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Mountain climbers

Market view

Expect a tougher climb

2018 in review— Let’s not do that again

Despite solid global economic growth, 2018 turned out to be the most challenging year for investors in a decade. The U.S., the world’s largest economy, expanded at its fastest pace of this cycle. Sales and profits climbed for global corporations, while central banks kept interest rates at well-below-normal rates. Yet, as we near the end of 2018, few major asset classes have outperformed cash. What happened?

This much is true: U.S. economic growth surpassed our expectations coming into the year. The Tax Cuts and Jobs Act, passed late in 2017, sent economists and Wall Street analysts scrambling to estimate its effects. We now know that U.S. consumer spending and private investment surged—at least temporarily— as tax rates fell. U.S. corporate profits rose by over 25% in the second and third quarters. But as Exhibit 1 shows, in contrast to 2017, positive economic surprises (i.e., economic performance relative to expectations) were essentially limited to the U.S. Results in the rest of the world were disappointing.


We feel this disappointment wasn’t due to any single factor, but rather to a confluence of moderate headwinds. Higher global tariffs and uncertainty about more on the way restricted country market access and drove up costs. Rising U.S. interest rates and a stronger U.S. dollar stressed the global financial system, and China’s economic policy in particular, by encouraging capital flight. It’s no wonder investors began to focus on the crosscurrents and fading tailwinds that we anticipated would hit in 2019 a bit ahead of schedule. And, as investment managers, it’s time we did the same.

What’s in store for investors in 2019?


Let’s start with what Nuveen’s Global Investment Committee does not expect to see in 2019: a recession in a major economy. But—there’s always a “but”—economic growth is set to slow in both the U.S. and China while failing to bounce back convincingly in the eurozone, Japan or United Kingdom (Exhibit 2). This slower growth tips the balance of risks toward the negative. An unusual amount of uncertainty remains on key questions like the direction of corporate credit spreads and the U.S. dollar, but we are more confident that market returns will improve only moderately from their lackluster 2018 showing. Despite this— or, rather, because of it—our investment teams are focused on finding opportunities to buy and own high quality assets without becoming too defensive in their approach. They’re walking a fine line, to be sure.


Fading tailwinds, stiffer headwinds


Global growth received a boost in 2018 when the U.S. opted for a late-cycle fiscal expansion, borrowing nearly $1 trillion to fund tax cuts and federal spending. Nuveen estimates that in 2018, these measures added more than 0.5% to U.S. gross domestic product (GDP) growth and helped lift S&P 500 sales and profits. But most of the positive effects of this stimulus have already begun to wear off and will vanish almost entirely by 2020. In their place we’ll find tighter financial conditions (Exhibit 3) thanks to rising interest rates, wider corporate bond spreads, falling equity market valuations and, yes, new and rising taxes on international trade.


Where might the world turn in 2019 to replace the boost it’s just received from the U.S.? China’s government has attempted a large monetary and fiscal stimulus to help support its economy amid attempts to de-risk its financial system. We should be seeing the effects of that effort more in 2019, which could produce upside surprises to growth in Asia. In addition, we’re looking for signs of economic strength in Brazil on the back of some pro-growth reforms and for low inflation to pave the way for another year of robust growth in India.

“Slower” doesn’t mean “negative”


Expectations are not particularly high for growth in developed markets outside the U.S. in 2019— and that may actually be a good thing. With less room to disappoint, the eurozone and Japan are positioned to deliver above-trend growth while keeping monetary policy exceptionally accommodative—historically a friendly operating backdrop for companies and the investors who own their stocks. These markets may also benefit from a pause—if not a reversal—in the trend of the strongly rising U.S. dollar. While a strong dollar provides a temporary advantage to international firms selling into the U.S., it also raises the cost for borrowers with dollar liabilities and drives investment flows away from many places that need them.

Of course, the fate of the dollar may rest primarily in the hands of the Federal Reserve. The Fed has been slowly but steadily raising short-term interest rates for three years and seems primed to hike at least twice more in 2019. In the Fed’s view, the currently low unemployment rate could generate higher inflation, which demands tighter policy. With rates rising in the U.S. but flat or down in most of the rest of the world, the dollar has been far and away the best-performing currency. We think it is now well above its fair value and could remain so unless and until the Fed shows signs of slowing or other central banks become less accommodative. Keep in mind that even if the Fed stops raising rates, its ongoing balance sheet shrinkage will effectively continue the tightening process. The resulting increase in the supply of high quality bonds—aided and abetted by a booming federal deficit—could push up longer-term interest rates and corporate borrowing costs.

A broader base for growth should help cushion against a global recession—technically defined as negative GDP growth for two consecutive quarters— despite a deceleration in both the U.S. and China. In our view, there is little chance the U.S. will go into recession before late 2020 given continued strength in consumer and business activity confidence, especially the strong labor market. We would expect to see a material degradation in these and other leading indicators at least a year before the economy begins to contract (Exhibit 4). And while it’s not hard to find areas of risk that could eventually contribute to a recession, we don’t see the types of massive macroeconomic imbalances that helped turn the past two recessions into genuine market crises.

Why do we care so much whether growth merely slows from its current pace or turns negative? Recessions, or so-called “hard landings,” have historically been associated with 20%+ drops in equity markets, falling interest rates and sharply higher unemployment. Decelerations, also referred to as “soft landings,” have not.


