28 Jan 2019

Principal Global Perspectives - 2019's biggest risks

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by Robert F. Baur, Ph.D. , Executive Director, Chief Global Economist
Seema Shah, Senior Global Investment Strategist
Todd Jablonski, CFA, Chief Investment Officer
Table of Contents: 

The new year holds some uncertainty for investors. Our investment professionals deliver the three biggest macro, market, and portfolio construction risks they’re focused on in 2019.

3 biggest macroeconomic risks

Bob Baur, chief global economist, Principal Global Investors

1. Debt problems in China. This isn't a near-term issue, but one that could have significant impacts. Over the last 15 years, China’s total debt has grown massively, and uncertainty around repayment of that debt could affect global markets. The catalyst might be a drop in housing prices in China. A broad drop might spook investors, pushing investment out of China. That movement would pressure the yuan. Interest rates would likely rise and China might move to devalue their currency. If confidence drops, business would likely lower capital investment. If consumers got more jittery, retail sales could fall. You could then start seeing debt problems in companies and state-owned enterprises, where the bulk of China’s debt sits. The impacts would likely expand out of China, pressuring emerging markets that do business with China and countries like Germany that export to China. Lower demand from China could also move oil prices and broader commodities down.

2. Big business pessimism spurs US recession. I don’t see a US recession on the horizon but, at the end of 2018, investors have seemed to catch the idea that a recession was in the cards precisely because the stock market was going down. As the stock market stumbled, sentiment among business leaders dropped as well. In the December Duke CFO Global outlook, nearly half of the chief financial officers surveyed said that they think the US will be in recession by the end of 2019. And a full 82% thought that recession would start by the end of 2020.1 The risk here is that continued downward momentum in the stock market convinces business leaders that a recession is coming, and they begin to hunker down and create the conditions to bring on a mild recession. Almost a self-fulfilling prophecy.

3. Central bank missteps.  Risks could come from either outright policy errors or from misinterpreted communications from some of the world’s largest central banks. As an example, in the US, Federal Reserve (Fed) chair Jerome Powell was chastened after the central bank’s December meeting. The stock market plummeted after his comments were interpreted as “full speed ahead” on tighter monetary policy. The Fed and Powell reversed course in January, emphasizing patience instead of further gradual rate hikes. Avoiding downside will require not only smart policy, but also deft communication.  

3 biggest market risks

Seema Shah, senior global investment strategist, Principal Global Investors

1. Widening credit spreads. Over the last decade, record-low interest rates and markets awash with liquidity led to a debt binge. BBB-rated corporate bonds (one notch above high yield) now account for around half of the investment grade universe in the US and Europe. Slowing growth and rising interest rates imply weaker profit growth, and corporates will face challenges improving their balance sheets after this significant increase in debt. If the Fed restarted its rate-hiking cycle and their balance sheet reduction continued, coupled with a continued economic slowdown, cash would become a viable asset class again, sharply squeezing credit when leverage is high.We could see BBB-rated credit falter and drop into the high yield universe, creating potential market liquidity problems. Be cognizant of the risks and focus on companies with strong balance sheets, wide profit margins, and stable revenues.

2. Self-fulfilling market meltdown. Market tantrums can sometimes feed on themselves as confidence starts to plummet. If financial conditions deteriorate significantly further–perhaps because the Fed defies market expectations and resumes its hiking cycle this year—a period of negative market performance might weigh heavily on business and consumer confidence. This could raise the risk of recession, causing markets to tumble even further. Financial markets would not just be a leading indicator of recession, but a driver.

3. Trade war evolves to tech war. Trade discussions appear to be advancing, but recently the focus has shifted from China’s current account to China’s quest for tech domination. Issues around technology and intellectual property take time and effort to resolve, and the technology sector is already feeling the heat. Recently introduced US controls of exports to a Chinese chip maker suggest that investors should be extra-cautious of US technology sub-sectors like hardware and equipment, given their supply-chain exposure to China. Further US pressure via export controls is likely, with negative repercussions for the tech sector. How important could that be? Between April 2009 and October 2018, earnings growth for the MSCI ACWI Index, excluding technology, was just under 400%, whereas the MSCI tech sector alone was over 950%. If the tech sector stumbles, the broader market stumbles.

3 biggest portfolio construction risks

Todd Jablonski, chief investment officer, Principal Portfolio Strategies

1. Total portfolio risk. From the perspective of an asset allocator, my biggest concern is the total amount of risk in a given portfolio. Even with the market corrections from 2018, many investors are still underestimating the amount of risk in their portfolios and overestimating their return potential. Investors should review and potentially pull back their allocations to higher-risk asset classes (equities, corporate credit, emerging markets, and high yield) to their neutral “true north” in their portfolios. If investors have shifted to a more defensive position, it might be good to ask if they’re defensive enough given current market conditions. The key here is to question your risk and return assumptions, and make sure that the previous decade of high returns and low volatility haven’t skewed your views.

2. Equity factor risk. I’m looking beyond just the portfolio allocation to equities and into the specific systemic factors or exposures that comprise your equity allocation. Liquidity, momentum, quality, size, value, and volatility are the most commonly cited equity factors. Getting that mix correct in 2019 is key. Right now, I’m emphasizing a US factor approach that biases toward quality and low volatility. From an asset allocation perspective, getting the factor mix right within equities is going to an important determinant of results.

3. Manager selection risk. Asset allocators often pick managers to do the investing. This is the risk that with the changing character of markets and the economic recovery, the managers you’ve identified, and their particular processes, may not be correctly suited to implement your active, passive, or smart-beta strategies. Within our long-horizon active-management focus, my primary worry is managers whose alpha series becomes unreliable—or whose volatility is higher than anticipated—in the current market regime. This is to say that in 2019, it will be more important to focus on manager selection than on the idiosyncratic components that their processes deliver.

 

1Source: Duke CFO Global Business Outlook, https://www.cfosurvey.org/wp-content/uploads/2018/12/Q4-2018-US-KeyNumbers.pdf

 

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