which cyclical and structural trends will drive markets in

Which cyclical and structural trends will drive markets in 2019?

Barings’ teams across public and private markets weigh in.

December 2018

FIVE TRENDS TO WATCH IN 2019

INTRODUCTION

The past year has been a strange one for global growth as the

recovery fell out of synch. The United States accelerated following

large tax cuts and loosening government regulation. European

growth was good, but stumbled under the political uncertainty

around Britain’s exit from the European Union and Italy’s boisterous

new challenge to bond markets. Japan offered some bright

spots in corporate earnings and wage growth, but reflationary

pressures remained weak. Meanwhile, China’s growth slowed as the

government tried to puncture real estate bubbles. While there were

no obvious signs of recession as 2018 ended, it is hard to make the

case for a global acceleration in the months ahead. This has left

most investors looking for attractive valuations and strong balance

sheets, as they look for signs that GLOBAL GROWTH may fade.

Speaking of balance sheets, the long global recovery has brought

with it RISING RATES AND HIGHER LEVELS OF DEBT,

especially in the developed world. Amid broad agreement that

quantitative easing proved indispensable after the financial crisis and

has been a significant contributor to recent growth, the second part

of the experiment has yet to play out. The asynchronous unwinding

of large central bank balance sheets will be tricky, and investors will

explore the implications of rising rates. The U.S. Federal Reserve

(Fed) is furthest along, with Europe following behind. China’s central

bank turned more accommodative toward the end of the year,

while the Bank of Japan (BOJ) seemed likely to continue its loose

monetary policy even as its economy showed signs of improvement.

Vulnerable emerging markets were suffering the effects of rising U.S.

rates and a stronger dollar, but careful investors were paying close

attention to the affordability of debt everywhere.

President Trump’s talk of more AGGRESSIVE TRADE MEASURES

against both allies and rivals seems to have triggered brief reactions

in the U.S. markets, but it has been difficult to connect these with

any broad impact on corporate profits. While agreements with

Korea, Mexico and Canada made those trade relationships more

predictable, the escalating tariffs on U.S.-China trade persisted

amid even more acrimonious exchanges. The dialogue continued

and both sides hinted at the possibility of more talks, but it was hard

to imagine a durable solution. These added costs were not likely to

undermine global growth on their own, but they had an immediate

impact on some firms and sectors and created fresh investment

risks amid rising uncertainty about the longer-term direction of the

world’s largest bilateral trading relationship.

D R . C H R I S T O P H E R S M A R THead of Macroeconomic & Geopolitical Research

Amid these key cyclical trends, investors are also struggling

increasingly to assess the impact of technological change and

especially A DATA REVOLUTION THAT IS RESHAPING BUSINESS MODELS in the most unexpected sectors. There

are already clear winners across both public and private markets,

especially among firms that own valuable data sets and know how

best to exploit them. Some of the losers are already apparent, but

many more will likely materialize next year if they fail to understand

the ways in which their value propositions can be undermined by

cheaper, faster and better alternatives.

Demographic changes are slow but mostly predictable. Developed

economies have been grappling with the CHALLENGES OF AGING POPUL ATIONS, and especially the costs of rising

dependency ratios as fewer workers support more retirees. The

macro challenges will likely contribute to expectations of lower

growth and rising public debts. Yet increasingly, these policy

challenges come with investment opportunities in more effective

ways to deliver health care, more affordable options in senior

housing and more creative ways of catering to retirees with

savings to spend.


WILL GROW TH FADE NEX T YEAR?TREND ONE‘Steady as she goes’ remains perhaps the best bumper sticker for

the global economy as the year ends, even if investors remain alert

for signs of deceleration. The International Monetary Fund (IMF)

is projecting global growth of 3.7% for 2019, which would match

the growth rate for both 2017 and 2018 (Figure 1). Although global

growth is expected to remain fairly stable, there are divergences

among several economies. In the U.S., momentum is still strong as

Fed tightening is offset by potent fiscal stimulus. Solid growth, low

inflation and restrained labor costs continue to produce a favorable

environment for strong corporate profit growth. In Europe, leading

indicators point toward a modest slowing of growth momentum,

with Purchasing Managers’ Indexes (PMIs) continuing to decline

from cyclical highs reached in 2017 (Figure 2). Within the eurozone,

trade protectionism concerns and Italian fiscal woes are weighing

on the economy and impacting confidence. Similarly, the ongoing

Brexit process continues to cloud the U.K. economic outlook.

Among emerging market economies, initially the outlook of many

energy exporting countries had brightened due to higher oil prices,

but prospects have dimmed for countries like Argentina, Brazil and

Turkey due to tighter financial conditions and domestic political

concerns. China may also encounter weaker growth in 2019 amid

the fallout from trade tensions, but policymakers have deployed

bold measures to cushion the pain.

