Bull market to wind down next year, warns BofA Merrill Lynch
The long bull market cycle of excess stock and bond returns is expected to finally wind down next year, but not before one last hurrah, according to BofA Merrill Lynch Global Research in its outlook for the global markets and economy in 2019.
The bear market vibe at the end of 2018 is expected to continue, with asset prices finding their lows in the first half of 2019 once rate expectations peak and global earnings expectations trough. But BofA Merrill Lynch also forecasts a record high in earnings for the S&P 500 next year and plenty of upside potential for investors that make volatility their new best friend.
‘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,’ says Candace Browning, head of BofA Merrill Lynch Global Research, in a statement.
For the year ahead, the research team 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. This comes against a backdrop of slowing – but still healthy – economic growth, mild inflation, except in the US where inflationary pressures are building, and a notable slowing in global earnings per share (EPS) growth from the torrid pace of 2017 and 2018.
Two big themes are expected to affect asset returns and the pace of economic growth in 2019: first, an unprecedented level of global monetary policy divergence as the US Federal Reserve continues to hike interest rates and other major central banks don’t, and second, whether a strong US economy decoupled from the rest of the world, particularly Europe and China, can be sustained.
The answer to that question could depend on big wild card risks in 2019: resolution of the trade war between China and the US, an EU political/economic crisis, and political gridlock in the US that could slow capital investments and deteriorate investor sentiment.
Analysts from the global research firm summarize their views on the market and make the following 10 macro calls for the year ahead.
1. Global profit growth declines: Earnings growth is expected to decline sharply next year, from more than 15 percent to less than 5 percent on a year-over-year basis. The BofA Merrill Lynch Research team is bearish on stocks, bonds and the US dollar, bullish on cash and commodities, and long on volatility. The investment bank expects to turn tactically risk-on in late spring, but to start 2019 with a bearish asset allocation of 50 percent stocks, 25 percent bonds and 25 percent cash.
2. S&P 500 Index peaks: Earnings growth is also likely to slow in the US, though the near-term outlook remains somewhat positive. The S&P 500 Index is expected to peak at or slightly above 3,000 before settling in at a year-end target of 2,900. BofA Merrill Lynch forecast EPS growth of 5 percent, which would put the S&P 500 EPS at a record high of $170 next year. The investment bank’s US equity strategists are overweight healthcare, 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 percent of the S&P 500 already, cash becomes even more competitive in 2019. BofA Merrill Lynch’s Fed call puts short rates close to 3.5 percent by the end of 2019, well above the S&P 500’s 1.9 percent dividend yield. Moreover, in a rising-rate environment, cash-generative investments have outperformed credit-sensitive assets. Given cash’s rerating, 2019 boils down to a strategy of buying sources of cash and selling users of cash.
4. US economy slows as fiscal stimulus fades: Real US GDP growth of 2.7 percent 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 percent by year-end, pushing wage growth of 3.5 percent in aggregate. Consequently, core price inflation should gradually rise to 2.2 percent through 2019 and hold as rates continue to rise. The housing market is no longer a tailwind for the US economy: BofA Merrill Lynch believes housing sales have peaked and house price appreciation is forecast to slow.
5. Global economic growth decelerates: The global economy is forecast to grow 3.6 percent in 2019, down slightly from 3.8 percent in 2018, with inflation hovering around 3 percent. Most major economies are likely to see decelerating activity, with real GDP growth of 1.4 percent in both Europe and Japan, and 4.6 percent 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. But 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 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. BofA Merrill Lynch forecasts the Fed will hike rates four times in 2019, reaching a terminal funds rate of 3.25 percent-3.5 percent 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 25-50 basis points of upward pressure on investment-grade and high-yield bond spreads. In the US, total returns of 1.42 percent are forecast for high-grade corporate bonds and 2.4 percent for high yield. The US-leveraged loan market remains a bright spot in the credit spectrum, with total returns of between 4 percent and 5 percent. High-grade and high-yield corporate credit are expected to deliver total returns of 1 percent in Europe and, in Asia, 3 percent and 4.9 percent, 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 emerging markets remain highly vulnerable to spillover effects of the US-China trade tensions. BofA Merrill Lynch is bullish on Brazil and expects its post-election rally to continue – and Russia is expected to improve as BofA Merrill Lynch believes 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, though 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. BofA Merrill Lynch forecasts the euro/US dollar and US dollar/Japanese yen to reach 1.25 and 105, respectively, at year-end. The strength of the dollar will depend heavily on the 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. BofA Merrill Lynch forecasts Brent and WTI crude oil prices to average $70 and $59 per barrel, respectively, in 2019. In metals, BofA Merrill Lynch remains cautious about copper because of Chinese downside risk. BofA Merrill Lynch also forecasts gold prices will rise to an average of $1,296 per ounce, but could go as high as $1,400, driven by US twin deficits and Chinese stimulus.