The cycle’s end is far from imminent
Early December’s decision to embrace a more optimistic outlook for 2020 has proved advantageous. Easing geo-political tensions and signs of stabilising growth have seen international and domestic equity markets reach new highs in early 2020 while bond yields remain well above their cycle lows. But as is often the case, each year brings new challenges. Market valuations in early 2020 have quickly become stretched, while the recent coronavirus outbreak in central China is denting sentiment about near-term growth.
Yet 2020 does not appear to hold an imminent end to the cycle. Absent a new array of geo-political shocks, the world’s current ‘new normal’ of moderate growth, low inflation and relatively stable rates looks set to persist for now. While equity indices were up strongly in 2019, average gains look less threatening when the late 2018 correction is included. Together, even as the cycle matures, these features argue for remaining invested and engaged, and taking tactical risk opportunistically.
Macro data and geo-politics have unfolded favourably
As December last year got underway, the potential de-escalation in a number of 2019’s geo-political hotspots, together with tentative signs that the rout in global industrial activity was beginning to ease, led us to adopt a more optimistic portfolio position. We closed our tactical underweight to equities, moved more underweight fixed income, and instigated regional equity overweights in the UK and emerging markets. Since then, macro data trends and geo-political developments have unfolded favourably.
Geo-political tensions have eased over the past two months. The UK Conservative Party secured a larger-than-forecast majority at the mid-December election, with the Brexit Withdrawal Agreement subsequently passing both the UK and European parliaments. In mid-January, the US and China signed a phase-one trade deal. China agreed to buy more US goods over the next two years and increase penalties for intellectual property theft. The US agreed to cancel the mid-December tariffs (while prior tariffs largely stay in place), while also recanting its designation of China as a ‘currency manipulator’. In a move that could extend the calm, the US and China agreed to delay a phase-two deal until after November’s US presidential election. Military action between the US and Iran was also avoided.
Activity data have also shown signs of stabilising. Over the past couple of months, signs of stabilisation have emerged in China (with a December pick-up in industrial production, retail sales and exports). Purchasing manager indices (PMIs) across the UK, Japan and Europe have moved higher in January, while US growth has proved resilient near 2% (with solid consumer spending and signs of a pick-up in housing activity). In Australia, business and consumer confidence remains subdued, and concerns have grown about the impact on growth from the recent devastating bushfires (and any impact of the coronavirus on tourism). However, in late 2019, jobs growth has accelerated, the unemployment rate has fallen to a nine-month low, house prices and lending have continued to rise and consumer spending has lifted.
Are stretched equity markets now more vulnerable?
In December, when we closed our underweight to equities, already full valuations at the later stages of the cycle (admittedly in absolute terms rather than relative to low bond yields), led us to open tactical overweights in those markets where valuations were relatively more attractive. This included emerging markets and the UK, funded by an underweight to Australia.
Since then, equity markets have rallied solidly, rising almost 2.7% in the US, over 2.5% in Australia and by more than 2% for emerging markets. Indeed, a casual glance at equity returns for 2019 undoubtedly flags caution about expecting similar returns for 2020. World equity markets rose by around 25% in 2019, led by a rise of 29% in the US. In Europe, the UK and Australia, equity indices gained more than 20%, while Japan and emerging market indices rose by more than 15% (see the table below).
However, as also shown in the table below, when we include the sharp (near-bear market) correction for equity markets in late 2018, over the past couple of years, the per annum (pa) returns, excluding dividends, look far less breath-taking. Indeed, global equities have risen by just 6% pa over the past two years. The US market remains the stand-out with annualised gains of about 10%, followed by Australia with 6%. Most other markets returned less than 4%, while emerging markets, including Asia, have contracted.
Of course, with little material improvement in the earnings outlook, valuations have risen from arguably fully valued levels in early December to be well above their 10-year averages (see table above). In particular, on a 12-month forward price-to-earnings (P/E) basis, domestic and US markets are now more than three points higher than their 10-year average.Source: Bloomberg, UBS, Crestone.
Reflecting this, we continue to hold a tactically neutral position in equities (though overweight relative to fixed income). And we are tactically overweight those markets where valuations are closer to their long-term averages, such as the UK and emerging markets. In terms of our key tactical positions:
We are underweight domestic equities—we remain constructive on the Australian economy, with the consumer and housing sectors showing some signs of stabilisation. By mid-2020, we expect growth to pick up to 2.0-2.5%, supported by 2019’s rate cuts and modest income tax cuts. Reduced geo-political tension should also help, as should recently announced fiscal measures supporting post-bushfire reconstruction and aid. However, at 18.2x forward earnings, the Australian market is trading at its highest valuation in over 15 years. Moreover, calendar year earnings expectations are at a little over one third of that projected for the rest of the world.
We are overweight UK equities—the UK economy has endured a multi-year headwind of Brexit uncertainty that has led to material equity market valuation compression and macro weakness, particularly stalled business investment. Following Brexit, the UK has now entered an 11-month transition. While the UK equity market performed strongly in 2019, valuations remain relatively cheap and absolutely cheap on a 20-year comparison. Valuation metrics, such as dividend yield, free cash flow and price-to-book also remain relatively attractive. Capex intentions have recently rebounded and most forecasts for the British pound see further solid appreciation through 2020.