The year ahead will likely bring continuing headwinds: more rate

hikes, more conflict on trade and more volatility in emerging

markets. There are also countervailing forces that may offer

support. Fiscal stimulus in the U.S. and China continues to work its

way through the financial system. Aggressive easing by the People’s

Bank of China (PBOC) should also eventually help boost global

growth prospects. While the U.S. yield curve has flattened, global

yield curves, especially in China, have steepened.

A key balancing act will be the unfolding policy handoff from

monetary stimulus to fiscal stimulus and structural reform. The

transition from a slower central bank balance sheet and money

supply growth to higher money velocity will be key to maintaining

steady growth, in our view. Although corporate earnings growth

has been strong, the lagged effects of corporate tax reform could

support future capital expenditure growth. If these offsets do not

prove sufficient, investors will likely take a more cautious approach

and focus on companies with strong balance sheets and reliable

cash flows.

Figure 1: Steady as She Goes?IMF Global Growth Forecasts

SOURCE: IMF. As of November 13, 2018.

2.362.34

2.131.72

89

0% 1% 2% 3% 4% 5% 6%

2.031.88

1.65

2.39

Euro Area

2.882.22

2.541.82

U.S.

DM

4.684.72

4.684.93

EM

3.733.74

3.653.66

World

2018 (f) 2019 (f) 2020 (f)2017 (a)

Figure 2: Fading From Cyclical HighsGlobal Purchasing Managers Index

SOURCE: Factset. As of October 31, 2018.

Jul-16 Oct-16 Jan-18 Apr-18

54.0

53.5

52.5

51.5

50.5

JP Morgan PMI Manufacturing Sector, PMI Index, SA—World

54.5

53.0

52.0

51.0

50.0

Jan-16 Apr-17 Jul-17 Oct-18


WILL RISING R ATES END THE DEBT BOOM?TREND TWODebts have been rising and now they are getting more expensive.

Global central banks continue to inject liquidity into the financial

system. The Fed has signaled a continuation of the tightening cycle

and expects to raise rates three times in 2019. The European Central

Bank (ECB) is likely on hold for the next 12 months, and Bank of

Japan (BOJ) rate hikes appear to be distant at best. While rising

rates represent a return to normalcy and a partial validation of the

unprecedented post-crisis monetary response, the expanding levels

of debt will likely amplify the effect of rate increases. Data from the

Institute for International Finance shows global debt levels swelled

by $8 trillion in the first quarter of 2018 to over $247 trillion, or 318%

of global GDP.1 In the U.S., total credit market debt outstanding

ballooned 30% over the last decade to $70.2 trillion as interest rates

hit historical lows2 (Figure 3). Over that time, however, we have

had a significant risk transfer from the private to the public sector.

Households deleveraged significantly and are arguably in their best

financial position in decades. The aggregate level of corporate debt

has increased, but we believe that measures such as debt-to-cash

flow or debt-to-net worth suggest reasonable levels of leverage.

Government sector debt, however, has more than doubled since

2008. This has resulted in more federal revenue going to interest

expense despite record-low borrowing levels. As rates rise, this

burden will likely become even more onerous.

Outside of the U.S., higher rates and a stronger U.S. dollar have

exposed some of the weakest links in emerging markets. Recent

selloffs and major currency depreciation have so far been limited

to the more vulnerable economies—those with a combination of

excessive short-term external debt, a large current account deficit

and high domestic inflation. A stronger U.S. dollar and higher rates

increase these countries’ debt servicing costs. Still, most emerging

market countries appear more resilient. Even among the countries

with current account deficits, the balance of payments has

improved recently. Additionally, we have generally seen emerging

market inflation rates converge toward developed market levels.

Corporate fundamentals remain strong despite the increase in

debt levels. Profit margins are near all-time highs and cash flow

growth is robust. Despite their recent rise, spread levels are still

well below average in both the investment grade and high yield

corporate markets, an indication that investors feel adequately

compensated for default risk. While duration has increased in the

investment grade segment over the last decade, making those

bonds more sensitive to rising interest rates, duration in the high

yield market has remained fairly constant (Figure 4). Ultimately, the

ability to digest a higher cost of capital will come down to whether

or not the current growth environment enables companies to

spend borrowing proceeds productively and generate the earnings

required to service debt.

Figure 3: Rising U.S. DebtsU.S. Total Credit Market Debt & Leverage

SOURCE: Factset. As of June 29, 2018.

$10T

$20T

$30T

$40T

$50T

$60T

$70T

2.2x

2.4x

2.6x

2.8x

3.0x

3.2x

3.4x

3.6x

3.8x

Total Credit Market Debt Outstanding—U.S.

Credit Market Debt Outstanding/GDP—U.S.

