Global Central Banks: Taking 2019 Off!

21 March 2019

At its March meeting, the US Federal Reserve signaled it would keep interest rates unchanged in 2019. In a similar fashion, the European Central Bank (ECB) at its recent gathering signaled interest rate hikes will be delayed until next year, and additional monetary support was forthcoming. But, that’s not the end of the story! Indeed, with the exception of Turkey  (where monetary policy will be eased significantly), monetary policy in all G20 countries will remain on hold this year. In fact, of the 40 countries I cover, only a handful of small markets will shift interest rates in 2019 (and even in these cases, rates will be altered only once in India, Norway, Czech, Colombia, and Indonesia). The world’s central bankers are taking the year off!

An additional year of accommodating monetary conditions should be supportive of global equities this year, if a global reccession is avoided. However, important differences exist with the previous holding period for monetary policy (2010-15). During the earlier interval, accelerating US profit growth propelled inexpensive stock markets higher, with the S&P 500 outperforming world-wide markets by a significant margin. In 2019, by contrast,  economic activity and improvements in corporate profitability (Earnings per Share advances) are expected to be lacklustre, with an especially sharp deceleration in the USA.  As we will discover, these conditions lead to important strategic conclusions. First of all, the US S&P 500 will underperform global markets. And, unlike the earlier period in which growth-oriented sectors/markets outperformed, I anticipate the combination of low, steady interest rates and sub-trend economic growth will favour income/dividend generating opportunities. Both factors point to Europe.

Receding Inflation Risks: The Heart of the Matter

The central reason for the extension in the period of ultra-low interest rate policy is that despite the long economic expansion, tightening labour markets, and accelerating wage growth (in some cases), inflation remains stubbornly low. However, important distinctions exist between countries. The Chart above illustrates that amongst the G4 nations, core inflation has risen only in the USA during the past year,  reflecting accelerating US labour compensation (wages gains are up 3.4% compared to 2% in 2017). Even in the USA, however, underlying price pressures have receded lately: core inflation has risen only 1.5% (annual rate) since last Summer compared to the Fed’s 2% target. The Chart also shows headline inflation has slowed as well. Lower oil prices will continue to cap both headline and core inflation in the USA and elsewhere in 2019.

In the other G4 nations, despite 10 years of economic expansion, core inflation actually has decelerated during the past year! In the Eurozone, despite a modest pickup in pay gains (from 1.8% to 2.3% during the past 12 months – still lower than in the USA), core inflation remains stubbornly low at 1%. Moreover, falling petroleum quotes are already producing sharply lower headline inflation, which will cap  underlying price rises in 2019. Indeed, the ECB’s recent cuts in its inflation forecasts indicate they believe price gains will remain well below its 2% goal through 2022 at least. And in the United Kingdom, now that the inflationary impact of sterling’s depreciation has run its course, both headline (below the BOE’s target currently) and core pressures have receded, despite rising wage growth. And, Japan…need I say more!

The low, stable inflation conditions also exist within Emerging Markets. In Asia, the Chart highlights that in all cases except Indonesia, price gains are lower than a year ago — in part helped by reduced energy costs (in particular, note the deceleration in inflation since last Summer). In both Mexico and Brazil, the impact of past FX weakness has run its course, and price growth will decline this year. Similarly, the deleterious effect of previous FX devaluations is now over in Turkey, South Africa, and Russia. Inflation will head lower, especially in Turkey (which might actually meet its 12% objective).

Profit Growth: Not Like It Used to Be!

Financial markets would not be encouraged by the continuation of low interest rates, if it signaled the onset of global recession.  And, to be sure, the combined impact of slower US growth (as the impact of last year’s fiscal stimulus fades), European political and economic woes, Chinese deleveraging, and growing concerns about protectionism have taken their toll on global manufacturing activity. Therefore, unlike the 2010-15 period when corporate earnings advanced strongly, the Chart above indicates that world-wide EPS gains are already slowing markedly — a pattern which will prevail through 2019.

The Chart above illustrates the EPS slowdown will be most significant in the USA, as growth slows, wages rise, and the impact of corporate tax cuts fades. With US exports, capex, and housing all slowing, the consumer must be relied upon to prevent a more serious slump. But, despite healthy fundamentals (solid wage, employment, and income gains), US retail sales have cooled in recent months. I do expect a pickup in coming months, but this must be watched.

Adjustments in Germany’s auto industry led last year’s slowdown in industrial activity throughout the region. Fortunately, however, recent indicators point towards a tenative recovery, especially outside Germany (Chart below). And, the Chart above illustrates that resilient (if unspectacular) household spending has offset the weakness in the factory sector.

Even though Europe will avoid a recession in 2019, the region’s long-term growth potential remains less than 1.5% annually. Therefore, while EPS growth will outpace the USA this year, I expect only a 4-5% gain. However, the following Chart illustrates that European corporate profits are still well below the peak level of the previous economic cycle, suggesting EPS has scope to expand further in coming years if recession is avoided.

Already, concerns about the Sino-US trade dispute are taking a toll on Asian exports, as the next Chart highlights. Fortunately, the earlier Chart illustrates hefty retail sales gains throughout the region have helped cushion the impact of slumping external trade. Even in China, where household spending has cooled, retail sales are still expanding over 8%.

However, China confronts additional growth headwinds. In particular, the following Chart shows that little progress has been made in addressing the nation’s ballooning debt burden. I do expect further efforts to stimulate GDP, which should focus on measures to boost household incomes and spending (and encourage the desired transition to consumer-led growth). Policies that impede inevitable deleveraging (e.g. supporting SOEs) run the risk of making the inevitable adjustment more painful and disruptive.

Valuation: Dividends Becoming More Valuable?

To be sure, the continuation of low, stable interest rates are supportive of global equity markets. However, additional monetary easing will not be a market driver in 2019. Likewise, modest and slowing EPS growth is not likely to be the fuel propelling stock markets meaningfully higher.

Under these conditions, I believe dividends will be an increasingly important component of returns during the next 12-24 months, which should influence country and sector relative performance.

Where can value be found? The Chart above indicates that the gap between European dividend and bond yields has never been more attractive. Likewise, the Earnings Yield Gap (the spread between the yield on corporate earnings and fixed income) is also near record levels. Thus, the European P/E could still expand significantly, and propel equities higher if recession is avoided. Buy Europe!

Exactly the same situation exists in Japan. Overweight Japan!

Stable US interest rates also favour EM equities, which are cheap on Price/CashFlow metrics. Likewise, EM stocks are inexpensive relative to bonds, although not to the extent existing in Europe and Japan.

The United States is an exception. The next Chart indicates that after the recent rally, US equities are not especially cheap versus bonds. (To be fair, however, a longer-term chart does suggest that equities still represent good value compared to fixed income). Relative valuations, therefore, favour international markets compared to the USA in the next 12-24 months. In my 2019 Global Strategy (published last September) I forecasted the S&P 500 would remain in a volatile 2,400-2,900 range this year, with the prospect of higher interest rates producing periodic, sharp setbacks. With the Fed on hold diminishing downside risks, I reset this year’s range at 2,600-3,000 with a year end target of 2,800 (16X 2019 EPS).

Strategic Implications
  • Central banks are taking 2019 off: only a handful of monetary authorities will alter interest rates this year.
  • Monetary support and the avoidance of global recession will support equity valuations again through 2019, even as profit growth slows. Favour equities over bonds.
  • Overweight Europe, Japan, and EM versus the USA.
  • Dividends will be a greater component of returns, which should influence sector and country allocations.