19 September 2018
As analysts return from summer holidays, they tend to extend their earnings forecasts into the next year. In this spirit, I am casting my strategic gaze into 2019 as well. In order to set the stage, a brief review of our 2018 strategic themes may be helpful. In our December essay “Aging Rally or More to Play For?” our projection of small, single-digit global equity returns has been reflected in a meagre 1% advance in the MSCI global index this year. We projected also that stocks would outperform bonds; and Barclay’s global bond index is down 2% this year. Other favourable outcomes include our overweight position in small caps equities, and a focus on the beneficiaries of tax reform in technology, health care, and capex (financials, not so good), and a strong US dollar. An important mishap, however, was our belief that international markets would outperform the USA (even though we did reduce overweight positions in Europe and emerging markets after their stellar 2017 performance). Superior US returns have reflected the out-performance of the American economy following the fiscal stimulus implemented in early 2018.
Many of the key drivers of 2018 performance should continue into next year. While I expect overall global growth will decelerate in 2019, the world-wide economy should enjoy another year of expansion, which should once again become more synchronised than in 2018. Chart 1 illustrates that tax cuts fueled stronger US growth this year, while European output slowed somewhat following a very strong 2017 gain. In 2019, I anticipate the American economy will decelerate as the fiscal stimulus fades — the Chart already hints in that direction. Likewise, the graph illustrates that European growth remains healthy, and appears posed to accelerate in the period ahead. On the other hand, China and other emerging economies are likely to cool, reflecting uncertainties on global trade and fiscal/monetary adjustments following the recent bout of FX volatility.
While global inflation risks remain modest, price pressures still are greatest in the USA. Chart 2 illustrates that US core inflation has accelerated this year, and now threatens to breach the 2% target (indeed, core CPI is already above the threshold). On the other hand, in Japan, Euroland, and the United Kingdom inflation is lower than a year ago and remains well below target.
The US Federal Reserve will continue to set the pace in tightening G4 monetary policy. I expect the Fed to maintain its quarterly 25bp rate hikes through mid-2019. By that time, with the Fed funds rate in the 3.25-3.5% range, monetary conditions would have passed through a “neutral” setting, and will have moved to a “restrictive” posture. Moreover, as the US economy cools next year, the Trump Administration is likely to become increasingly vocal in its criticism of Fed policy (I am sure you know what I mean). At that stage, I expect the Fed to pause in its rate hikes. This mix will pose considerable risks to US markets. Markets will need to assess whether the Fed has engineered a soft-landing or tightened too much, and whether they are simply reacting to White House pressure.
And, the Fed will not be alone in tightening global monetary conditions next year. Just as the Fed is pausing, the baton will be handed to the ECB who will begin raising rates next summer, albeit ever so cautiously, as will the Banks of England and Canada.
The upcoming US Congressional mid-term elections could play an important role. For now, I am assuming the Republicans will give up seats in the House of Representatives (which is normal), but not lose control of both chambers. Under these conditions (or if the Democrats do win both chambers), the White House’s legislative agenda will come to a halt, and I suspect President Trump would become even more aggressive on the trade and foreign policy fronts (which often does not require legislative support). On the other hand, if Republicans gain on polling day, I believe the President will attempt to repeal Obamacare again.
I expect the threat of trade wars will become an even greater driver of market volatility in 2019. Despite the measures implemented thus far, America’s trade deficit has actually widened over 15% in 2018. As I have written in past blogs, America’s external imbalance primarily reflects its low savings rate, which continues to decline following the recent fiscal expansion. This year’s larger shortfall reflects a 15% surge in demand for imports, while exports have risen by a similar magnitude. As the Chart above illustrates, America’s export/import ratios with Canada, Mexico, and the European Union are in line with the overall average. Consequently, despite lots of bluster, trade deals should be achievable.
China (and much of Asia, including Japan), however, is a different story. American efforts to open these markets are likely to persist, adding to risks for the region’s economies and markets. There is much China could do to assuage US concerns; however, President Trump’s tactics make this outcome unlikely at least in the near term. I believe it is now likely that US tariffs on Chinese products will be raised to 25% in January 2019.
S&P 500: Transitioning Towards a More Defensive STrategy
At the outset of 2018, we projected modest gains and heightened volatility for US equities, despite the expected earnings bonanza arising from the huge cut in corporate taxes. I still believe our S&P 500 year-end 2018 target of 2,750 is realistic. I am also establishing an S&P 500 target of 2,900 for the end of 2019 — roughly 16X 2019 Earnings Per Share. In other words, another year of modest returns. Indeed, I already detect the US equity market is transitioning towards a more defensive posture. After a long period of poor returns, more defensive sectors such as utilities, telecoms, and consumer staples have begun to outperform the overall market. As I suspect this shift is just beginning, I advocate overweight positions in telecoms, utilities, and health care; neutral stances in technology, staples, industrials, and financials; and underweight consumer discretionary, materials, and energy.
Part of the rationale is simply optical. After this year’s bonanza, EPS growth (GDP too) will decelerate sharply in 2019. I expect corporate earnings to expand in line with the overall economy next year: specifically, 5% at best.