Most investable assets are now available at lower prices


It’s hard to put a happy face on the swoon in global risk assets that occurred during the fourth quarter of 2018. As of this publication, few major asset classes have bested cash this year—never a welcome development for an investor (let alone an investment manager). If this cloud does have a silver lining, it’s that financial markets are already pricing in a moderate global slowdown heading into 2019. So while our investment committee is far from ebullient in its outlook, our investment leaders generally expect better returns in their respective markets next year.

One reason for this is that most publicly traded assets offer higher yields today than they did a year ago (Exhibit 5). Interest rates have risen, and credit spreads have widened. In addition, global equity valuations have fallen, in some cases substantially. And while there are important exceptions, like wheat and natural gas, most commodity prices will end 2018 lower than where they began. In short, during a year in which economic fundamentals generally improved, market prices remained flat or fell. This creates value.


The crucial question is whether investors who buy risk assets at this stage—cheaper though they may be—would be better served by moving to cash and awaiting an even more attractive entry point. We don’t think so. But given our view that both economic and earnings growth are likely to slow over the medium term, relying on broad market trends to boost portfolio values may no longer suffice. Instead, we think increased selectivity within asset classes, with a focus on quality and valuation, will yield the best results.


We think increased selectivity within asset classes, with a focus on quality and valuation, will yield the best results.


What if we’re wrong?


At its year-end meeting, the Nuveen Global Investment Committee coalesced around a cautiously optimistic outlook for 2019. At the same time, we also took time to discuss a critical question for our clients: What if we are wrong, especially on the downside? What would that look like in the real world and what would that mean for Nuveen’s clients? Most likely, we’d see a flatter yield curve, driven by sharply higher short-term rates (the Fed’s response to perceived overheating, perhaps) or sharply lower long-term rates, typically a product of recession risk. In this scenario, credit spreads would widen, earnings and stock valuations would be lower, and the direction of the U.S. dollar would be uncertain.

Our downside scenario also includes an unanticipated escalation of event risk in two key areas: Brexit and trade. The U.K. seems determined to leave the European Union (EU) in March, but the precise nature of its departure is still a huge source of uncertainty for global investors, particularly throughout Europe. A “crashing out” scenario— one in which the U.K. exits without a deal in place to manage the transition and tips itself into recession or, worse, stagflation—is not our base case, but it remains a serious risk until Parliament agrees to a plan.

Tariffs also seem destined to plague markets for at least another year. The steady escalation in the tit-for-tat between the U.S. and China, resulting in higher bilateral taxes on a broader basket of imported goods, has produced no clear winner but plenty of losers: U.S. producers facing higher costs and Chinese consumers and businesses losing access to U.S. farm and energy output. The negotiations at this point appear to hinge more on politics than economics, which means the resolution of this dispute is beyond our current ability to forecast. But should new U.S. tariffs spread beyond measures that have already been announced or threatened, the damage to the U.S. economy and investor sentiment could be severe.

Virtually the only refuge for investors seeking positive returns during a period of acute event risk or recession is long-duration, high quality bonds. On the equity side, while few stocks could eke out positive returns in a bear market, defensive sectors like consumer staples and health care would likely beat technology and financials. Moreover, established commercial real estate and defensive real assets like farmland could help provide at least a partial shield against the forces of the public markets.


Conclusion: seeking quality at a fair price in a slowing world

When the dust clears, the global economy in 2019 may not behave all that differently than it did in 2018, but we are hopeful for better investment returns across most public and private asset classes. The world is slowing, but only gradually. Furthermore, we believe a global recession and bear market are still at least a few years away, leaving room for portfolios with risk assets to benefit. The preceding views from our GIC members on their respective asset classes provide some of Nuveen’s best thinking about specific investment opportunities, while the perspective from our Solutions team in the following serves as a roadmap for investors looking to optimize their portfolios for a particular outcome.

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Nuveen's Global Investment Committee brings together our most senior investment leaders from across the firm.
Data Source: FactSet and Bloomberg for market and economic data

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The Bloomberg Barclays Municipal Bond Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. The Bloomberg Barclays High Yield Corporate Bond Index is an unmanaged index considered representative of non-investment-grade bonds. The MSCI ACWI (All Country World Index) is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Nuveen’s Third Annual Responsible Investing Survey: Nuveen commissioned Harris Poll and was conducted online from June 1 - 27, 2017 among 1,012 affluent investors. (U.S. residents over age 21 with $100,000 in investable assets (excluding workplace defined contribution accounts or real estate), who consider themselves the decision maker for financial decisions and who currently work with a financial advisor). A covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out. Algorithmic trading refers to automated trading by computers which are programmed to take certain actions in response to varying market data. Alpha is a measure of performance on a risk-adjusted basis. Middle market refers to medium-sized businesses (neither small nor large).

A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Equity investing involves risk. Foreign investments are also subject to political, currency and regulatory risks. These risks may be magnified in emerging markets. Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Credit ratings are subject to change. AAA, AA, A, and BBB are investment grade ratings; BB, B, CCC/CC/C and D are below-investment grade ratings. As an asset class, real assets are less developed, more illiquid, and less transparent compared to traditional asset classes. Investments will be subject to risks generally associated with the ownership of real estate-related assets and foreign investing, including changes in economic conditions, currency values, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties. Socially Responsible Investments are subject to Social Criteria Risk, namely the risk that because social criteria excludes securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies. Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not suitable for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. The historical returns achieved by alternative asset vehicles is not a prediction of future performance or a guarantee of future results, and there can be no assurance that comparable returns will be achieved by any strategy.

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