Foresight | October 2019: key macro themes and market outlook

In the past six months, financial markets have had to counterbalance two opposing market forces: trade tensions and dovish monetary policies. How will these conflicting developments impact risk assets?

As we move closer to 2020, it appears the headwinds created by trade-related uncertainty are beginning to outweigh the benefits of lower rates. The global economy is in a manufacturing recession; U.S. growth is slowing materially, China’s economy remains, at best, a neutral global influence and, at worst, a structural drag on global trade. However, against this backdrop of muted growth and elevated uncertainty, there remain upside risks that we believe are worth considering, such as the possibility of a de-escalation in trade tensions, a structurally strong U.S. consumer that exceeds expectations, and the beneficial effects of looser financial conditions globally, thanks to monetary easing.

It’s through this lens that we formulate our return forecasts for the various asset classes over the next five years. Our forecasts are derived from a wide number of sources, including input from the team of macroeconomic strategists who are embedded within the asset allocation team. While our long-term forecasts lean heavily on model-based valuation estimates, we firmly believe that macroeconomic views play an important role in identifying short-term investment opportunities in actively managed portfolios.

Chart of five-year asset class forecasts, expected returns, as of September 30, 2019. In U.S. dollar terms, 5-year expected total returns for U.S. large cap is 3.7%, 6.8%  for U.S. mid cap, 6.3% for U.S. small cap, 8.1% for Canadian large cap, 6.8% for Europe, Australasia and Far East large cap, 7.4% for Europe, Australasia and Far East small cap, 9.4% for emerging market equity, 5.1% for U.S. real estate investment trusts, 5.7% for global real estate investment trusts, 8.6% for global natural resources, 1.9% for U.S. investment-grade bonds, 4.5% for U.S. high-yield bonds, 5.1% for U.S. bank loans, 5.1%  for emerging-market debt, and 1.4% for global bonds.

Key macro views

Short-term macroeconomic themes

  • Uncertainty caused by trade tensions is weighing on global trade volumes, manufacturing activity, and business confidence. While the unpredictable nature of geopolitical developments means that uncertainty could rise as well as fall in a short span of time, we don’t expect these tensions to disappear over the next year. This continued uncertainty around the outcome implies that investors will seek safe assets, which would in turn provide sustained support for the U.S. dollar (USD).
  • Globally, central banks in both developed and emerging markets are engaged in a monetary policy easing cycle which we expect to continue in the coming six months. Lower rates should ease financial conditions and support rate-sensitive sectors.
  • An interesting divergence is unfolding in the U.S. economy: When combined, these two factors imply that the United States might experience a few quarters of more modest growth and negative sentiment attached to it. However, given the important support provided to the consumer and residential real estate markets in the form of lower interest rates, we don't expect a recession in the near term and would view overly negative sentiment as an intriguing entry point.
  • Asia remains caught in the crosscurrents of trade tensions and China’s increasingly active stimulus program. Unfortunately, we expect that Chinese growth will, at best, stabilize; the “positive feedthrough” on the region and global trade will be much more muted than before.
  • With key economies in the region flirting with a manufacturing recession and prolonged geopolitical uncertainty weighing on the outlook—a lot of which has already been priced into European assets. On a longer term basis, continued easy monetary policy and any removal of the above factors could lead to a re-rating, sending prices higher, which would make European equities an attractive asset class from a valuation perspective over the medium term.
Table indicating the asset allocation team’s views of different asset classes in the next 6 to 12 months, as of September 30, 2019. The team has a moderately positive view of U.S., European and Japanese equities. It has a neutral view of emerging-market equities and Canadian equities. The team has a moderately negative view of U.S. fixed income, European fixed income, Japanese fixed income and Canadian fixed income. However, it has a moderately positive view of emerging-market debt.

