Calm in Storm: Beyond the trade war

Calm in Storm: Beyond the trade war

21-11-2019 | Yearly outlook
Over the past year, regional equity market allocation has been heavily influenced by investors’ expectations on the outcome of the US-China trade war. We have nicknamed this ’pinball investing’, where, in reaction to a world of binary outcomes, equity markets have been bouncing off tweets in whichever direction makes more sense at the time. The trade deal is on, equity markets are up and risk-on trades outperform; the trade deal is off, equity markets are down and turn more defensive.
  • Fabiana Fedeli
    Global Head of Fundamental Equities

This is not only due to the fact that investors are a temperamental bunch. The outcome of the trade disputes has a significant impact on corporate earnings, arguably a key determinant of equity allocation. There still remains uncertainty surrounding the trade conflict, not only between the US and China, but to a large degree between the US and the rest of the world.

This, combined with the intellectual property disputes in information technology, is having an impact on economic activity and earnings across the globe: directly (through higher costs and lower revenues) or indirectly (as companies refrain from spending or investing more). Brexit has been the other topic at the forefront of equity investors’ minds, although its impact is by and large contained to the UK and Continental European equity markets. 

Depending on which one of our two scenarios (base case or alternative) develops over the next year, regional allocation in equity portfolios in our opinion should look very different.

This article is part of our investment outlook 2020: ‘A Tale of Two Scenarios’.
This article is part of our investment outlook 2020: ‘A Tale of Two Scenarios’.
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Look outside of the US

Our base case scenario – with no hard Brexit and a slimmed-down version of a US-China trade deal; sufficient to bring back some business confidence, capital expenditures and corporate earnings growth – makes the case for equities outside of the US compelling. The current equity risk premium of US equities is at a 20-year low vis à vis Japan, Europe and emerging markets.

Arguably, US equity markets are discounting a world where US corporates are not only firing on at least most of their cylinders, but also where the rest of the world’s corporates remain far behind. However, a look at the current earnings expectations across major equity markets paints a very different picture. Markets outside the US have already priced in a lot of uncertainty, and earnings growth (or lack thereof) is now at levels that do not justify the wide disparity in valuations.

Take EM, with an expected earnings growth of 2.3% for 2019 and 13.4% for 2020, and a P/E of 13.2x and 11.4x, respectively. This compares with the US’s 2.3% and 10.5% 2019 and 2020 earnings growth and 18.6x and 16.9x P/E, respectively. For Japan, earnings are expected to fall by 0.9% in 2019 and grow 5.8% in 2020, while P/E is at 13.7x and 12.8x, respectively. Europe’s earnings expectations are for a 1.3% and 9.7% growth respectively, priced at a P/E of 14.8x and 13.4x.

Key driver for regional allocation

The relative earnings outlook is a key driver for regional allocation in equity markets. This is most evident in emerging markets, where their relative performance to developed markets over the long term has coincided with the forward earnings gap (see the graph below).

EM-DM forward earnings gap and relative price performance

Source: IBES, as of September 2019. GEM vs MSCI World represents the ratio of the MSCI Emerging Markets Index to the MSCI World Index.

Of course, for equities outside of the US to outperform, we need their earnings expectations not to fall below their current levels. A poor earnings environment would set markets back on the defensive and quality-seeking path into the arms of US equities. That macro improvement, that is part of our base case scenario, is therefore a key prerequisite to support earnings.

The case for outperformance of non-US equity markets becomes even more compelling given the persistent underperformance that we have witnessed over the last ten years, as shown in the following graph.

Global equity markets performance 2009-YTD

Source: MSCI (EM – MSCI EM Index; US – S&P; Japan – Topix; Europe – Euro Stoxx) 31 December 2008-30 September 2019

The alternative scenario: keep on hugging US equities

In our alternative scenario, which in our view is less likely, we have either no resolution or a meaningful setback in the US-China negotiations, the path to a US recession is already irreversible, and corporate earnings across the world weaken. Such a scenario would most likely bring back the risk-off stance, with global equity markets underperforming other asset classes and, within equities, the US market and more defensive bets most likely prevailing.

Depending on which one of our two scenarios develops over the next year, regional allocation in equity portfolios should look very different. In our base case scenario, the case for equities outside of the US is compelling, given relative earnings growth, valuations and prolonged underperformance. In this scenario, there is no hard Brexit and a slimmed-down version of a US-China trade deal, sufficient to bring back some business confidence, capital expenditures and a return of corporate earnings growth.

Our alternative scenario would most likely bring back the risk-off stance. Within equities, the US market and more defensive bets would probably prevail. That said, we see the risk-reward between the two scenarios as asymmetric. Further degeneration in either the trade war or Brexit is likely to cause a negative price reaction, the latter limited to the UK and Europe. But the upside to non-US equities that would be triggered by positive news at this point looks far greater.

Outlook 2020: A Tale of Two Scenarios
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