At the start of 2018, we argued that while the economic outlook was strong, the certainty of rising short-term interest rates will have implications for the relative valuation of all asset classes. This implied that for equity markets, P/E multiples will need to fall, and consequently price returns will be less than earnings growth. For fixed income markets, this implied that long duration bonds will perform poorly, but credit spreads are likely to remain stable.
Developments during the course of the year have demonstrated our view to be right in many ways. US equity valuations have indeed declined, even though the US equity market rallied through part of the year. Long term US dollar bond yields rose, while credit spreads did not widen in a meaningful way. However, developments in the rest of the world pointed to important additional factors at play.
The loss of growth momentum in Europe proved to be a significant headwind to European equities, despite attractive valuations. The rally of the USD against other currencies triggered sharp falls in emerging market equities and fixed income assets. The Chinese equity market showed signs of considerable stress, due to a deterioration of the growth outlook as well as rising trade tensions. By October, increasing uncertainties in the US led the market to erase all gains for the year, despite solid earnings growth and GDP data.
As we look to the period ahead, there are three questions that dominate our outlook. At what point will the adjustment in relative valuations stabilise? What is the outlook for corporate profitability, and how is it being impacted by the shifting landscape of global trade? How sustainable is global growth?
The “buy the dip” paradigm is over
Looking over the past 9 years, buying equities at every market correction was a rewarding strategy. Two forces underpinned this performance. The economic growth trajectory was solid, and monetary policy was exceptionally loose. The nominal return on cash was zero, or even negative in some regions.
Cash has a positive real return again. With US inflation at 2%, and Libor above 2%, the return on cash has a slightly positive real return, compared to a negative real return for most of the period since the global financial crisis.
At the start of the year, cash yielded about 1% while the S&P was trading at forward P/E of 17x, implying an earnings yield of almost 6%, a difference of about 5%. Today, cash is yielding more than 2%, but the forward earnings yield of the S&P 6.25%, a difference of 4.25%. This means that despite the market correction, and increase in earnings, the attractiveness of equities relative to cash has declined, not increased.
Valuation metrics are open to various interpretations and are not the only driver for the market. A key driver of the market is the outlook for corporate profitability.
Corporate profitability is at risk
The outlook for corporate profitability is complex. On one hand, global growth continues at a solid pace. In the US, the economy is growing above its long-term potential rate. In Europe, while some deceleration has been experienced this year, employment and retail figures do not suggest an imminent downturn. The same is true in China, where growth has slowed, but the government has loosened monetary policy.
Why, then, are we concerned about profitability? We see two red flags. The first is the current point in the economic cycle. The second is the evolution of the global trade environment.
Corporate margins, especially in the US and some Asian markets (including China) are at, or near, all-time highs. Global growth has become more uneven across different regions but is decelerating in most major economies. This will be especially true of the US in 2019, where the impact of this year’s tax cut stimulus will begin to dissipate next year.
Being in a late stage of an economic expansion, the early signs of lower profitability have started to emerge. Full employment in the US has pushed wage growth above inflation, an early indicator of margin compression. The picture is similar in some European economies, such as Germany. The trade disputes initiated by the Trump administration cloud the picture further. Following two decades of progressive trade liberalisation that integrated global supply chains, rising tariffs are a new cost on business that, if not passed through to consumers, will take a toll on profitability.
No one can credibly claim to foresee how the trade disputes will ultimately be resolved. What is becoming increasingly clear, however, is that they will not be resolved soon. China is accusing foreign microchip manufacturers of price collusion, dragging Korea and Taiwan into the maelstrom. The US is offering to subsidise telecom infrastructure in countries that spurn Chinese manufacturers. In Europe, public unease with the taxation of large global IT companies has triggered proposals for taxation based on national revenue streams, rather than overall profitability. In other words, the trade disputes are metastasising beyond the rhetoric of a narrow arithmetic of bilateral trade balances, to encompass national security and issues related to global taxation and competition.
The implications of these developments on corporate profitability cannot be easily deduced. Some global sectors are less exposed to disruption than others. Lower value-added industries are less exposed to globally integrated supply chains, and hence less impacted by rising trade costs. But lower-value added industries are also the most commoditised, and hence face the highest price competition, while having structurally low margins.
While the exact impact of these developments is hard to foresee, the direction of the impact is not. All indicators point to downward pressure on profit margins. The only factor that can sustain margins at current levels is a pick-up in global growth.
How sustainable is the global economic expansion?
We’ve pointed to a lot of reasons why we see more downside than upside risks to earnings, but is it possible that growth can be sustained at current levels or accelerate? The answer to this question depends on investment and productivity, and subject to a high degree of uncertainty.
Fiscal and monetary policies are unlikely to provide further stimulus. In the US, fiscal policy has already provided a substantial stimulus in 2018, and given the divided outcome of the mid-term elections, it is highly unlikely Congress will accept further widening of the deficit. In Europe, developments in Italy and the UK, are raising risks, and consequently tightening financial conditions throughout the EU. At the same time, the ECB is eyeing an end to quantitative easing. In China, the government is inclined to provide further stimulus, but only to the extent that it cushions the deceleration of the economy, not to engineer an acceleration. In other words, we see policies geared away from fiscal and monetary accommodation in most regions.
This leaves only one source of potential growth: productivity growth through the deployment of new technologies. This is certainly likely to play a critical part in the next phase of growth. However, it is also important to recall that the penetration of many new technologies, whether robotics or Artificial Intelligence, remains relatively low in most sectors.
The point at which the economic cycle turns, however, may not be very material to the markets, which are invariably forward looking. We are currently seeing the beginning of what is likely to be a recession in earnings that will precede any recession in the real economy. By the time a recession materialises, markets will be looking forward to the next recovery.
Next year is unlikely to be a rerun of 2018
While many of the questions we pose for next year are similar to the questions we had earlier in 2018, we also believe that the markets are unlikely to produce a similar outcome. At some point early next year, we will have greater clarity regarding the end of the Fed’s tightening cycle. The trajectory of Brexit is expected to have greater clarity by the end of March. The ECB would have ended its quantitative easing program. More importantly markets would have had more time to absorb the reality that global trade flows are adjusting to a less globalised, more national-focussed economic paradigm. In other words, many of the factors underpinning the current uncertainties should begin to decline. While we started to progressively increase our allocations to cash in early 2018, we expect to gradually start reinvesting over the course of 2019.