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Key points:

  • We see slower global growth and corporate earnings in 2019, while the U.S. economy approaches the late stages of the business cycle. But make no mistake: balancing risk and returns is getting harder.
  • The year 2018 was filled with geopolitical events that impacted markets, a trend likely to continue in 2019. However, valuations have reset and risk premiums are higher this time around. Being selective, as always, is key.
  • We survey the economic and geopolitical risks facing markets around the world. Top risks include European fragmentation, U.S. –China relations and trade tensions.
  • Outside the U.S. (which we would still overweight) we favor China (and EM Asia broadly), India, and Brazil.

Canada: Warming to the North

Canadian real GDP growth is tracking just above 2%, inflation is stable, financial conditions are benign, and downside risks to trade are abating1. Growth momentum and business confidence looked strong before the announcement of the U.S. Mexico Canada Agreement (USMCA) and should benefit further. The USMCA has yet to be approved, but the announcement has lowered risk premiums, which has allowed financial conditions to remain benign despite the Bank of Canada hiking rates. Slowing U.S. growth and weaker oil prices are likely to weigh on Canada’s economy, as could a faster-than-expected hiking cycle. For now, however, we believe downside risks have eased, equity valuations look cheap, and analysts expect earnings to grow 11% in 2019 — among the highest in the developed world.2

Mexico: Policy risk

Policy uncertainty remains elevated following the Mexican elections. Andres Manuel Lopez Obrador’s (AMLO) decisive victory as president has given his administration a clear mandate for change, and he has congressional backing to enact reforms. However, after AMLO cancelled the Mexico City airport project, investors are reconsidering just how significantly policy could shift. Top of mind is the risk of deteriorating fiscal discipline, as fiscal health is needed to maintain sovereign ratings and support domestic and external confidence. Absent policy errors, Mexican assets look reasonably attractive. Analysts currently expect 16% earnings growth in 2019 and USD/MXN and equity valuations appear quite cheap.3

Brazil: Implementation risk

While Mexico’s risk lies in policy direction, Brazil’s risk lies in execution. President-elect Jair Bolsonaro faces an unsustainable fiscal position desperately in need of reform. Bolsonaro secured a clear mandate, however, the lower house and Senate are very fragmented and likely to complicate passage of economic reforms. Bolsonaro will inherit a bloated bureaucracy, inefficient state owned enterprises, and a precarious fiscal position requiring pension reform. However, Brazilian real GDP growth is expected to accelerate from 1.3% in 2018 to 2.4% in 2019 and inflation remains well anchored thanks to excess capacity and 12% unemployment.4 Brazil’s accelerating growth and excess capacity are a powerful combination for earnings growth. Analysts currently expect 20% earnings growth in 2019, but even that may be too low if Bolsonaro can implement some economic reforms, which include privatizations, social security and tax reform, and trade liberalization.5

Japan: External demand, internal taxation

A number of forces will challenge Japanese growth in 2019. External demand should weaken due to slower Chinese and U.S. growth and from trade uncertainty with the U.S. Domestic demand will likely peak in the third quarter of 2019, ahead of the October value-added tax (VAT) hike from 8% to 10% as demand is pulled forward. We expect the Bank of Japan (BoJ) to remain accommodative, however, any changes could led to yen appreciation and further undercut export growth. Japanese equities are already cheap relative to history, but 2019 earnings growth expectations are weak (4%) and economic risks look skewed to the downside.6

China: Stimulus & sentiment

Amid the trade tensions, Chinese policymakers have rolled out a number of monetary, regulatory, and easing measures to help support growth. Yet China is also grappling with a large debt overhang from prior stimulus measures, and sentiment has weakened over fears of a return to the debt-driven growth model and possibly diminished role of the private sector. To improve sentiment, China will likely need to shift from cyclical measures and towards structural reforms while ensuring growth and financial stability are kept in check. The U.S./China trade détente post G20 has lifted sentiment, however, the structural issue of technological supremacy is likely to keep U.S.-China tensions elevated. We find trade tensions are reasonably priced in to Chinese equities, and view the current risk/return profile as quite attractive. Analysts currently expect Chinese earnings to grow 15% in 2019, and any improvement in sentiment will likely lift equity multiples off their depressed levels as well.7

