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Cracked, but still intact

How long will markets defy the economic slowdown?
Letter to Investors

Cracked, but still intact

Christian Nolting
Global CIO

Trade conflict fears have disrupted trade chains and put a dent in global economic prospects. In response, central banks have stepped in. The Fed has said that it will “act as appropriate” and the ECB has said that, without improvement, “additional stimulus will be required”.

For the moment, this is just a statement. The global economy has yet to slow further and central banks haven’t yet cut rates. But the central banks’ commitment is an important one. Financial markets believe that policymakers’ promises will be honoured and that monetary policy intervention will blunt the market impact of slower growth. Such central bank promises create some risks. Even though inflation remains stubbornly low, and below target, most economic data do not yet provide a good reason to cut rates shortly. But if central banks do not cut rates, their authority could start to be undermined because they have raised expectations about lower rates to the point where it would be awkward to backtrack. This may provide an incentive to cut rates more than would normally be the case – good news for markets in the short term, but not necessarily in the long term. There is also a non-optimal solution in that central bank action is partly being used to counter the effects of an escalation in the trade dispute and the resulting shifted patterns in trade flows – thereby quite possibly prolonging trade friction longer than it might have lasted. Which direction the trade dispute goes and whether there will be new tariffs remains unclear. What we know is that the effects of a trade conflict are long-term and predictably negative; the effects of monetary easing are perhaps short-term and not predictable.

This situation has a direct bearing on our six themes for 2019, which we discuss below.
  • 01
    Growth deceleration – still expected, but we think that it will be rather gradual.
  • 02
    Vigilant on volatility – markets will be pulled around by policy uncertainty, geopolitics and corporate earnings.
  • 03
    (U.S.) yields on the return – the fixed income segment has posted strong returns year-to-date. At the beginning of the year we considered the short end of the U.S. yield curve to be particularly attractive. It has fared well since then thanks to falling yields, which in turn are caused by economic uncertainty and accommodative monetary policies. The upshot of lower yields across the board, however, is that the hunt for yield has intensified within all fixed income sectors, including emerging markets.
  • 04
    Earnings will certainly ease – due to the slowdown in economic growth, exacerbated by import tariffs eating into corporate profits.
  • 05
    U.S. dollar centre stage – we expect the arguments for USD weakness and USD strength to be roughly balanced in light of trade uncertainty and the projected interest rate cuts on both sides of the Atlantic.
  • 06
    Long-term investment themes – with ESG and enhanced infrastructure the newcomers for 2019, these themes are still a key recommendation of ours for their diversification properties.

What does this mean?

Our forecasts acknowledge that central banks have become a lot more concerned about the economic outlook, expecting momentum to slow down to the point where rate cuts are deemed to be necessary. Even though this is nothing but an expectation, financial markets have been quick to take ultra-accommodative monetary policy for granted, meaning that mere words by the Fed and the ECB have provoked a tangible reaction in equity and bond prices. We advise not to rely too much on these expectations: financial markets have a habit of over-relying on central bank support, leading to disappointment further down the road. On the simmering trade dispute, it is by now fair to assume that it won’t go away anytime soon. An agreement of sorts between the U.S. and China may be imminent, but it’s unlikely that it will resolve all hostilities at once. To the contrary, the trade dispute has spilled over into Europe, threatening the manufacturing sector. Therefore, we should be ready for sudden spikes in volatility across asset classes. In fixed income, lower rates across the board mean that the hunt for yield is likely to intensify even further. As a result, selection becomes ever more critical. The same can be said for equities, where we advise to look for quality and scale back on cyclicals, as these will be the first to suffer as and when uncertainty increases and volatility spikes. On currencies, the USD looks solid, but not to the point of threatening the value of emerging market currencies, as it did last year. Therefore, we stick to our constructive view on Asian emerging markets. Finally, now more than ever we advise looking at long-term themes that feature a low correlation with day-to-day movements in financial markets. In particular, we highlight the potential that structural changes in the world economy offer, such as the need to maintain and upgrade ageing infrastructure in many developed countries. In conclusion, now that half of the year has passed, our six themes for 2019 still look up-to-date as they offer a lens through which to interpret current market developments. We consider investors’ manifest belief that central banks will extend this late economic cycle indefinitely to be disingenuous. It is worth remembering that monetary policy, like so many other tools, suffers from decreasing returns of scale. That is to say, as interest rates shrink, each successive rate cut tends to have a smaller impact on the real economy. The old adage to hope for the best but prepare for the worst sounds apt in our current market environment. Our advice is to review portfolio allocations carefully, taking into account political and market risks, rather than relying on either fiscal or monetary policy to keep the economy afloat.