We are overweight emerging markets—in a later-cycle low-growth world, stronger growth in the emerging markets is a somewhat defensive position. The benefits of secular themes, such as digitisation and disruptive tech, are being underestimated as an accelerant to the industrialisation process. Relative to developed markets, emerging market earnings momentum and leading indicators, such as PMIs, are at seven-year highs. Asia particularly offers exposure to improving growth in the wake of the US-China trade war de-escalation, along with recently supportive policy (particularly in China) and significant corporate ‘self-help’.
Where are the risks to the 2020 outlook?
Global growth over the past couple of years has been ebbing and flowing through what can best be described as some sort of new normal. Key features of this include low growth, low inflation but still very healthy jobs markets around the world. This has tended to see growth not slow too much, nor accelerate in response to easier policy.
As discussed, over the coming year, while not quite the most dynamic of starting points, it still appears the most likely outlook for the new year, absent shocks, will be modest growth. With more stable activity and geo-politics than 2019, central banks globally are also likely to be far less active. This is a reasonably supportive backdrop for risk markets.
The risks to this relatively benign outlook come from shocks that could push the world economy more sharply in either direction.
On the downside, renewed political turmoil out of either Brexit or the US-China trade dispute has the potential to dent the macro outlook. Less likely, a near-term upswing in inflation would challenge the ongoing low interest rate environment. Either of these risks could cause a material correction unless it is offset by already unfolding improving corporate earnings momentum.
On the upside, an uplift in productivity and global investment that spurs a resurgence in global demand, trade and manufacturing activity could deliver a significantly better growth backdrop. In this scenario, stronger earnings would deliver better-than-expected equity returns (and higher bond yields).
For 2020, we once again establish key macro and market signals, which we will monitor to determine the extent we will tactically engage with risk. As with last year, geo-politics is a feature. Key macro signals around inflation and growth, as well as market signals for earnings, are included. As shown in the graphic below, relative to last August when we moved underweight equities, and November 2019 when we decided to lean more into risk, our signals have started 2020 in a more positive light.
Latest developments in the coronavirus outbreak
The recent outbreak of the 2019-nCoV (coronavirus) in central China has destabilised markets in late January. At present, its severity remains uncertain. There are some comparisons that can be made to the 2002-2003 Severe Acute Respiratory Syndrome (SARS) outbreak in Greater China.
According to experts in the US, the coronavirus appears to be more contagious than SARS; it took four months for 1,000 SARS cases to be recorded, versus less than 25 days for the coronavirus (where latest estimates put the number of confirmed cases at over 14,000). China’s economy is also a larger contributor to global activity than it was in 2002-2003. However, a significantly lower mortality rate (around 2% compared with 10% for SARS) suggests the disease may be less severe. In addition, China’s response has been earlier and more proactive than during the SARS outbreak. According to UBS, China’s health system is also more experienced than it was in 2012-13.
Like previous outbreaks, these events have the potential to significantly impact activity and dent market sentiment in the short term before activity bounces back. It is likely forecasts for growth in China, Australia and other regions may be revised lower for Q1 2020. The most significant impact of these type of events typically falls on sectors such as retail, travel and entertainment. For Australia, export sectors linked to China, such as resources and tourism, are also vulnerable.
While it remains premature to draw conclusions, there are reasons to believe that the current coronavirus outbreak may be contained in a shorter time frame than SARS (nine months). Key will be signals from authorities that the peak in the pace of the infection’s spread has been reached.
The past couple of years have been dominated by geo-political volatility that has weighed from time to time on the growth outlook, most particularly as 2019 drew to a close. Ongoing geo-political skirmishes are likely to be a feature of the ‘new normal’ investment horizon, as is the rise of emerging economies, including China, tech disruption and ongoing accelerating digitalisation of the world economy.
Behind the scenes, the preconditions for moderate global growth remain in play, including strong jobs markets, low inflation and accommodative monetary and fiscal policy. Valuations are arguably fully valued in traditional assets, particularly equities. Alternative investments continue to look attractive, reflecting end-of-cycle risks, as well as better risk-adjusted returns.
Overall, the potential for some stabilisation of global growth that underpins an improved earnings outlook in the wake of only moderate equity gains over the past two years argues that the cycle’s end is far from imminent. However, the recent coronavirus outbreak has likely somewhat delayed our more constructive outlook into mid-year. Signs the outbreak is being contained should encourage some stabilisation in markets and a refocusing of investors’ attention on medium-term fundamentals.
Finally, diversified portfolios provide the best defence to an uncertain outlook. Despite the elongated macro cycle (a feature of the unfolding new normal), conditions do not support being disengaged or disinvesting from markets. As recently highlighted by Wayne Thorpe, Senior Financial Analyst at the American Association of Individual Investors Journal, since 1871, the average time for the US equity market to fully recover is 7.9 months. Indeed, 50% of market downturns recover within two months and 80% of market downturns recover within one year, according to Thorpe’s analysis.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.