Invesco’s Head of US Equities, Simon Laing and Co-Heads of Asian and Emerging Market Equities, Will Lam and Ian Hargreaves, on their outlooks for 2019
Simon Laing’s US outlook for 2019
- A balance of cheaper cyclical companies – especially within the energy sector – and more defensive companies – notably in health care and telecom – is an appropriate approach to 2019.
- Key to restoring both business and consumer confidence is a resolution to the Chinese tariff situation.
- Investors will keep a close eye on the Fed, led by a new chairman, as it continues to define its priorities. Expect three rate raises in 2019.
The US equity market entered 2018 buzzing with optimism. After strong 2017 gains, expectations for 2018 were high, fuelled by the president’s tax cut bill, improving global growth and strong corporate earnings growth. The S&P 500 Index was up over 7% by the end of January.
The subsequent fall back to earth was swift and painful and a sign of things to come in 2018. Despite the acceleration in gross domestic product (GDP) and the substantial step up in earnings growth driven by tax cuts, the S&P 500 has struggled to hold onto gains. The escalating trade war and its implication for global growth have weighed heavily on sentiment. Volatility returned in 2018 and is unlikely to hibernate in 2019.
When we think about equity markets, there are three components to return: corporate earnings growth; the valuation multiple we will pay for those earnings; and return of those earnings via dividend.
It is the valuation multiple that will be the most intriguing aspect of market returns for 2019. Essentially it represents confidence in the economic and business cycles. In 2018 that confidence has eroded meaningfully, and multiple developments would be needed to restore it in 2019.
Most importantly, China’s tariff situation needs to be resolved. Although the blunt economic effect of tariffs on the US is small, the ripple effect is significant, particularly on business confidence and consumer confidence. This has repercussions for capital spending, hiring and consumer spending. The effect on China is a lot more significant, and with global growth again looking somewhat precarious, a growing (or at least stable) Chinese economy would be positive for global economies overall and US equity markets (let’s not forget that 44% of S&P 500 revenues are generated outside the US). To reiterate: A resolution is key.
But an agreement looks some way off. US President Donald Trump’s Chinese tariffs policy is one that resonates with both Republicans and Democrats as well as with voters. Hence there is little pressure to act quickly. It is equally unclear what a satisfactory resolution for both sides would even look like. But if Trump’s presidential form is anything to go by, it may not be as severe as investors are thinking. Trump needs something that can be presented as a trade victory. Our sense is that as we see US GDP start to decelerate (probably Q1 2019), the timing will look better to declare a victory.
The Federal Reserve (Fed) also represents a source of uncertainty for investors in 2019. With the change in chairman, the market is still trying to get a feel for this new Fed. For now the Fed seems a lot more focused on its goal than the path to get there. Under previous Feds there were more intra-meeting speeches from governors that were clearly meant to influence the stance on interest rates. For now, this Fed has taken a line and appears reluctant to sway from that. Consensus seems to be to expect three rate rises in 2019. The market is crying out for the “Fed put” – the confirmation that rate rises are data-dependent and not set in stone. We expect the Fed’s stance to soften through 2019. Fed chairman Jerome Powell’s decision to start giving press conferences after each rate decision, starting in January 2019, is a step toward a more market-savvy Fed.
So all this suggests confidence could improve as we move through 2019, but perhaps not in the first several months. That should help equity market multiples eventually. But expect volatility.
While the risk of US recession in 2019 is low in our mind, the market’s potential to worry about a recession in 2019 is high. We suspect corporate earnings growth in 2019 will be solid low double digits – but still well below that of tax-boosted 2018. The market is likely to become comfortable with this growth outlook only later in the year, though, leading us to a barbell approach in portfolio construction. We want to own cheap cyclical sectors, balanced by a healthy weighting in more defensive sectors.
We still believe there is substantial risk in the technology sector, where earnings are more cyclical than the market believes and valuation multiples are still very high. This year’s late pullback in technology has lured many to “buy the dip” (after so many years of technology outperformance, the fear of missing out is enormous), but our sense is that there is more damage to come. Although we recognise that if the market worries about a recession, our cyclical positions also will be out of favour, we take comfort in the fact that the low valuations we are paying for these companies compensate us for much of any earnings risk. Technology companies do not have this luxury. Our favourite cyclical sector remains energy.
