Outlook 2019: Answers to 7 key questions

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Can the U.S. bull market continue? Will the Fed keep raising rates? Our Chief Investment Office (CIO) addresses these questions and more — and points to potential investing opportunities.
The opinions are those of the author(s) and subject to change.
After a strong year for the U.S. economy, but a volatile one for the markets, investors have many questions about what's ahead in 2019, both here and abroad. Our CIO team sees several powerful waves of change on the horizon — and how they play out could have a significant impact on the markets, the global economy and opportunities for investors in the coming year and beyond. The answers below provide some insight into what these changes could mean for you. For a more detailed analysis, please read Year Ahead 2019: Powerful Waves of Change.
Outlook 2019
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Outlook 2019

1. You forecast several "waves of change" coming in 2019. What are they — and do they suggest an end to the great bull market of the past decade?

Christopher Hyzy, chief investment officer for Merrill Lynch and U.S. Trust
Christopher Hyzy, chief investment officer for Merrill Lynch and U.S. Trust
"One wave is an ongoing change in the environment for investing, as we make the transition from low economic growth, low inflation, record low interest rates and low volatility in the markets, to higher growth, higher inflation and rates and a return to more 'normal' volatility levels.
The second is cyclical, marked by a change in investor sentiment and a move away from lower-quality assets — those with high debt loads and more volatile earnings — as the business cycle shifts. We support a move toward higher quality across the board, to companies that have healthy balance sheets, don't need capital market financing, have strong global brands and are able to protect their profit margins.
The third wave of change is geopolitical, and it largely involves the U.S.-China trade relationship. Any short-term resolution is likely to be less than stellar and temporary in nature — like the 90-day 'tariff truce' that emerged from the G20 meeting in Buenos Aires in late 2018. And in the longer term, the dispute could significantly disrupt the global supply chain, negatively affecting corporate earnings.
We don't think the bull market is over, but we do believe we're in the beginning stages of the ending process.
Despite these concerns, we don't think the bull market is over, but we do believe we're in the beginning stages of the ending process. Meanwhile, as global economic growth remains challenged, the U.S. expansion should slow. We expect U.S. gross domestic product growth of around 2.5% in 2019, and for equity markets to rise about 5% from their year-end levels, in line with growth in corporate earnings."

2. What's ahead for stocks after the volatility of late 2018 — and how should I prepare?

Niladri Mukherjee, head of CIO Portfolio Strategy, Bank of America Global Wealth and Investment Management
Niladri Mukherjee, head of CIO Portfolio Strategy, Bank of America Global Wealth and Investment Management
"Investors should be prepared for ongoing market volatility in 2019 and should expect moderate levels of returns from U.S. stocks. The Federal Reserve is planning to continue raising interest rates, inflation should gradually rise as the job market tightens further, and there are looming political concerns such as trade tensions with China. Given these and other factors, it's unlikely that investor sentiment will flip from its current pessimism to euphoria. Thus, valuation multiples are unlikely to expand, putting the onus on corporate earnings to support stock prices.
Still, it's important to put the current situation in the context of a bull market that is the longest since World War II. Since March 9, 2009, stocks have provided a total return of around 378%Footnote 1 (as of late November), surpassing all expectations. And the bull market may not be finished, even as the pace of economic growth slows. Though not matching the torrid 20% or higher growth rate of 2018, corporate earnings are expected to rise by a respectable 5%-6% in 2019.
Though not matching the torrid 20% or higher growth rate of 2018, corporate earnings are expected to rise by a respectable 5%-6% in 2019.
We believe investors should be well-diversified across all asset classes and regions, and consider large, high-quality companies with healthy balance sheets, higher levels of cash and lower debt. And while we recommend U.S. over international stocks, investors shouldn't abandon international stocks completely, since they offer attractive values.
Finally, as interest rates rise, investors should consider the income potential of dividend growth stocks — both U.S. and international — as well as cash and short-term corporate bonds."

3. Interest rates have been creeping up for a while now, but what's the Fed's plan for the coming year, and how might it affect my finances?