Longer-term strategic views

  • We expect global interest rates to remain at current or lower levels for several years as global growth struggles to hit “escape velocity” to above potential. This low growth environment in turn implies a prolonged period of easy monetary policy, because key central banks would lack the conditions required to allow them to embark on a path toward normalization.
  • With a global trend toward structurally low interest rates, “search for yield” will continue to be an important investment theme that will favor asset classes that can provide investors with positive carry; emerging-market debt would be one such example.
  • We continue to see limited inflationary pressures over our five-year forecast horizon. The combination of low growth and low inflation suggests a flatter yield curve over the multi-year period than we have seen in prior economic cycles.
  • China, the world’s second-largest economy, is likely to continue to structurally decelerate, creating downside pressure on global trade activity on a long-term basis. While the country’s economic growth previously translated into a tide that lifted all boats, its transition to a developed market and consumer-based economy has global market implications. That said, for both valuation and carry reasons, emerging markets (EM) remain an attractive asset class over our forecast horizon.
Table indicating the asset allocation team’s views of different asset classes from a three to five-year perspective, as of September 30, 2019. The team has a moderately negative view of U.S. equities. It has a moderately positive view of emerging-market equities, European equities, Japanese equities and Canadian equities. In terms of fixed-income assets, the team has a neutral view of U.S. fixed-income assets and Canadian fixed-income assets during that time frame. It has a moderately negative view of European fixed income, and a bearish view of Japanese fixed income. However, the team has a positive view of emerging-market debt from a three to five-year perspective.
Table outlining the team’s views for each asset class. Short-term view for U.S. fixed income. Over the last 12 months, the key question relating to monetary policy has morphed from “how many more hikes?” to “are recent Fed cuts a simple policy adjustment or something more akin to a conventional easing cycle?” We currently anticipate two more interest-rate cuts by the end of the first half of 2020, but acknowledge that there is a distinct possibility of more aggressive easing should the macroeconomic backdrop deteriorate further. From a more strategic perspective, we believe, at this stage, that the U.S. Federal Reserve (Fed) will opt for a prolonged pause once the current easing cycle has ended. This is why we expect longer-duration U.S. Treasuries to come under some pressure, but corporate returns are likely to remain favorable. We view high-yield bonds (HY) and leveraged loans more favorably than U.S. investment-grade (IG) debt. In our view, HY should benefit from the relatively benign interest-rate and credit environment.  Short-term view for emerging-market debt. We expect EM central banks, particularly those in Asia, to embark on a sizable monetary easing exercise. This is particularly true in China, where monetary and fiscal policy is supportive of the asset class. From a strategic perspective, we think the quality of EM debt has been improving on a structural basis, and we view the asset class as a higher quality credit relative to U.S. HY and loans. We also favor the “carry” that the asset class offers. Within the group, we expect local currency sovereign debt to provide the most returns. Broadly speaking, we believe EM debt stands out from a total return perspective. Short-term view for European fixed income. As with the United States, the current picture in Europe is completely different from what it was earlier in the year. With the European Central Bank (ECB) having cut rates and engaged in another round of quantitative easing (QE), we expect European sovereign yields to remain anchored at current levels. From a strategic perspective, the “Japanification” of Europe (i.e., sustained deflationary pressure and weak demographics) could be problematic and keep a lid on rates and hamper growth. With the ECB having explicitly linked QE to inflation, we believe the central bank will either maintain its current level of policy accommodation or ease further over the next few years. Short-term view for Canadian fixed income. While Canadian fixed income has benefited from lower global yields, we expect the Bank of Canada to follow other global central banks’ lead and eventually ease monetary policy. From a strategic perspective, we think Canadian rates should benefit from a stronger Canadian dollar (currency return), marginally higher rates (matching U.S. rates) over the medium term, and positive price returns. Returns for Canadian investment-grade (IG) bonds should match their U.S. counterparts, with mild currency appreciation potentially providing a modest benefit to Canadian IG issues. Short-term view for Japan fixed income. In the short term, we expect minimal movement in the country’s interest rates, barring any material appreciation in the Japanese yen. From a strategic perspective, we expect interest rates in Japan to remain at, or near, 0%, subject to some volatility. Inflationary pressure in the country is likely to remain negligible throughout our five-year forecast period, and we expect muted total returns in this asset class.
A table showing the expected five-year returns for fixed-income assets in U.S. dollar terms. As of September 30, the asset allocation team expects five-year total return for U.S. investment-grade bonds to be 1.9%, 2.6% for Canadian investment-grade bonds, 4.5% for U.S. high-yield bonds, 5.1% for U.S. bank loans, 1.6% for U.S. Treasury Inflation Protected Securities, 5.1% for emerging-market bonds, and 1.4% for the fixed-income multiverse.
