We believe three key factors – all necessary – could facilitate the flow of capital back into emerging market assets in 2019: The Fed; fiscal and monetary policy in China; and U.S.-China trade relations.
With 2018 behind us, we think it’s also time to bid farewell to the peak in U.S. growth for this cycle.
A central part of our outlook hinges on the idea that the U.S. could “trade places” with the global economy in 2019.
In order for this switch to happen, the U.S. economy needs to slow down while the rest of the world either stabilizes or produces a slight increase in growth. If we’re right about this view, the U.S. dollar should undergo a year of weakness similar to 2017. Emerging market assets stand to be a primary beneficiary from the idea of trading places, particularly as they are undervalued and under-owned coming into 2019.
We will be looking for three constructive factors to facilitate the flow of capital back into emerging market assets in 2019—all three factors are necessary: Federal Reserve (Fed) policy, fiscal and monetary policy in China, and U.S.-China trade relations.
The U.S. economy can no longer remain immune to tightening financial conditions. In 2019, we expect that a convergence of factors will dampen growth: peak fiscal stimulus—there isn’t any more in the pipeline—the lagged effect of higher rates, accelerated balance sheet reduction, the effects of 2018’s strong dollar environment, and trade tariffs. Even the Fed has suggested that U.S. growth should drift lower in 2019 to around 2.3% and will follow a modestly lower trajectory for fed funds rate increases. We are in the camp of 1-2 Fed rate hikes in 2019; if we’re wrong, it’ll be because the Fed didn’t need to hike rates at all in 2019, and will continue to tighten through balance sheet reduction. At its December meeting, the Fed pledged to monitor global conditions after acknowledging that global growth moderated in 2018. We found this development encouraging, though we think the Fed really needs to listen to the message embedded in the yield curve.
The Fed also needs to realize that balance sheet normalization is a form of tightening, and that quantitative tightening shouldn’t necessarily remain on “autopilot.” There is a lag when it comes to the effects of monetary policy, and three years of rate hikes—nine in total—and over one year of balance sheet contraction will have an impact on the U.S. economy. The biggest risk here is if the Fed continues to fight cyclical inflation while ignoring secular disinflationary forces and powers ahead with tightening, and thus prolonging the countertrend rally in the dollar.
Conversely, we need to see more stimulus out of China in 2019, both in terms of fiscal and monetary policy. China’s policy response last year was underwhelming, and policymakers did not implement enough stimulus to counteract U.S. tariffs or the strong dollar environment. In order for global growth to remain stable or modestly improve, the Chinese economy needs to do the same.
U.S. - China Trade
The unresolved trade dispute between the U.S. and China remains the biggest threat to economic growth in China, and our trading places theory. We will continue to monitor whether this trade skirmish develops into a full-blown economic cold war.
Conclusion: Policy is the Key Factor
This year, we’ll be looking for policymakers to set the tone for the global financial markets, whether it’s Fed officials, the People’s Bank of China, or the U.S. or Chinese governments and trade officials looking to make progress. In 2019, we simply need these macro factors to remain stable. The best case and most probable scenario is for the U.S. economy to slow but not fall into recession, China’s economy to stabilize, the U.S. dollar to weaken, and the Fed to pause. Collectively, these events would provide strong positive catalysts for emerging markets out performance this year.
Quantitative tightening (QT) refers to policies design to reverse the flow of central bank reserves, reducing the excess reserves by selling from their inventories of debt securities.
The U.S. Federal Reserve, or “Fed,” is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.
This material is only for distribution in those countries and to those recipients listed.
All investors and eligible counterparties in EU and EEA countries:
In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.
In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.
Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.
All Investors in Hong Kong and Singapore:
This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.
This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.
All Investors in the People’s Republic of China (“PRC”):
This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.
This material has not been reviewed by any regulatory authority in the PRC.
Distributors and existing investors in Korea and Distributors in Taiwan:
This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.
This material has not been reviewed by any regulatory authority in Korea or Taiwan.
All Investors in the Americas:
This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
All Investors in Australia:
This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.