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Beware of positive surprises

Beware of positive surprises

26-10-2018 | Column

Markets have reminded us that everything that goes steeply up will at some point come steeply down. Having been the uncontested outperformer in 2018, US equities had their longest losing streak since the start of the Trump presidency in early October. With emerging market jitters also spreading to European stocks, has the market sent a message on the outcome of the trade dispute?

  • Fabiana Fedeli
    Fabiana
    Fedeli
    Global Head of Fundamental Equities, Portfolio Manager Emerging Markets

Speed read

  • Jitters spread to DMs in October
  • Trade talks (or the lack thereof) still hold the key
  • Value returns in Q3, fundamentals determine the road ahead

At the start of Q4, US Equities had their longest losing streak of the Trump presidency, and European stocks hit a two-year low. EM Equities actually outperformed, although they were still down, and US Tech stocks - for a change - were a clear underperformer.

So, has the market told us we’re facing the double whammy of earnings hits from trade tariffs and inflationary pressures ramping up in the US, prompting the Fed to hike rates not in line with the improvement in economic growth but to stem inflation? Has the market decided? Not so fast. Trade disputes are still dragging but negotiations, rather than breaking down, have not yet happened.

The new tariffs imposed at both ends remain limited, with the biggest potential negative impact expected for China limited at an estimated 0.5% to 1% of GDP. Although impactful, we believe the effect can be offset by domestic stimulus policy.

What most likely happened in global equities, is that investors realized that the conjuncture of events that is not good for equities markets outside of the US - a more hawkish Fed, protracted trade hostilities and geopolitical concerns - is actually not that great for US Equities either. With the US Equities risk premium at a historical low versus all other major equity markets then we can not only understand the selloff but also why some of the growth names in the US (aka Tech) have borne the brunt.

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President Trump holds the keys to trade dispute

Will the weakness continue, with US Equities entering a bear market and dragging other markets down with them? I don’t have a crystal ball, but I suspect the answer is no. President Trump is the Market Watcher Supreme and holds the key to the trade dispute. Market weakness could bring pledges for more stimulus or maybe a more conciliatory tone towards China, together with some not-so-subtle Jay Powell-blasting.

While the market’s dip has attracted a lot of attention, it was interesting to see value outperforming growth, starting in Q3 for all major equity markets except the US. So, is this the start of long-awaited resurgence of value versus growth? There are arguments for both a positive and a negative answer. On one hand, growth outperforms during a late bull market cycle – where US equities are now. On the other hand, the discount of value to growth stocks globally is now at its highest since 2000.

More importantly, in Europe, value stocks have now been seeing better EPS forecast trends than growth stocks for a while and, more recently, this is also true for the US. The answer will lie in fundamentals. If the trade disputes continue to escalate and earnings are impacted, this would not bode well for a resurgence of underappreciated stocks, as bear markets don’t like value.

Caution against over-negativity

For our five-factor framework, which tracks the changes in macro, earnings, valuations, technical analysis and sentiment, the fundamentals haven’t materially changed for Developed Markets. For Emerging Markets, we’ve downgraded the macro factor from positive to neutral. The reasons include the dragging on of the trade disputes and geopolitical risks, such as the Brazilian elections and potential for new sanctions on Russia.

While still not significant enough to warrant a downgrade of the Earnings factor across DM or EM, Q3 saw some earnings downgrades in EM, and more recently in Europe and Japan. These are anecdotally driven in many cases by concerns over the trade war. It’s too early to tell if this will continue, but part of the answer depends on how much further the trade war will go from a time and product breadth perspective.

The US remains the stalwart of earnings growth but the outlook for 2019 is less certain given the tough comps from the tax cuts and fiscal stimulus. While the direction of both earnings expectations and investor sentiment are not very supportive in most markets, given still-robust growth, attractive valuations and low expectations, we’d caution against over-negativity on EM, European and Japanese equities – a lot of downside has been priced in and positive surprises are possible.

Piece of cake

The convincing outperformance of Mexican equities and currency has shown this, with the peso being the best performing currency against the US Dollar. Not that Mexico is doing great, but it is at least doing better than expected. Watching the US market jitters, President Trump might even decide to sit down with his good friend President Xi at the negotiating table. Perhaps he might even offer him another slice of chocolate cake.

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