1994 1998 2006 20101990 2002 2014 2018

Figure 4: Investment Grade More Susceptible to Rate HikesU.S. Corporate Investment Grade & High Yield Bond Duration

SOURCE: Factset. As of October 11, 2018.

3.5

4.5

4.0

5.0

5.5

6.0

6.5

7.0

7.5

Bloomberg Barclays U.S. Corporate Investment Grade—Modified Duration

Bloomberg Barclays U.S. Corporate High Yield—Modified Duration

2010 2011 2013 20142009 2012 2015 2016 2017 2018

1. Source: Institute for International Finance. As of July 9, 2018.2. Source: U.S. Federal Reserve. As of November 13, 2018.


WILL TR ADE RHETORIC FINALLY HIT PROFITS?TREND THREEThe trade war expanded through 2018, but its impact differs across

countries and sectors. From a macroeconomic perspective, even

the expanding list of goods that have been subjected to tariffs

is unlikely to alter the course of global growth significantly. U.S.

exports account for only 12% of the country’s economy and China’s

exports are barely 19%, with the actual Chinese contribution

even smaller.3 In any event, trade volumes to the U.S. through the

summer were actually expanding by 4%.4 While the IMF warned of

the consequences of rising trade barriers, its forecasts only suggest

a cumulative 0.3% reduction in global growth in 2019.5

Yet the questions remain high on the minds of investors as they

grapple with the potential impact of trade rhetoric on their returns.

Average global tariffs have been steadily falling, from 8% in 1900

to roughly 2% today6 (Figure 5). But populist politics in many

countries may stall further progress, and there will be winners and

losers as a result.

Emerging markets that have grown along with expanding volumes

of trade now face the consequences of this greater friction. Firms

that have been increasingly dependent on complex international

supply chains have been forced to reconsider the risks and potential

costs. Even those that are more reliant on supplies closer to home

can find themselves victim to ricochet effects—a foreign competitor

shut out of the U.S. market by a tariff, for example, may redirect

larger volumes to a market a U.S. firm had hoped to enter.

In some cases, tariff costs will be quietly passed along to the end

consumer. In others, a stronger currency may help cushion the

impact of what have become more expensive imports. Sooner or

later, however, these costs will begin to erode corporate profits, an

area we expect investors to be watching carefully over the next year.

Harder to assess is the added uncertainty around investment

returns. Firms planning to expand production facilities will need to

assess the likelihood that a fresh round of tariffs may shut them out

of what they believe is a promising market. Rather than building

one large plant, they may feel compelled to hedge their bets—at

significantly greater cost. They may be forced to forego economies

of scale for guaranteed market access. The early trends have been

worrying with Foreign Direct Investment to the U.S. falling 24%

(Figure 6) and to China rising 25%.7

Figure 5: The Trade War in ContextGlobal Tariff Rate

NOTE: Average tariff rates across 16 countries, including Australia, Canada, Germany, Denmark, Spain, France, the U.K., Italy, Japan, Norway, Portugal, Sweden and the U.S.SOURCES: Goldman Sachs; Clemens and Williamson (2002); World Bank. As of October 15, 2018.

0%

5%

10%

15%

20%

25%

1890 1915 1965 19901865 1940 2015

Average 1 Standard Deviation Band

Figure 6: Long-term Risks to Foreign InvestmentU.S. Net Foreign Direct Investment

$0B

$60B

$40B

$20B

$80B

$100B

$120B

$140B

SOURCES: Factset; U.S. Bureau of Economic Analysis. As of June 29, 2018.

1988 1993 2003 2008 20131983 1998 2018

3. Source: International Monetary Fund. As of October 15, 2018.4. Source: Factset. As of Oct 15, 2018.5. Source: International Monetary Fund. As of Oct 15, 2018.6. Sources: Goldman Sachs, Clemens and Williamson (2002), World Bank. As of Oct 15, 2018.7. Source: International Monetary Fund. As of October 15, 2018.


WHO IS LEADING THE DATA REVOLUTION?TREND FOURComputing and storage costs have been falling for more than a

century. Annual performance gains by some calculations topped

30% per year through the 1900s.8 More recent data suggests that the

exponentially declining trend for computing costs has yet to abate

and will likely continue well into the future (Figure 7). Together with

cheaper storage and expanded mobile networks, this technology

now supports complex algorithms to make better decisions on a

range of activities from the operations of critical infrastructure to the

behavior of consumers. In our view, while companies that own or

control the data will enjoy a tremendous advantage, the real winners

will be those who know what to do with it.