Having avoided defensive sectors for much of the last five years, we saw good value emerge in some companies through 2018 and think 2019 could be a good year for many of them. In particular, we think healthcare looks very opportune, particularly in the area of large cap biotech. We believe the result of the mid-term elections removes the overhang of punitive actions on drug price controls. We still expect some pricing pressure – but far less than the market appears to be discounting – and demand should hold up given strong demographic forces. Innovation is still very important, and there are several therapeutic areas that have unmet needs that are being targeted. In many cases there is limited value being attributed to the drug pipeline, which we think is too harsh.
Telecom is another sector we have recently re-appraised. It is a sector we had long avoided due to heavy capital investment requirement, poor balance sheets and too much competition, resulting in destructive price wars. With AT&T broadening its focus to non-telecom areas and T-Mobile attempting to acquire Sprint, the wireless environment has improved measurably. The upgrade to 5G technology looks much less capital-intensive than previous upgrade cycles. We also see it as expansionary to their addressable market, again in contrast to previous upgrade cycles. Over time 5G will open the markets of home broadband and Internet of Things (IoT) to wireless providers. IoT examples include autonomous vehicles, home appliances, even clothing – all of which will want to connect to the internet via wireless.
We see a tricky year in 2019 where markets will debate the potential for sustained US growth with the potential for a globally driven US slowdown. We believe a balance of cheaper cyclical companies and more defensive companies is appropriate.
Will Lam and Ian Hargreaves Asian and Emerging Markets outlook for 2019
- Emerging markets face increased external uncertainties
- Valuations are beginning to reflect the risks
- Economic and corporate fundamentals remain solid.
2018 has been a challenging year for both Asian and global emerging equity markets. The year began with upbeat earnings expectations and valuations above long-term historical averages. However, since the start of the year, valuations have contracted due to a number of factors. Firstly, we have seen a marked increase in the risk premium for emerging markets given increased uncertainty surrounding trade tensions and geopolitics. Secondly, this has led to greater concern about China where growth has already been slowing due to the government’s deleveraging campaign. Lastly, the tightening of US monetary policy has led to a deteriorating US dollar liquidity environment with negative implications for emerging market equities and currencies.
This backdrop is likely to continue into 2019, but emerging economies are better placed to withstand these pressures than before, in our view. Valuations are also beginning to reflect the risks being faced, and are currently nearer the bottom end of their historical range.
Escalating trade tensions between the US and its major trading partners have dominated the headlines in recent months and have accelerated the broader market’s derating. Negotiations between the US and China have not yet yielded any results, with President Donald Trump happy to ratchet up the pressure by announcing further rounds of potential tariffs. The outcome is unpredictable, and there is a danger that tensions may escalate further. However, as the negative implications of tariff increases for the US economy become clearer, there is also a possibility that striking a deal becomes expedient. In the near term, we expect not only a direct impact on trade activity, but also an impact on corporate and consumer behaviour, with implications for investment and consumption. This would impact companies in different ways, and we are seeing more opportunities for investment where the market’s reaction has been indiscriminate.
US monetary policy tightening
Although policy normalisation in the US has been well telegraphed, investors have been concerned about a potentially faster-than-anticipated rise in interest rates. As the risk free rate rises, so does the cost of capital, leading in theory to a valuation de-rating of long duration assets such as stocks. Also, a stronger US dollar has led to tighter global liquidity conditions and greater headwinds to global demand growth, which could impact emerging market earnings.
Corporate earnings have so far been fairly resilient. However, leading economic indicators of global growth have declined, suggesting export growth is likely to slow from current double-digit levels. This is a key driver of earnings growth in emerging markets.