Table outlining the team’s views for each asset class as of September 30, 2019. Short-term view for U.S. equities. Trade policy uncertainty is weighing on consumer and business sentiment, which is beginning to filter through to hard economic data. While this softening at the margin is something that needs to be closely monitored, we maintain that the United States still has the best overall growth profile among developed economies. From a more strategic perspective, the United States has the healthiest macro profile in the developed world. Unfortunately, unsustainable valuation, profit margins, and sales growth point to possible relative downside risk that could hamper returns. Over the medium term, the USD could also hurt the asset class’s returns as other economies’ currencies appreciate relative to the greenback during a cyclical upswing. Short-term view for emerging-market equities. We remain cautious about this asset class during the next few months due to uncertain global trade conditions, which are closely linked to EM earnings growth and market returns. From a strategic perspective, valuation remains attractive in the EM equities space with potential for further upside, driven by expectations for a structurally weaker USD in the long run. We believe this asset class retains the most attractive growth profile, which should provide attractive returns in the event of a global cyclical upswing. Short-term view for European equities. Despite the likelihood of short-term volatility due to geopolitical events (Brexit and potential trade tensions are top of mind) we believe that depressed valuations will revert back to higher levels as global manufacturing/trade impulse stabilizes. From a strategic perspective, our analysis suggests that valuation and dividend profiles for this asset class remain attractive; however, the investment case for European equities is partly counterbalanced by their weak growth profile. While an expected appreciation in the euro could translate into a tailwind, the ECB’s recent dovish turn is likely to cancel out any benefits from exchange rates in the medium term. On balance, we continue to view the asset class as being modestly attractive. Short-term view for Canadian equities. Valuation for Canadian equities remains bifurcated, with financials and energy trading at a discount while the other major industry groups are richly valued. Slowing global fundamentals also warrant caution. From a strategic perspective—an analysis of the dividend profile for Canadian equities suggests the asset class remains attractive over the longer term. The same can be said from a valuation perspective (particularly with reference to the energy and financials sectors, which make up about half of the index). Short-term view for Japanese equities. There are reasons to be incrementally more optimistic about Japan: Earnings momentum has improved relative to other developed markets and, while not positive, some higher frequency data points suggest they’re stabilizing. While the consumption tax increase could be disruptive in the short term, we expect the government to be better equipped to insulate the effects of the hike than in previous instances. From a strategic perspective, we believe structural factors in favor of Japanese equities include inexpensive valuation, continued improvement in corporate governance, and buybacks, which should provide a good counterbalance to the market’s modest growth profile. We remain mildly positive on the asset class.
A table showing the expected five-year returns for developed market equities in U.S. dollar terms. As of September 30, the asset allocation team expects five-year total return for U.S. large cap to be 3.7%, U.S. mid cap to return 6.8%, U.S. small cap to return 6.3%, Canadian large cap to return 8.1%, Canadian small cap to return 9.3%, Europe, Australasia and Far East large cap equities to return 6.8%, Europe, Australasia and Far East small cap equities to return 7.5%, world equities to return 5%, European equities to return 6.9%, and Japanese equities to return 5.8%
A table showing the expected five-year return for emerging-market equities in U.S. dollar terms. As of September 30, the asset allocation team expects five-year total return for emerging-market equities to return 9.4%, Chinese equities to return 7.9%, Indian equities to return 9.3%, Latin American equities to return 11.9%, Brazil equities to return 11.7%, and equities in all Asian countries excluding Japan to return 8.9%.
Asset allocation's views on alternative assets. Short-term views of U.S. real estate investment trusts. Sentiment toward the asset class continues to be positive on the back of the Fed’s dovish stance and the potential returns on offer relative to investment-grade fixed-income securities—a not insignificant factor within the current “search for yield” environment. The promise of consistent cash flows against a backdrop framed by stable interest rates and declining equity growth forecasts can be very appealing. However, rising long-term interest rates remain the biggest relative risk for this asset class. From a strategic perspective, we expect U.S. REITs to outperform modestly over a longer timeframe. From a yield perspective, we favor the asset class over many IG bonds. Fundamentals supporting the asset class are likely to stay solid, but late cycle concerns could continue to limit its appeal. Additionally, valuation for the asset class looks set to remain rich, even as growth slows. Short-term views of global natural resources. Oil is at the lower end of our rangebound outlook. Valuations for energy equities are attractive but more catalysts needed for investors to return to this unloved asset. From a strategic perspective, we expect the asset class to outperform global markets (including EM) based on the potential for valuation expansion and high dividend yield. Expectations for higher oil prices, along with positive dynamics in gold and copper markets, should provide additional support for natural resource equities. Short-term views of hard assets, or real estate in the United States and Canada. We expect income growth to remain above average, driven by generally strong demand fundamentals and a restrained supply pipeline. Although valuation gains have moderated from their peak earlier in the cycle, we expect these gains to remain near current levels given the strength of capital market activities and stable interest-rate outlook. From a strategic perspective, we have a favorable view of the asset class. In our opinion, its characteristics— income generation, stability of returns, low correlation with other assets and inflation protection—will continue to appeal. Specifically, we think the overall strength in underlying fundamentals and an environment that emphasizes “search for yield” will support continued gains in the North American real estate markets.
A table showing the expected five year return for alternative/real assets in U.S. dollar terms. As of September 30, the asset allocation team expects five-year total return for U.S. real estate investment trusts to be 5.1%, 8.6% for global natural resources, 6.6% for global listed infrastructure, and 6.3% for commodities.
A table showing the expected five-year return for hard assets in U.S. dollar terms. As of September 30, the asset allocation team expects five-year return for global farmland to be between 9% - 11%, with a historical deviation of 4.5%. They expect global timberland to return between 9% - 11%, with a historical deviation of 6.6%. The team expects five-year return for U.S. commercial real estate to be between 6% and 8%, with a historical standard deviation of 7.6%. The expected five-year return for Canadian commercial real estate is also between 6% and 8%, with a historical standard deviation of 3.5%. Finally, the expected five-year return for U.S. infrastructure is between 9% and 14%.