More materially, however, I believe the US economy and monetary policy will enter a particularly tricky phase in the coming period. If my projection that the Federal Reserve will raise interest rates towards the 3.25-3.5% range is correct, the stance of US monetary conditions will have shifted from ultra-easy, through neutral, and into a restrictive setting. In addition, the US yield curve will continue to flatten, and 3-month rates could exceed 10-year bond yields by the end of 2019. As the Chart above illustrates, an inverted yield curve, has been a reliable predictor of future recessions during past cycles. While I believe the risk of a 2019 recession remains low, markets will begin to consider whether the combination of tight monetary conditions and escalating trade tensions could lead to a slump prior to the 2020 election.
From a valuation perspective, the US market is also nearing a tipping point. Indeed, the market P/E has fallen sharply this year, as investment returns have not kept pace with booming EPS growth. Moreover, the US stock market has remained pretty immune to rising interest rates in recent years. The following Chart highlights that the equity risk premium — the gap between the market’s EPS yield (the inverse of the P/E ratio) and 10-year Treasury yields — has narrowed as interest rates have risen. Now, however, the valuation of US bonds compared to stocks is approaching long-term average levels, e.g stocks are no longer cheap relative to fixed income. Ging forward, therefore, as bond yields rise (as I expect), the stock market P/E ratio will need to decline to prevent equities from becoming overvalued. All in all, the expect the P/E ratio to de-rate towards 16X 2019 EPS, which will be a major headwind and limit stock market returns again next year (target 2,900).
The Case For Europe
There are many reasons for Europe’s disappointing under-performance this year: weaker-than-expected growth, Italy’s budget and political worries, Brexit, vulnerability to a trade war, and the lack of progress on EU reform and securing the Euro’s future. Many of these issues will not be fully resolved in the near term, but there is a solid case for over-weighting European markets. First of all, Europe’s economy appears to be regaining momentum. And, European markets are considerably earlier in the earnings cycle compared to USA. The Chart below illustrates that EPS remains 20% below the peak of the previous cycles.
Moreover, European market valuations have rarely been so cheap compared to USA.
In addition, European monetary conditions will remain more accommodative than the USA, even after the ECB begins to tighten policy next summer. And, as a cushion against higher interest rates, European stocks have rarely been cheaper compared to bonds.
With deadlines looming, Brexit will be a central focus during the next six months. As I have discussed elsewhere, I believe Brexit will (indeed already has) harm the UK’s long-term growth prospects. In the next few weeks, however, I expect the EU and UK governments will find a formula to both agree a “transitional” arrangement and commit to detailing their “future relationship” over the next couple of years. To be sure, a fudge. But, UK stocks are very cheap (see Chart), so I am putting my toe in the water, and going overweight UK equities.
I encourage you to read my earlier blog, as I believe Italy still poses an existential risk to the Euro’s future (“Growth, Not Quitaly Is the Remedy to Italy’s Problems“). The following Chart highlights that considerable risks are already priced into Italian stocks, but bonds remain more vulnerable if Italy implements its planned populist fiscal agenda.
Emerging Markets: Still Too Early
Last year, I wrote that Emerging Markets faced three headwinds: The Fed, Trump’s trade policy, and weaker Chinese growth as the economy transitions (hopefully, in an orderly manner) from an exports-led to a consumer-driven growth model. As all these issues are still in play, investors should wait at least another six months before considering re-entering Emerging Markets.
Higher US interest rates and the accompanying appreciation of the US dollar will remain headwinds for export-oriented Emerging markets until the US Federal Reserve pauses next summer. Moreover, Argentina and Turkey highlight additional vulnerabilities posed by the US rate cycle. Many EM countries borrowed heavily in order to boost their economies following the Global Financial Crisis. As US rates rise, these nations are now most vulnerable, especially those with large amounts of short-term external debt. The Chart above illustrates that Turkey and Argentina are the extreme cases, but South Africa, Chile, and Indonesia are at risk. Also, nations with upcoming elections and weak macro-policy credibility remain vulnerable, e.g. Brazil. Tighter monetary and fiscal adjustment in the most vulnerable countries — such as the recent rate hikes in Turkey and Russia — will pose downside economic risks.
I will soon write in-depth about the economic challenges China confronts: Trade wars, high debt (see above), and economic transitions. But, as analysts fret about quarterly performance, I worry more that China’s long-term growth trajectory is downshifting far more sharply than markets imagine, e.g. not to 6-8% but rather towards 4-5% GDP growth. To be sure, Chinese authorities will pull on monetary and fiscal levers to easy the pain, but markets still need to adjust to the extent of China’s secular deceleration.
EM opportunities, however, will reemerge — once the Fed moves to the sidelines. The following Charts illustrates that EM stocks are not expensive, and many Emerging market currencies are very undervalued following recent volatility (especially Turkey, Argentina, Russia, South Africa, and Mexico).
strategic Implications
- Global equities will record another year of modest single-digit gains in 2019. I also expect the combination of escalating trade tensions, and signs of economic deceleration in both China and the USA will lead to a 10% slide in stock prices sometime during the next six months.
- Easy money, cheap relative valuations, and improving economic conditions should lead to a outperformance in European markets. Italy, Brexit, and the December EU summit on the region’s reform agenda make the next few months vital.
- The combination of loose fiscal/tight money US policies will continue to boost the US dollar in the months ahead. Eventually, the Fed will pause. At that stage, FX markets will shift focus to the growing American twin deficits, as well as the Trump Aministration’s apparent preference for a weaker American currency, which will reverse the USD’s appreciation. Perhaps at that stage (mid-2019), a reconsideration of emerging markets will make sense.