Korea & Taiwan: Technologically challenged

Korea and Taiwan are likely to see weakening external demand as global growth slows, but they both must also deal with a slowing semiconductor cycle. Already in Nov 2018, South Korean exports declined from 23% year-over-year to 5% as chip exports sharply weakened to two year lows.8 Analyst earnings estimates match the disappointing growth slowdown, with Korean and Taiwanese equities last among emerging markets in earnings growth projections for 2019 at just 2.3% and 1.8%, respectively.9 Unless the semiconductor cycle gets a major reboot in 2019, Korea and Taiwan could face a daunting external demand backdrop that’s unlikely to provide strong earnings growth.

India: Vulnerable leadership

India is projected to lead emerging markets next year with the fastest real GDP growth (above 7%) and earnings growth (22%).10 However India’s fiscal and external imbalances and political uncertainty ahead of the general elections in May 2019 present challenges. The current account deficit is expected to widen from -1.8% of GDP to -2.8% in 2019.11 Higher oil prices are the key variable here: a sharp rise would likely further stress the current account balance and exchange rate as we saw in 2018. Weaker fiscal discipline is also a concern. Higher deficits mean less savings, which in turn requires less investment — needed to sustain high potential growth rates — or a larger current account deficit. While the May elections present their own challenges, any major reforms are likely to be pushed to 2020 given a fragmented Parliament.

U.K.: More uncertainty to come

Brexit developments will likely dominate the first quarter of 2019, and if things go as planned, focus will then shift towards the transition period that is expected to last until the fourth quarter 2020. March 29, 2019 marks the two year anniversary of triggering Article 50 and is the deadline for a deal. We expect volatility to remain high beyond the March deadline but ultimately see a no-deal exit being avoided. Even in our base-case view, we see U.K. growth remaining anemic with meaningful downside risks. Earnings growth is expected to remain below peers as well, with just 7% earnings growth forecasted for 2019.12

Italy: The costs of budgets

Italy’s growth slowed sharply in 2018 and we see more downside ahead. Political uncertainty has weighed on business and consumer confidence while Italy’s budget proposal and battle with Brussels has raised borrowing costs and tightened financial conditions. Although the 2019 draft budget projects a fiscal stimulus of around 0.8% of GDP, tighter financial conditions are likely to mitigate any positive stimulus effects as the International Monetary Fund (IMF) recently estimated a 100 basis points (bps, or 1.0% — a basis point is one hundredth of one percent) rise in bond yields could lower GDP by 0.4%.13 Given Italy has one of the weakest potential GDP growth rates among EU members at just 0.5%, debt sustainability concerns will remain and any fiscal stimulus measures that lack structural reforms will likely tighten financial conditions, offsetting any fiscal impulse.14 Until structural reforms improve potential growth, cyclical measures to improve growth will likely fall flat.

Germany: A strong core

At the nexus of European fragmentation and trade risks sits Germany. Domestically, the German economy looks quite stable with household consumption growth continuing at 2% year-over-year while transitory factors affecting the auto industry fade in 2019.15 Instead, Germany’s risks in 2019 appear to be external, with a weaker export backdrop, continued trade tensions with the U.S., and political risks from Italian budget and Brexit negotiations. Despite the broader eurozone deceleration that economists anticipate in 2019, analysts expect 10% earnings growth for German equities in 2019.16/17

South Africa: Reform momentum intact

We expect South African growth to modestly accelerate in 2019, however, uncertainty surrounding reforms, fiscal discipline, and elections cloud the outlook. The budget, set to be announced on February 20th, will shape the fiscal outlook yet is unlikely to constrain spending ahead of the parliamentary elections expected on May 8th. Instead, additional fiscal reforms, such as a rules-based fiscal anchor, could be announced and would join a broader set of reforms targeting structural unemployment, the debt burden of state owned enterprises (SOEs), and governance issues. The upside: South Africa is relatively cheap and analysts expect 20% earnings growth in 2019.18 Amid slowing global growth, economic and reform momentum appear quite attractive.

Christopher Dhanraj
Head of iShares Investment Strategy
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