Matthew Diczok, fixed income strategist, Merrill Lynch and U.S. Trust
Matthew Diczok, fixed income strategist, Merrill Lynch and U.S. Trust
"The Fed has sent signals that it's likely to raise interest rates several times in the next few years. At the same time, markets are suggesting that the Fed is probably closer to what it considers the 'neutral' rate — the rate that's neither too hot nor too cold, where the economy grows and inflation is stable — than the Fed thinks it is. The investor nervousness we've seen in both stock and bond markets suggests that we're closing in on the neutral rate — that going too much further too quickly could risk derailing the economic expansion. But so far, statistics on business investment, consumer spending and bank lending still look healthy. If those start to slow, the Fed may see a reason to press pause on rate hikes — and comments from Fed chairman Jerome Powell in late November suggested the Fed may be beginning to lean in that direction.
The Fed may see a reason to press pause on rate hikes — and comments from Fed chairman Jerome Powell in late November suggested the Fed may be beginning to lean in that direction.
The Federal Reserve has two things that it focuses on: stable prices and full employment. Right now, it's got both. The U.S. economy has continued to add jobs and we're not yet seeing inflationary pressures build up.
Last year was painful for fixed income investors. We saw increases in both short- and long-term interest rates and this led to price drops across the board for high-quality bonds and other fixed income assets.
The silver lining is that most of those rate increases are behind us. You can now invest at higher yields and could easily beat inflation, which wasn't the case for years. Also, mortgage rates are expected to grow more slowly going forward, and they're still very low historically."

4. What can we expect from Washington, given the outcome of the midterm elections? How could divided government affect the markets?

Marci McGregor, investment strategist, Bank of America Global Wealth and Investment Management
Marci McGregor, investment strategist, Bank of America Global Wealth and Investment Management
"To sum it up in one word: gridlock. That's not necessarily bad. It means there likely won't be anything significant policy-wise coming out of Washington between now and 2020. But at the same time, there's probably not a consensus to undo any of the policies we've seen that have helped growth. So maybe nothing gets done, but nothing gets undone, either.
There is the potential for a modest infrastructure bill that could get bipartisan support. Another bipartisan target could be lower drug prices. That could be a negative for certain parts of health care, but with the divided Congress, there's also a reduced risk that the Affordable Care Act will be repealed, and that could be helpful.
One potential risk to the markets is that the debt ceiling will have to be raised. We think ultimately that will happen, but the road to get there could be quite bitter and divisive.
One potential risk to the markets is that the debt ceiling will have to be raised. We think ultimately that will happen, but the road to get there could be quite bitter and divisive. That process, or any threat of a government shutdown, could bring uncertainty to capital expenditures by businesses. Usually Washington doesn't have much impact on the market, but if business investment slows, that could certainly have an impact on growth.
In all of these scenarios, investors would do well to remain focused on fundamentals and long-term goals. There could be investment opportunities if an infrastructure bill passes. But also keep in mind that while there is often a market correction in midterm election years, markets tend to bounce back afterwards. We think the type of mixed-government gridlocked scenario we have now is often actually pretty good for markets."

5. The U.S. economy has been pretty good for a while now. Looking into 2019, does it still have room to run?

Jonathan Kozy, senior macro strategist at U.S. Trust
Jonathan Kozy, senior macro strategist at U.S. Trust
"If the economy keeps growing through the middle of 2019, the current economic expansion will be the longest in the postwar period. But just because this cycle is long doesn't mean it's coming to an end.
One reason to be optimistic is the strength of U.S. consumer spending, which makes up 70% of the economy.Footnote 2 Consumers are benefiting from a strong labor market, decent wage growth that is probably accelerating, low gas prices and manageable debt levels.
One reason to be optimistic is the strength of U.S. consumer spending, which makes up 70% of the economy.
Among businesses, spending growth hasn't been as high as many hoped following the recent tax cuts, but businesses did ramp up technology spending in 2018, which could lead to higher productivity down the line.
Housing starts began slowly in this cycle and never really took off. We're still building only enough homes to keep up with demand, so inventory is lean. On the other hand, Millennials are providing a tailwind as they move into single-family homes. Even with rising mortgage rates, housing could grow at a decent clip in the coming year.
Add all this up, and it means growth is likely to slow somewhat but still hold in the 2.5% to 3% range, which is above the long-term trend. If there's a recession around the corner, it's likely to be mild, given that overall leverage in the economy is not excessive."