Index definitions

 

NCREIF Farmland Index
The NCREIF Farmland Index is a quarterly index that measures the performance of a large pool of individual U.S. farmland properties acquired in the private market for investment purposes only. The composition of the index can change over time—for example, when assets are sold, and when new Data Contributing members are added. As such, the Farmland Index may not be representative of the agricultural investment market as a whole.

NCREIF Timberland Index
The NCREIF Timberland Index is a composite return measure of investment performance of a large pool of individual U.S. timber properties acquired in the private market for investment purposes only. It is updated quarterly and is reported on a national level. The index is subdivided into three regions: the Pacific Northwest, South, and Northeast. The composition of the index can change over time, and as such, may not be representative of the Timberland investment market as a whole.

NCREIF Open End Diversified Core Equity ODCE Index
This is a capitalization weighted, gross of fee, time-weighted return index with an inception date of December 31, 1977. Open-end funds are generally defined as infinite-life vehicles consisting of multiple investors who have the ability to enter or exit the fund on a periodic basis, subject to contribution and/or redemption requests.

MSCI/REALPAC Canada Quarterly Property Fund Index
The MSCI/REALPAC Canada Quarterly Property Fund Index covers unlisted open-end real estate funds operating in Canada. The index measures the investment performance at the property and fund level. The index is based on funds with a total net asset value of CAD$32.1 billion, as at December 2018.

Cambridge Associates LLC Infrastructure Index
The Cambridge Associates LLC Infrastructure Index is a horizon calculation based on data compiled from 93 infrastructure funds, including fully liquidated partnerships, formed between 1993 and 2015. Private indexes are pooled horizon internal rate of return (IRR) calculations, net of fees, expenses, and carried interest.

 

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Nathan W. Thooft, CFA

Nathan W. Thooft, CFA, 

Senior Portfolio Manager and Global Head of Asset Allocation

Manulife Investment Management

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Frances Donald

Frances Donald, 

Chief Economist and Head of Macroeconomic Strategy

Manulife Investment Management

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Alex Grassino

Alex Grassino, 

Senior Investment Strategist, Macroeconomic and Strategy Team

Manulife Investment Management

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Benjamin W. Forssell, CFA

Benjamin W. Forssell, CFA, 

Client Portfolio Manager, Global Multi-Asset Team

Manulife Investment Management

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