Christian Nolting
Global CIO
Instant Insights
2019 Themes

  • A growth slowdown is still expected, but we think that it will be gradual.
  • Look out for new quantitative easing in the Eurozone. The hunt for yield will continue.
  • Long-term themes are still a key recommendation of ours for their diversification properties.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in July 2019.

Theme 1
Economy – Growth deceleration

Slower despite a foot on the gas

Deceleration can be smooth or abrupt – and it can be voluntary or involuntary. At the start of this year we predicted easing growth, as central banks continued to gently scale back liquidity as part of long-awaited policy “normalization”.

Consensus gets gloomy

So far in 2019, headline GDP growth numbers have held up well – with U.S. growth hitting 3.2% year-on-year in Q1 and Eurozone growth 1.2% year-on-year. But consensus growth expectations have shifted down sharply: in the U.S. they are at 2.5% for 2019 and 1.8% for 2020 and in Europe at 1.2% for 2019 and 1.3% for 2020. Escalating trade conflicts have triggered the general gloom. Our central scenario remains for a measured slowdown in global and individual country growth rates, with the U.S. keeping well clear of recession: we forecast 2.5% U.S. growth in 2019, and a 3.4% global expansion. Eurozone growth, at 1.2%, will be low but positive. In Japan we expect GDP growth of 0.5% and in the UK 1.4%. China, meanwhile, will be piling on the policy initiatives to keep growth on a relatively-even keel: Chinese growth is forecast at 6.0%. India has already been busy cutting rates against some signs of slowdown: Indian growth is predicted at 7.2%.

Consumer resilience tested

Slower global growth will not just be due to slower exports. Corporate investment expectations are being scaled back in response. Manufacturing is suffering the most: services industries are doing better for now, according to purchasing managers’ indices, but could be next to fall. Resilient consumer confidence may be challenged. Trade disruption is already causing structural shifts in trade flows and global supply chains.

2.5%
U.S. growth in 2019
1.2%
Eurozone growth in 2019
6.0%
Chinese growth in 2019
7.2%
Indian growth in 2019
Central banks respond

Central bank policies are already changing in anticipation of a slowdown. Rather than taking their foot off the accelerator, central banks are now promising (if needed) to put a foot on the gas. The Fed has the option of repeatedly cutting rates if needed: we expect it to cut the Fed funds rate twice over the next 12 months, reducing it by a total of 50 bps. The ECB and Bank of Japan have a more difficult task. Cutting already low or negative policy rates in Europe or Japan could have significant economic costs. We still expect the ECB to reduce its deposit rate by 10 bps over the next 12 months, and to accompany this move with a tiering system in order not to hurt the banking sector. The Bank of Japan is likely to mirror these actions by the end of the year with similar nonconventional policy tools. Their focus will include other policy loosening tools: in Europe’s case, damage from Brexit or Italian budget rows could add to the urgency here. China is already pursuing a multi-faceted approach to keep credit flowing. Inflation is expected to remain low. Even in the U.S., where a buoyant labor market has helped push up wages, it is forecasted at just 1.9% in 2019. In other developed markets inflation, and inflation expectations, are both much lower. The Fed is already debating how long-term policy needs to shift in this low inflation world: any upward shock from higher tariffs is unlikely to be major. In summary: Expect a further slowdown in global growth in the second half of this year – but no recession either in the U.S. or in Europe.