6. What geopolitical events are you watching for, and how might they affect U.S. and global markets?

Joseph Quinlan, head of CIO Market Strategy, Bank of America Global Wealth and Investment Management
Joseph Quinlan, head of CIO Market Strategy, Bank of America Global Wealth and Investment Management
"First and foremost is the ongoing tension between China and the United States. That's not just about trade; it also involves security, technology transfer and investments. At the same time, if there is lower than expected Chinese growth, that could hurt U.S. exporters, which depend on China as a big source of earnings.
Second is how fragile the European Union looks given Brexit, the populist movement across the continent and EU parliamentary elections in May that could add to the populist surge. We're not predicting disaster for the EU, but any further fraying could bring weaker growth, a weaker euro and a stronger dollar and a decline in earnings for U.S. multinationals.
Finally, there are concerns about the Middle East and about the emerging markets in general. Many are caught in the backwash of the U.S.-China trade spat. And with the Fed raising rates, investment capital typically will be pulled out of emerging markets as risks there go up.
The best-case scenario for the U.S. and China is that they find some path by which they can both carefully move on.
The best-case scenario for the U.S. and China is that they find some path by which they can both carefully move on. In Europe, the best hope is for the status quo — the EU holds together and Europe muddles along at, say, 1% growth. In the Middle East, it will be important for oil production to be at a level that keeps oil prices in the $60 to $80 per barrel range. But the U.S. could be slightly more insulated from what happens in the Middle East because this year it became the largest oil producer in the world, surpassing Russia and Saudi Arabia.Footnote 3 In the emerging markets, investors need to avoid a lot of failed states — in North Africa, Venezuela, Afghanistan and Syria, and Russia is an outlier — but there are also plenty of places to put money to work, including Thailand, Taiwan, Malaysia and South Korea."

7. Looking beyond trade tensions, what's ahead for China and other emerging markets?

Ehiwario Efeyini, senior market strategy analyst, Bank of America Global Wealth and Investment Management
Ehiwario Efeyini, senior market strategy analyst, Bank of America Global Wealth and Investment Management
"China has slowed from a peak of well over 10% GDP growth before the 2009 global crisis to around 6.5% today. Even aside from the trade tensions, that trend should continue as its population ages, incomes rise and the economy shifts from being investment- and export-driven to relying more on services and domestic consumption. Growth will also be constrained in the nearer term by government efforts to rein in the rapid debt buildup of the past decade. But even though growth will be lower than it has been in the past, China will still be one of the fastest-growing economies in the emerging world.
The strong dollar and the rise in U.S. interest rates have been the biggest challenge for countries with large current account deficits, high levels of dollar liabilities as a share of their GDP and high inflation rates. This applies more to Latin America and EMEA (Europe, the Middle East and Africa) than to the Asia-Pacific region, and the severe market weakness in Turkey and Argentina has been the most extreme case in point. These markets would be the biggest beneficiaries of a Fed pause or a dollar reversal.
We still like emerging markets as long-term opportunities for investors, especially from current valuations. For Asia in particular, we think the rise of the middle class will remain an important theme.
Despite these uncertainties, we still like emerging markets as long-term opportunities for investors, especially from current valuations. For Asia in particular, we think the rise of the middle class will remain an important theme. Large, lower-income economies like India, Indonesia and the Philippines, among others, remain an important theme. Those economies are still growing at over 5%, which implies a rapidly growing demand for discretionary items. This should favor sectors such as technology, consumer discretionary, consumer staples and health care, which account for more than half the market capitalization of Asia."
For weekly insights on the markets and the economy from the Chief Investment Office, read "Capital Market Outlook."
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Footnote 1 Source: Bloomberg, as of 11/20/2018

Footnote 2 Source: U.S. Bureau of Economic Analysis, 2018

Footnote 3 Source: The Energy Information Administration, Sept. 2018 https://www.energy.gov/articles/us-becomes-world-s-largest-crude-oil-producer-and-department-energy-authorizes-short-term

This material was prepared by the Chief Investment Office (CIO) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the CIO only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch or U.S. Trust entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

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