When we wrote our last Quarterly, in early October 2018, the US equity market had just had its longest losing streak since the start of the Trump presidency. The key question at the time was if US Equities would enter a bear market and drag other equity markets further down with them. Our answer was and remains: no. This is because the Market Watcher Supreme is President Trump himself, the same individual who holds the keys to the trade disputes which, in our opinion, played a significant part in the weakness of equity markets. We believed that any continuation of a meltdown could be followed by pledges for more stimulus or maybe, just maybe, a more conciliatory tone versus China.
Lo and behold, President Trump did make an overture to President Xi at the G20 meeting, that started on November 30 in Buenos Aires. The two sides agreed to postpone by 90 days the planned tariff increase on January 1 and to initiate talks. Granted, not everything ran smoothly from the get-go. It hardly ever does. The arrest of the CFO of one of China’s most prominent technology companies, Huawei, kept markets doubting that a deal would ever be possible. Also, a solution to the trade disputes would be more of a truce, in what will most likely be a long-term ideologically driven conflict between China and the US. That said, talks at the time of writing are proceeding and a solution will be a key overhang to be lifted for equity markets.
We have maintained for a while that any positive news on the trade disputes could ignite a rally, more so in those markets that had been heavily battered, such as Emerging Markets Equities. Even in the doldrums of last December’s market volatility, with still a significant lack of clarity on the trade disputes and all major regional markets posting negative returns, EM outperformed US Equities by a wide margin, followed by Europe and Japan. This was no surprise to us.
It was too good to be true that US earnings would be unscathed
Of course, the trade wars were not the only issue that affected equities outside the US, over the better part of 2018. The Fed tightening at a time when global growth was potentially being affected by protectionism, geopolitical concerns in Emerging Markets and Europe, and the dollar strength that ensued all contributed to a perfect storm of potential threats. Eventually, when investors realized that this conjuncture of events, which is not good for equities markets outside of the US, is actually not that great for US Equities either, US Equities also started to nosedive. Investors began selling the Goldilocks scenario, where US Equities risk premium had reached an historical low versus all other major equity markets, because it simply was too good to be true that US earnings would be unscathed by all the ills that would affect the rest of the world.
Well, it is now time to turn to markets outside the US. EM, Europe and Japan have all underperformed the S&P500 over the course of 2018 (in USD terms). Even with the outperformance last December, they still all closed the year about 10% behind the US. While geopolitical risk and some European countries playing with the odds of a recession are likely to keep volatility high in European Equities for the time being, there is less uncertainty on the horizon for Japan and EM Equities, as most of the potentially negative catalysts ahead appear to be already expected and discounted by markets.
Take Emerging Markets, for example, where investors have been discounting an Armageddon scenario with a 17% underperformance against US Equities in the 11 months to November 2018.
Not that everything is perfect in EM. Earnings growth is slowing down and economic growth in China continues to weaken. For one, we are likely to have more earnings disappointments in the near term. Yet, earnings growth for 2019 is still estimated at 9% and a good part of the negative revisions that we have seen in recent months were due to direct and indirect consequences of the trade disputes (as companies have either been directly impacted or have become more cautious with their spending plans). While a ‘’deal’’ between Trump and Xi would not fully reverse the earnings outlook, it would certainly eliminate a significant overhang. China’s economic growth will structurally continue to weaken, but the government can still manage the soft landing with stimulus measures and our investment team expects more of these later in the year.
At the same time, every other issue that was dogging EM Equities in 2018, while it has not disappeared, has started to relieve the pressure. For one, the Fed’s recent language is more dovish hinting to a pause in rate increases. While the balance sheet shrinkage at this stage will most likely continue, the fact that the Fed is moving more cautiously indicates that, if the macro outlook would warrant it, a pause in quantitative tightening could also be in the cards. With a more dovish Fed, and a less buoyant US macro backdrop, the US dollar is also likely to pause its ascent. In the meanwhile, a number of the geopolitical concerns that characterized EM besides the trade disputes (such as elections in Brazil and Mexico) are now behind us.
Don’t get me wrong, nothing is ever straightforward, and the risks remain high. Yet, the odds have turned. Those Damocles swords that were hanging over EM are slowly being pulled back: the Fed has become more dovish, Xi and Trump are talking, and the Trump administration seems more willing to ink ‘the deal’, and geopolitical concerns have dissipated. If all this also means a normalized dollar, as the US economy cools off and the Fed errs on the side of caution, this is the recipe that we have all hoped for: we sold a false sense of Goldilocks, now we should buy a misplaced fear of Armageddon.