Quantitative easing has been the only game in town for years but the game is now changing. Ten years into the longest bull run in history, major dislocations are starting to appear, characterised by bouts of volatility as we return to a more normal investing environment.
The US effect
In this more volatile environment, we expect US corporate earnings growth to slacken in 2019, but remain positive, at around 8 or 9 percent. An unusual set of circumstances boosted year-on-year growth in US earnings per share to an average of around 24 percent in the first three quarters of 2018. The cocktail of lower corporate taxes, a reduced regulatory burden, and a growing economy helped the US market outperform those of other countries. These factors are however one-offs and we expect their impact on earnings growth to fade in 2019. US earnings will grow but at a reduced pace, more in line with the performance of the real economy.
Companies may well start to see headwinds, such as rising cost inflation, intensifying in 2019. Labour-intensive sectors are the ones most exposed, and we will be closely watching the extent to which freight cost inflation and increasing wage costs are borne by consumers. We see a risk that companies will have to absorb some of this, putting pressure on margins.
The debt threat
The biggest threat to equities in 2019 is debt.
The 10-year quantitative easing experiment, coupled with a debt-fuelled boom in China, has left the world with a big tab to pay.
Central banks lowered the cost of debt funding in response to the global financial crisis in 2008, and there is a natural limit to how far and how fast they can normalise it. Given the sheer amount of debt in the global economy, a full return within a few years to the aggregate interest rate of last cycle (around 4.5 percent) is simply unaffordable. While the global aggregate interest rate increased from 1.2 per cent to 2.2 percent over the last two years, going further than this could risk triggering a new financial crisis, something no central bank is willing to do.
Markets are also prone to over-react to events that cloud the short-term outlook. As an investor, it is important to take a step back at these times and keep an open mindset.
Problems in the debt market have the potential to spread to other parts of the financial system which is why we’re paying attention to the Italian bond market and the Chinese corporate bond market. We’re more concerned about China than Italy. While the Italian bond market is the biggest in Europe, it’s predominately in the hands of domestic investors, who think long term and don’t panic in periods of market volatility. The Chinese market is less mature and is experiencing its first ever credit cycle, marked by a first wave of defaults. Chinese policymakers have a lot of tools available to them to stimulate the economy in response but it remains to be seen how investors will react.
A note on volatility
Above all else, financial markets dislike uncertainty. Yet markets are also prone to over-react to events that cloud the short-term outlook. As an investor, it is important to take a step back at these times and keep an open mindset. When we’re prepared at the outset for episodes of volatility on the investing journey, we’re less likely to be surprised when they happen, and more likely to react rationally. By having an open mindset and a longer-term investment perspective that accepts short-term volatility, investors can begin to take a more dispassionate view. Not only does this help with the job of staying focused on long-term investment goals, it also allows investors to begin to exploit lower prices rather than lock in losses by emotionally selling at lower prices.