Perhaps one of the most important macroeconomic implications

of the data revolution is its ability to greatly improve productivity

across the entire economy, as robots, driverless cars and natural

language processing systems all powered by this underlying data

slash labor costs across a variety of tasks. An equivalent increase in

output is also likely. Though the capital costs associated with any

new technology tend to be high, the benefit achieved over the long

term will likely be much more pronounced. As increased capex

spending and technological integration flow through to increased

productivity, we expect the improving fundamental picture to also

be supportive of valuations. This should create a virtuous cycle of

risk-taking, investment, productivity and growth.

The generation of new data will likely only accelerate (Figure

8). The greatest challenge, in our view, is how best to use the

results for business decisions or operational gains. Another part

of the challenge is implementing a business model that is unique

and creative enough to take advantage of data and technology

in ways that legacy competitors often cannot. Moreover, while

media giants are able to harness consumer data and activity,

these datasets are largely isolated from one another. Even within

individual firms, large media players struggle to keep systems

connected and operable across business units, which can prove

a herculean task. One final hurdle is that as the predictive quality

and value proposition of raw data itself becomes a competitive

advantage, management teams may be increasingly reluctant to

share it publicly. Still, through the next year and beyond, we expect

to see winners and losers across all industries, from health care to

financial services to entertainment. Opportunities will also likely

emerge around companies that are building the ‘picks and shovels’

of this next revolution, whether that be 5G networks, cloud storage

or semiconductors.

Figure 7: The Falling Cost of ComputingTotal Cost Per Unit Computing Power (Nominal Dollars)

CO

ST

OF

CO

MP

UT

ING

$140B

NOTE: Computing cost is measured in Giga-Floating Point Operations Per Second, a unit measure of computing power. Y-Axis is in logarithmic scale. SOURCE: AI Impacts. As of November 13, 2018.

2008 2010 2012 2013 2014 2016 20172006 2009 20180.01

0.1

1

10

Figure 8: The Exponential Growth in Data

NOTE: Measured in zettabytes. 2013-2017 (a); 2018-2025 (f). SOURCES: Goldman Sachs; IBM; IDC; McKinsey Global Institute (Dec 2017). As of October 3, 2018.

180

44

2211

5.52.81.40.70.3

2013 2016 2017 2018 2019 2020 20252014 2015

8. Source: Nordhaus, William D., The Progress of Computing (September 2001). As of November 13, 2018.


HOW WILL AGING SOCIETIES BEGIN TO AFFECT RETURNS?TREND FIVELow birth rates and lengthening lifespans in developed nations are

leading to an aging workforce and to stagnation in the size of the

national workforce. Average life expectancy grew 5.5 years between

2000 and 2016, according to the World Health Organization, the

fastest since the 1960s. While much of this is driven by better health

care in developing countries, the ratio between the elderly and

those of working age (15-64), has been steadily increasing globally.

Nowhere is the story more advanced than in Japan, where the

total number of elderly account for nearly half of all working aged

individuals. Europe and China are not too far behind (Figure 9).

At the macroeconomic level, more people working longer and

saving longer may help keep the natural rate of investment lower.

There are broad consequences for individual savings and spending

patterns, too. Workers can be productive for longer and many

people will live to an age they thought unimaginable when they

started saving for their pensions. Retirement is being pushed to a

later date, as evident in the labor force participation rate of those

between 60 and 64, which has seen a steady global increase since

the start of the century (Figure 10). This is perhaps due to both

individual choice and institutional and government decree.

For investors, an aging population means opportunities may arise

from a greater number of elderly consumers. Among the more

active, there are demands to fill leisure time with a wider variety

of music, live entertainment and travel options. There will also be

demand for new configurations of real estate designed specifically

for older residents, ranging from more active communities to

assisted-living facilities to intensive care. We expect to see more

creative ways to deliver appropriate medical care, from simple clinics

to hospices. There is also a potential role for artificial intelligence in

the provision of elder care as firms develop robots that can provide

24-hour monitoring. Meanwhile, for elderly consumers who did not

save enough during their lifetimes to fund their retirement, there will

be an increased demand for creative retirement solutions such as

reverse mortgages and life settlement agreements.

Figure 9: The Expanding Ranks of RetireesAge Dependency Ratio

NOTE: Age dependency ratio is the ratio of older dependents (>64) to the working-age population (15–64). Data are shown as the proportion of dependents per 100 working-age population. SOURCES: Haver Analytics; World Bank. As of December 31, 2017.

0

5

15

30

40

45

35

25

20

10

50

U.S.Euro Area WorldJapanChina

1962 1974 1998 201019561950 19861968 1980 1992 2004 2016

Figure 10: The Graying WorkforceLabor Force Participation (60–64)

SOURCE: OECD. As of December 31, 2017.

0

10

40

60

70

50

30

20

80

OECDEuropean UnionU.S.Japan

1974 1982 1998 2008 201219721968 19901978 1986 1994 2002 2016

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