Figure 1: Reversal in Fed rate market expectations
Source: Bloomberg Finance LP, Deutsche Bank AG. Data as of June 28, 2019.
Instant Insights
Economy

  • Central banks have made it clear that financial markets can count on their support.
  • However, markets may have got ahead of themselves. We don't expect the Fed to deliver as many cuts as are currently priced in.
  • Beware of moral hazard: once central banks are expected to step in, markets may become complacent about risks.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in July 2019.

The Fed turns dovish

Market-implied probability of an interest-rate hike in January 2020

Market implied probability is derived from the derivatives market.
100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Feb 19 Oct 18 Aug 18 Jun 18 Dec 18 The Fed raises rates by 0.25% 13 JUNE 19 December 30 January 20 March OCTOBER 2018 26 September JUNE 2019 10 October The Fed raises rates by 0.25% Fed removes “further gradual increases” and says that it will take a “patient” approach in setting policy, indicating that it would be less likely to raise rates over the coming year Fed downgrades its forecast of GDP growth in 2019 from 2.3% to 2.1% President Donald Trump accuses the Fed of “going loco” in continuing to raise rates, criticisms that he repeats several times in subsequent months The Fed raises rates by 0.25%. It removes “accommodative” from the statement, which markets interpret as meaning that it may be nearing the end of its rate-hiking cycle 91.8% 0.0%

Past the peak

GDP growth has held up so far during Jerome Powell’s tenure as Fed chair, but the outlook is getting weaker

GDP growth is quarterly and annualized

Better-than-expected GDP growth in the first quarter of 2019 was largely due to rising inventories and falling imports, and the headline figure disguised signs of a slowdown in both consumer spending and business investment. Meanwhile, inflation is well below target, the latest employment data was disappointing and wider fears such as the threat of a U.S.-China trade war have not gone away.

Growth in the second quarter of 2018 was the strongest result in almost four years An abrupt fourth-quarter slowdown suggested that the economy may be losing momentum MARCH 2018 JUNE 2018 SEPTEMBER 2018 DECEMBER 2018 MARCH 2019 2.2% 4.2% 3.4% 2.2% 3.1%
Theme 2
Capital markets – Vigilant on volatility

The certainty of uncertainty

Financial markets have had many reasons to be volatile since the start of the year – but not all of these have been predictable.

Reasons for volatility

Reasons for volatility are many – both global and local. Many are interlinked – but often in different ways, with different drivers and running on different cycles. The key recent volatility driver has been trade fears. The sharp market fall in late May was triggered by an unexpected reversal in U.S./China trade negotiations; with no comprehensive U.S./China trade deal likely quickly, this will stay the case. Trade concerns will feed into growth fears which in turn will destabilize policy expectations. Of course, this can work both ways: increasing expectations of central bank policy loosening lifted markets in June. Volatility could also be boosted by corporate earnings shifts: the Q2 U.S. earnings reporting season, starting in late July, will show how much current gloom reflects reality. Finally, don’t ignore geopolitical risks, even if apparently running on a different tangent. Increasing Iran tensions in June reminded us that old tensions can reignite. Other political problems around, for example, Brexit and Italy can also have a non-economic impact.

The Q2 U.S. earnings reporting season, starting in late July, will show how much current gloom reflects reality.

Markets have put aside fears about political and geopolitical upheaval, but these risks haven't abated.

Volatility is not just the VIX

Just as the causes of volatility are many, so are the consequences for markets. Single volatility measures cannot capture the full story. Recently, for example, growing hopes around monetary policy easing have driven volatility – on the most quoted measure, the VIX – down. But the numbers here need to be treated with caution. The VIX measure, which is of implied volatility through S&P 500 index options, addresses only one aspect of volatility and relatively low values don’t necessarily indicate calm – as we found out most recently in late 2018, before the equity market falls.

