force. During periods of recession, an economy usually experiences a relatively high unemployment rate.