Secondly, China’s economy has been slowing as a result of tighter policy settings. Initiatives to tackle excessive credit growth, reduce financial risk and improve environmental protection are all long-term positives in our view, as they address some of our biggest concerns, but in the near term we would expect a further weakening of economic growth in China. Given the backdrop of slower global growth, it is likely that consensus earnings forecasts for 2019 are still too optimistic. Over the last six months earnings have been revised down 5% from the peak, and we would expect further downward revisions to the current 10% earnings growth expectations for 2019.1
In China, deleveraging efforts have led to an economic slowdown while trade issues have increased uncertainty in the outlook. The authorities are likely to be more tolerant of slower growth than they have been in the past, in our view, but they are keen to protect the downside risk to the economy. As expected, we have started to see some moderate easing measures such as reserve requirement cuts, increased export tax rebates, tax deductions on household income and support measures for SMEs in the private sector. At the same time, authorities will not want to see another significant leveraging up of the economy given that this is a major macroeconomic concern. The balance between avoiding a sharp slowdown in growth and avoiding excessive stimulus is becoming more delicate.
Elsewhere in the region, economies do not look particularly vulnerable. Current accounts are generally healthy and credit cycles are not extended. Where current account deficits do exist – Indonesia, Philippines and India – they seem manageable and growth forecasts have already been lowered. Those economies more sensitive to global demand, such as South Korea and Taiwan, are likely to be impacted by ongoing trade and Chinese growth concerns, but we believe their innovative companies have strong competitive advantages that should sustain them better than many fear.
Operational strength in Asia
Meanwhile, there have been some significant improvements at the corporate level in Asia over the last decade. The region’s capex/sales ratio has been steadily declining. In part, this reflects lower structural growth, but it also demonstrates that Asian companies are more cautious, focused and better managed than they were historically, and suggests that better returns on capital are sustainable. In a weaker growth environment, it is also positive that there are few industries with significant excess capacity risk.
Less capital-intensive companies have also been generating stronger free cash flow. The challenge has been how to better allocate that capital, with management facing growing pressure from minority shareholders to pay better dividends. While valuations and positive surprises in earnings are less likely to drive equity returns in the near term, there is an increasingly good dividend growth story in Asia.
Market volatility in Latin America has been exacerbated by politics and uncertainty over the North American Free Trade Agreement (NAFTA). Presidential elections in Mexico and Brazil have resulted in populist candidates from either side of the political spectrum gaining power. Markets have been buoyed by a reduction in political uncertainty and strengthened hopes that key areas of reform will now be addressed.
In Brazil, the pace of economic recovery has been sluggish. Plans to push ahead with pension and tax reforms would help reduce a large fiscal gap, and go some way to restoring investor confidence and promoting consumption growth and investment spending. Meanwhile, the prospects for Mexico are likely to be bolstered by the successful replacement of NAFTA with the US-Mexico-Canada Agreement (USMCA).
Increased uncertainty over US-Russia relations may dampen economic growth, but the Russian economy is still expected to expand by 1.5% in 20192, drawing benefit from recovering oil prices, strong consumer demand and prudent fiscal policy. However, aside from an easing in tensions with the US, the country needs to introduce further reforms for gross domestic product (GDP) to accelerate.
Having said that, we still believe the status quo is a healthy environment in which domestically-focused companies can prosper. Unfortunately, our optimism is not being matched yet by market sentiment, which is currently being negatively affected by worries over the imposition of new sanctions.
Elsewhere in emerging Europe, countries such as Poland and Hungary are likely to enjoy healthy growth rates and low interest rates, in our view.
A bright medium-term outlook
Over the medium term, our outlook for emerging markets is cautiously optimistic. Economic and corporate fundamentals remain solid, and these economies remain the biggest driver of global growth. In particular, we are encouraged by the capital discipline being displayed by companies across emerging markets, with evidence of strong balance sheets and improving free cash flow generation. This is being reflected at the macro level too. Few countries are exhibiting signs of overheating — a far cry from the situation that prevailed in the run up to the global financial crisis in 2008. With valuations towards the low end of the historical range and at a significant discount to their developed market peers, the market appears too focused on short-term uncertainties and is ignoring the fundamental improvements that have taken place.