Figure 2: VIX not a perfect predictor
Source: Bloomberg Finance LP, Deutsche Bank AG. Data as of June 28, 2019. Chart of the VIX index vs. S&P 500 level over the last 12 months.
  • S&P 500 (lhs)
  • VIX (rhs)
  • S&P 500 (lhs)
  • VIX (rhs)
Views are volatile too

Another reason to be vigilant on volatility is that expectations are just expectations – and that we live in a highly uncertain environment where they could change quickly and profoundly. Financial markets will have multiple issues to fret over in the second half of this year: the impact of trade conflicts, European politics and so on could sorely test investors’ faith in the ability of future Fed policy to put matters right. As a result, we could see a resurgence in volatility in the second half of 2019. From a portfolio perspective, the threat of higher levels of volatility needs to be addressed in various ways. Equity positions need to be reassessed, with fixed income investments focused on achieving the best balance of risk vs. potential reward. But increased cash positions should be temporary: they carry their own risks in a higher volatility environment. In summary: Falls in volatility will be temporary and standard measures will tell only part of the story.

Instant Insights
Capital markets

  • Q2 data are likely to reveal an ongoing economic slowdown.
  • Therefore, financial markets may become more jittery, reacting badly to negative news.
  • Beware of cash positions: they carry their own risks in a higher volatility environment.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in July 2019.

Theme 3
Fixed Income – (U.S.) yields on the return

Rates reverse

At the start of 2019, gentle policy normalization seemed likely to ease up yields. But anticipation of further policy loosening has now pushed them down to unexpected lows, with (as of late June) U.S. 10-year Treasury yields only just above 2% and German 10-year Bund yields below -0.3% – a record low.

Doves ascendant

Worries about the global economic outlook, due in part to intensifying trade conflicts, have helped prompt this change of view. More dovish central banks – keen to prop up economic growth and reassure economic markets – have indicated that they are willing to intervene as needed. We believe that the two interest rate cuts by the Fed that we expect over the next 12 months may well be accompanied by changes to its balance sheet management process. The ECB’s Draghi has hinted at a revival of quantitative easing and says the full range of other policy tools are on the table – to be deployed in the absence of improvement. The Bank of Japan may also unveil some (probably limited) policy initiatives later in the year. In many key emerging markets, central banks may also be loosening policy – but in a more conventional way via interest rate cuts.

Figure 3: Rates under pressure: government bond yields fall again
Source: Datastream, Deutsche Bank AG. Data as of June 10, 2019.
  • U.S. 10-YR Treasury yields
  • German 10-YR Bund yields
  • U.S. 10-YR Treasury yields
  • German 10-YR Bund yields
Policy debate redirected

Growth fears are only part of the story. The downward trend in core government yields had been exacerbated – even before the most recent loosening – by safe-haven flows, as investors sought to move out of risky assets such as equities. But the long-term fear remains inflation: many measures of this in both the U.S. and Europe continue to fall as a result of slowing economic momentum. In spite of lower expectations for interest rates, we do not expect an inversion in the U.S. yield curve. We have lowered our 12-month forecast for 10-year U.S. Treasuries to 2.00% and for 10-year Bunds to -0.10%. We are also now neutral on duration in the expectation that rates will not increase dramatically from current levels.

2.00%
10-year U.S. Treasuries
12-month forecast
-0.10%
10-year Bunds
12-month forecast
Hunt for yield continues

Fixed income has proved resilient so far in 2019. At the start of the year, we highlighted investment grade credit and emerging market hard currency debt as areas of opportunity and both have done well so far this year. Indeed, emerging market debt offers some of the highest yields available, coupled with healthy expectations for spreads, making this asset class attractive for investors looking for carry. The hunt for yield will remain the dominant theme. But this should not blind investors to intrinsic risks. Italian debt, for example, is potentially a problem area. And slower global growth could cause problems for some high yield issuers, even with looser monetary policy: as we have noted before, you have to be sure that higher spreads are worth the risk. Within European credit, we think that so-called “cross-over” credit – issuers on the boundary of investment grade and high yield – could offer an attractive combination of risk and return. Summary: Fixed income’s time in the sun is not over. Investment grade and emerging market hard currency debt will particularly appeal.

Instant Insights
Fixed income

  • Anticipation of policy loosening has depressed yields to all-time lows.
  • Safe-haven flows have contributed to low yields.
  • Investment grade and emerging market hard currency debt are still appealing.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in July 2019.

