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The Equity Market Party's Almost Over - BoA Merrill Lynch

Tom Burroughes, Group Editor , London, 6 December 2018

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The broad bull market in equities that has been in place for almost a decade - far longer than some earlier phases - looks set to peter out in 2019, but performance in some other sectors is more promising, the banking and wealth management group predicts.

The long bull market in equities is likely to wind down in 2019, and emerging markets will bounce after a lousy 2018, Bank of America Merrill Lynch Global Research says as wealth managers continue to set out views on what 2019 will bring.

So far, wealth managers appear to converge on the idea that global economic growth is likely to decelerate next year, with headwinds from tariffs and rising interest rates taking an effect, while the boosting effect of last December’s US tax cuts fade.

“In our view, the current weakness in the markets is not a reflection of poor fundamentals. Rather, it’s caused by a confluence of idiosyncratic shocks that create very real risks for investors to be concerned about but also opportunities for vigilant, well-positioned investors to pursue,” Candace Browning, head of BoA Merrill Lynch Global Research, said.

“The bear market vibe at the end of 2018 is expected to continue, with asset prices finding their lows in the first half of the 2019, once rate expectations peak and global earnings expectations trough,” the firm said in its report. More positively, it also forecasts a “record high peak” in earnings for the S&P 500 next year and “plenty of upside potential for investors who make volatility their new best friend”.

BoA Merrill Lynch forecasts “modest gains in equities and credit, a weaker dollar, widening credit spreads, and a flattening to inverted yield curve, signaling a tighter squeeze on liquidity that calls for higher levels of volatility”. 

The organisation identifies two major themes driving the world economy: An “unprecedented” divergence in the path of central bank monetary policy, with the US hiking rates while other major countries hold fire, and secondly, doubts on whether decoupling of the US economy from others, such as Europe and China, can endure.

The firm gave 10 “macro-calls” for 2019:

1. Global profit growth declines: Earnings growth is expected to decline sharply next year, from more than 15 per cent to less than 5 per cent on a year-over-year basis. The firm is bearish on stocks, bonds, and the US dollar; bullish on cash and commodities; and long on volatility. The firm expects to start 2019 with a bearish asset allocation of 50 per cent stocks, 25 per cent bonds and 25 per cent cash.

2. S&P 500 Index peaks: Earnings growth also is likely to slow in the US, though the near-term outlook remains “somewhat positive”. The Standard and Poor’s 500 Index is expected to peak at or slightly above 3,000 before settling in at a year-end target of 2,900. The firm forecasts earnings per share (EPS) growth of 5 per cent, which would put the S&P 500 EPS at a record high of $170 next year. The firm’s US equity strategists are overweight health care, technology, utilities, financials and industrials, and underweight consumer discretionary, communication services and real estate.

3. Cash gets competitive: For most of this long cycle, cash yields couldn’t hold a candle to more compelling asset class alternatives like stocks and bonds; with cash yields higher than dividend yields for 60 per cent of the S&P 500 already, cash becomes even more competitive in 2019. 

4. US economy slows as fiscal stimulus fades: Real US GDP growth of 2.7 per cent is forecast for 2019, slowing in the second half of the year as the effects of fiscal stimulus begin to fade. The unemployment rate could reach a 65-year low of 3.2 per cent by year-end, pushing wage growth of 3.5 per cent in aggregate. Consequently, core price inflation should gradually rise to 2.2 per cent through 2019 and hold as rates continue to rise. The housing market is no longer a tailwind for the US economy: BoA Merrill Lynch thinks housing sales have peaked and home price appreciation is forecast to slow.

5. Global economic growth decelerates: The global economy is forecast to grow by 3.6 per cent in 2019, down slightly from 3.8 per cent in 2018, with inflation hovering around 3 per cent. Most major economies are likely to see decelerating activity, with real GDP growth of 1.4 per cent in both Europe and Japan, and 4.6 per cent growth in aggregate among the emerging markets. Chinese growth is likely to further weaken early next year as a result of still-tight financial conditions and the US-China trade conflict; however, a steady stream of monetary and fiscal stimulus measures to turn the economy around is expected.

6. Global monetary policy divergence: Global monetary policy is expected to become less friendly in 2019. A divided government means that additional fiscal stimulus in the US seems unlikely. Europe is largely frozen in place by its budget rules, and Japan appears ready to implement yet another ill-timed consumption tax hike. Further divergence in monetary policy between the Fed and other major central banks is expected to continue. The firm forecasts that the Fed will hike rates four times in 2019, reaching a terminal funds rate of 3.25-3.50 per cent by year-end. Meanwhile, the European Central Bank and Bank of Japan are unlikely to raise policy rates meaningfully above zero for at least another two years.

7. Credit cycle continues despite widening spreads and flattening curves: Globally, the credit markets face high levels of episodic volatility in 2019 with shrinking supply and quantitative tightening putting 25 to 50 basis points of upward pressure on investment grade and high yield bond spreads. In the US, total returns of 1.42 per cent are forecast for high grade corporate bonds and 2.4 per cent for high yield. The US-leveraged loan market remains a bright spot in the credit spectrum, with total returns of between 4 and 5 per cent. High grade and high yield corporate credit are expected to deliver total returns of 1 per cent in Europe and, in Asia, 3 per cent and 4.9 per cent, respectively.

8. Emerging markets: After a major sell-off in 2018, emerging market assets are cheap and under-owned and could be a big winner in 2019 as the dollar weakens, yet EM remains highly vulnerable to spill-over effects of US-China trade tensions. We are bullish about Brazil and expect its post-election rally to continue, and Russia is expected to improve as we believe sanction risk is priced in. Meanwhile, the outlook is bearish for Mexico, where credit rating downgrades are a concern and volatility surrounds policy changes under its new president.

9. Foreign exchange volatility on a weaker dollar: The US dollar was the best performing asset class in 2018, however, most of the dollar gains appear to be in the past. A weaker dollar is expected in 2019, against a stronger euro and Japanese yen. The firm forecasts the EUR/USD and USD/JPY to reach 1.25 and 105, respectively at year-end. The strength of the dollar will depend heavily on evolution of the trade relationship between China and the US, which in the short term may mean selling the dollar against a currency insulated from trade war rhetoric, such as the British pound and Swiss franc.

10. Commodities modestly positive: The outlook for commodities is modestly positive despite a challenging global macro environment. We forecast Brent and WTI crude oil prices to average $70 and $59 per barrel, respectively in 2019; weather-induced volatility is expected in the near term for US natural gas, as cold weather could propel winter natural gas over $5/MMbtu, yet we remain bearish longer term on strong supply growth. In metals, BoA Merrill Lynch remains cautious about copper because of Chinese downside risk. It forecasts gold prices will rise to an average of $1,296 per ounce, but could rally to as high as $1,400, driven by US twin deficits and Chinese stimulus.

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