A couple of pieces of the puzzle – more exactly, one and a half – are still missing. That said, we have all learned that markets move on imperfect information and, by the time all the stars align perfectly, they will have already made a big part of their move. If we combine this with the asymmetric risk-reward upside we discussed in our last Quarterly, the case for equity markets outside the US becomes compelling, starting with emerging markets.
Let me walk you through how we got here: last quarter, our stance on both developed and emerging equity markets was neutral. Investors were playing a pinball game, bouncing off President Trump’s tweets and the occasional news on monetary policy. At that time, we didn’t know whether we were going to have a China-US trade deal anytime soon and earnings momentum across all the major equity markets had meaningfully weakened, on the back of slower global activity. Yet, we concluded, while the news outcome was a 50/50, the risk-reward was asymmetric. Markets outside the US had already priced in a lot of uncertainty, and relative earnings growth (or lack thereof) across the largest regional equity markets was at levels that did not justify the wide disparity in valuations.
What has changed over the last three months, that tilts the needle toward more bullishness and makes us feel more sanguine about ex-US equities? Well, we have more clarity now. Not 100% visibility but that, I am afraid, we never really have. Global macro is proving to be more resilient than we expected, with some signs of bottoming out. More importantly for equity markets, the deterioration in earnings momentum seems to have halted. While still negative in most markets, earnings revisions are becoming less negative across all regions. The two best reads have been in the US, where the latest datapoint shows a small positive, and in emerging markets, where earnings revisions are now close to neutral. Needless to say, central banks remain supportive around the world.
The China-US trade deal offers hope that further escalation in the tariff war is now off the table
Last but not least, the pivotal trade deal between China and the US is moving in the right direction. The two countries have just signed their Phase I agreement. The agreement is far from comprehensive and has kept in place most of the tariffs that were imposed thus far. That said, it offers hope that further escalation in the tariff war is now off the table. Of course, this could all change at the next tweet, as we have sadly learned over the past two years. Yet, with an impeachment process in the US, an economy that purrs but has stopped roaring, and the upcoming November elections, President Trump would welcome a deal. Any deal, for that matter. The half-baked Phase I deal is the half piece of the puzzle that we have talked about. A more comprehensive agreement would be the other missing half.
Our hope is that the Phase I agreement, by stopping the escalation of tariffs, will pave the way for the base case scenario that we described in our Robeco Outlook 2020, i.e. not a comprehensive trade deal but a slimmed-down, skinnier version that is enough to bring back some business confidence and capital expenditures. This facilitates a return of corporate earnings growth and is a bullish signal for global equities. While a clear upward momentum in earnings would be the missing full piece of the puzzle, the backdrop and the catalysts are lining up.
Europe and Japan are lagging on earnings growth for 2019. Current market dynamics appear to reflect the relative earnings versus valuations outlook. Emerging markets have outperformed US equities in the fourth quarter of 2019 and are keeping pace so far in 2020, while Europe and Japan are still lagging. As we keep on reminding ourselves, the relative earnings outlook is a key driver for regional allocation in equity markets.
The picture looks even more compelling when looking at 2020 earnings expectations versus valuations, as earnings growth across all markets is expected to be close to that of the US. Of course, we have seen in the past how picture-perfect earnings expectations, particularly in emerging markets, can reverse and turn into a depressing slide of downward revisions. While we don’t have a crystal ball, two elements give us hope that this will not be the case, at least for the next year. First, the fact that earnings revisions across all major markets seem to have bottomed out, and second, our belief that a de-escalation of the trade war should allow the return of some business confidence, capital expenditures and, as a consequence, future corporate earnings growth.
One pushback that we often hear from our clients is that equities have already had such a great run, that they have little juice left. I agree that this may be the case for US equities, but we need to dispel such a myth when it comes to other regional markets. Since the end of 2007, i.e. since just before the global financial crisis, the US has returned (total returns in euro) a whopping +194%. Yet, returns of other regional markets have been far more meager: Japan saw a 57% rise, Europe was up by 32% and emerging markets a paltry 27%. This is the time to rerate the underdogs, as long as fundamentals continue to improve.
Now, let me turn to the other major underdog: value. After more than a decade of underperformance, it looked like it was returning to life, with some bouts of outperformance across global equity markets in September and October of last year. Yet it all ended up in a fizzle. Many clients have been asking for our opinion: will value come back? Yes, and no. To us, there are two considerations to be made.
First, that the short lived move to value shows that equity investors are increasingly uncomfortable with overpaying for arguably crowded trades, whether from a style (momentum and growth) or regional (US) perspective. They just need a trigger to make the switch. The resumption of the US-China trade talks last September and – to a lesser extent – some progress on Brexit, provided one. However, to follow through, investors need to feel more comfortable with the macro and earnings outlook.
Second, while we do believe that value is due for a comeback, as fears in investors’ minds fade, we do not believe that all traditionally-defined value stocks are bound for a sustainable outperformance. We believe that the traditional mono-dimensional definition of value, based solely on a low price-to-book ratio, is outdated. In a world of technological breakthroughs, where economies around the globe are increasing their services and consumption content, where retail and information flows have moved online, and where production processes are more about software than hardware, we need to look at a far more multi-dimensional definition of value.
Our search for value needs to be smarter, taking into account that, in a changing world, companies that do not keep up with innovation may well stay behind and become value traps
The outlook and sustainability of earnings over the longer term is just one of the key additional elements that should be part of the definition of value of the future. And while every initial value upswing is likely to start with a dash for trash, our search for value needs to be smarter, taking into account that, in a changing world, companies that do not keep up with innovation may well stay behind and become value traps.
Reflecting all of the above, our portfolio management teams have become more optimistic on their respective equity markets and have upgraded the conclusions of their five factor frameworks from neutral to positive. For the Developed Markets team, this was due to a macro backdrop remaining more resilient than initially expected and earnings revisions appearing to have bottomed out.
For our Emerging Markets team, earnings were also a factor behind the upgrades, as earnings revisions, while still showing a small negative read, are progressively improving. At the same time, sentiment has also improved. The Emerging Markets team expects the recent pick up in inflows to continue on the back of improvements on the China-US confrontation side and continued monetary policy support.
Finally, the most important question of all: what could go wrong? Barred a credit event with global ripple effects – which, however, central banks seem all-bent on avoiding –, we see geopolitics as the main source of risk. Thus far, the market has bounced back after every moment of panic, whether it was the drone attack on Saudi Aramco’s facilities, or the tensions after the killing of general Soleimani, until it will take a bit longer to do so. But that would be for another time to discuss. For now, enjoy the ride and don’t forget to embrace the underdog.
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