Theme 4
Equities – Earnings ease

Earnings under pressure

At a fundamental level, equity prices are influenced (inter alia) by two key factors – the macroeconomic environment and expectations of future corporate earnings. At the start of the year we cautioned about slower growth in both.

In the event, the Q1 2019 corporate earnings season was stronger than the consensus expected. Earnings per share measures on the S&P 500 and Stoxx Europe 600 surprised to the upside. S&P 500 Healthcare and Stoxx 600 Industrials showed the strongest earnings growth – up 8.8% and 11.0% YoY respectively. However, earnings expectations had been revised downwards as we expected. Attention now focuses on the Q2 earnings season, to start in late July. Current consensus is for a fall in S&P 500 earnings of -2.3%. Trade disputes are expected to have a growing impact. For companies with more than 50% of their sales inside the U.S., earnings growth is forecast to reach 1.4%; for companies with less than 50% of sales inside the U.S., earnings are expected to decline by -9.3%.

Trade dispute vs. interest rates

Firms and equity investors will continue to fret about trade. Even though the U.S. and China have several rounds of trade negotiations behind them and steps have been taken to reach an agreement, we don't expect a "big deal" resolution to be imminent. The tech dimension is giving rise to trade restrictions that go far beyond import duties – making this a geopolitical rather than an economic dispute. Delayed investment decisions as a result could have multiple implications, including for global consumer spending. Cars, semiconductors and industrial goods are likely to be the sectors worst hit by tariffs, but see growth potential in defensive sectors such as software, healthcare and digital payments. In regional terms we prefer U.S. equities over European equities and keep our constructive view on emerging market equities. Equity investors may also take heart from the new reality of lower interest rates for longer. This – everything else being equal – could make equities relatively more attractive in comparison with bonds and might help sustain valuations at, or even above, historical averages.

Valuations diverge

Our forecasts for the major equity market indices are given here. In the case of the U.S., valuations (price/earnings) are expected to rise slightly from current levels: elsewhere, valuations are expected to fall. We therefore forecast a widening European price/earnings valuation discount to the U.S. Europe lacks a clear catalyst for a rebound, but the collapse in bond yields could support flows into high-quality dividend stocks. Sectoral issues (e.g. autos) could however limit the rise in the German DAX. We also see only small potential 12-month gains for the MSCI Japan, given expected Japanese yen appreciation, unhelpful for many Japanese corporates. Emerging markets remain vulnerable to the trade war, but attractive valuations and 2020 earnings growth expectations could still underpin gains.

Figure 4: U.S. vs. Europe valuations gap is expected to rise
Source: DWS, Deutsche Bank AG. Data as of June 2, 2019.
* Price/earnings ratio, last twelve months.
  • S&P 500
  • Stoxx 600
  • Euro Stoxx 50
  • DAX30
  • SMI
  • FTSE 100
  • S&P 500
  • Stoxx 600
  • Euro Stoxx 50
  • DAX30
  • SMI
  • FTSE 100
Staying apprehensive

Overall, we enter the second half of the year slightly more apprehensive about equity markets than we were just a quarter ago. We would focus on long-term themes and protect portfolios against downside risks. Summary: Impact of trade woes intensifies, but low interest rate expectations provide support.

Instant Insights
Equities

  • We expect lower earnings growth in 2019.
  • The collapse in bond yields could support flows into high-quality dividend stocks.
  • Defensive equity sectors offer growth potential in this stage of the cycle.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in July 2019.

Global valuations in context

Chinese stocks and U.S. tech companies have led the charge amid a solid start to the year for global markets

Better performance year-to-dateear-to-date More expensive, relativeto other indices Average volume HOW TO READ
The area of the circles in this chart is proportional to the average volume of shares traded for each index over the past 30 days. Volumes in the Shanghai Shenzhen CSI 300 index have almost doubled so far this year. The inclusion of Chinese A shares in MSCI’s benchmark World index is often cited as a key catalyst for the rally, although ebbs and flows in trading volumes on mainland exchanges remain heavily driven by sentiment among large numbers of very active domestic retail traders.