2019 Market outlook: Emerging market debt and equities show promise

2018 was a year of exceptionalism for U.S. equities, however this was particularly for the first three quarters as U.S. equities were hit harder in the fourth quarter, says Dave Makarchuk, the strategic growth leader for Mercer’s Canadian Wealth Business. Year-to-date, the S&P 500 index was down 5.9 per cent as of Dec. 20, 2018 in U.S. dollars, whereas in Canadian dollars year-to-date it was up 1.3 per cent. This compares to the broader market, which was down 7.8 per cent in local currency year-to-date as of Dec. 20, 2018, while in Canadian dollars it was only down by 2.3 per cent year-to-date.

Looking ahead, emerging market equities are expected to outperform their developed market counterparts because their cheaper starting points give them more room to run, the outlook noted. At an earlier stage in their business cycle, emerging market stocks could also present an opportunity as negative sentiment driven by trade tensions and the stronger U.S. dollar has caused an outflow from these markets of late.

Fixed Income

Generally, the outlook also took a negative view on government and corporate bonds. However, it pointed to potential in emerging market local currency debt as an opportunity, noting attractive yields and that currencies that were oversold lately may be due for a rebound.

Further, the inflation outlook is reasonably positive for emerging market bonds as economies are expected to grow without significant capacity restraints and labour markets have room to tighten, the outlook said.

Is there a safe haven in the late-cycle?

Aside from cash it would be difficult to call anything a safe haven, says Makarchuk.

Canadian fixed income with any duration was close to flat for most of the year for 2018 and it’s quite possible that that’s the best it does in 2019 as well and perhaps even less if credit spreads widen out, he says.

It’s hard to argue why longer-term Canadian bonds are a good investment right now “other than for defined benefit plans that unequivocally just want to match their interest rate risk,” he adds, highlighting for example, Canadian long-term federal bonds yield 2.19 per cent as of Dec. 20, hardly enough to provide meaningful real returns into the future.

He recommends plan sponsors should look to low-beta solutions. “Anything that has low beta, but a higher expected return is the foundation of a tactical or dynamic recommendation for us right now.”

Diversification

Heading into 2019, defined benefit plan investors should focus on diversification, says Makarchuk.

“It’s very much about re-assessing and re-affirming what your objectives are. For plans that are very mature, that are closed, that might wind-up within five years or so, I think there’s a healthy conversation that they can, and should, have in terms of ‘what are we trying to achieve’, ‘how much more return do we need’ and perhaps now’s the time to take advantage of yields that are a little higher than where they were a year or two ago,” he says, explaining that annuity purchases and other de-risking strategies are a little cheaper than they were 12 months ago.

“Maybe we need to diversify our portfolios even further, find lower beta, find more alternatives . . . because it’s really difficult to see how traditional Canadian universe bonds are going to support a valuation discount rate that sponsors will find attractive. The yields just aren’t there.”