Since the beginning of the year, global equity markets have managed to turn around the dismal performance of the final quarter of 2018. Year-to-date, the MSCI World is up almost 16% in US dollar terms and 17% in euro terms1. Notably, all major regional equity markets have kept up this pace, with the US just marginally ahead. The obvious laggard has been Japan, where an unfavorable USD/JPY exchange rate also contributed to the underperformance.
So, what’s next? Is this it? In my most recent conversations with clients, one recurring question has been: should we take profit from emerging markets after the rally? The question that I don’t get asked is: should we take profit from US equities and move it elsewhere? And while there seems to be an increased interest in specific markets such as China, the temptation to assume that the US equity market will continue to outperform as it has in recent years – while eventually the other major markets will fizzle out – is great.
We dare to utter the four most dangerous words ever spoken: “This time it’s different”. Let me rephrase that: “This time, it could be different, as long as a number of elements fall into place.”
What we believe will be different, is that there will be more opportunities for outperformance outside of the US. This does not mean that we expect the US equity market to collapse (if it did, it would take all other markets down with it), but simply that we believe that now that the sugar rush of President Trump’s tax cuts is over, the earnings growth differential between the US and other markets no longer warrants the wide disparity in valuations.
2019 IBES consensus earnings growth figures for the MSCI US, Europe and Emerging Markets are 4.1%, 5.5% and 6.8% and price/earnings ratios for 2019 are 17.2x, 13.6x and 12.1x, respectively. Of course, this is provided that earnings expectations outside of the US do not fall from the current levels and that the differential is maintained. This means that earnings revisions, which took a turn for the worse in all major markets during the last quarter of 2018, need to improve from the current levels.
The rally that we saw in 1Q was nothing more than investors realizing that the fourth quarter panic had caused stock prices to overshoot (on the downside) what was warranted based on fundamentals. The global economy was weakening, but not collapsing. And the dark clouds that were making the outlook appear even more ominous, namely a hawkish Fed and an escalation of the US-China trade conflict, did eventually dissipate.
Now, 16% later, markets have caught up with fundamentals. What we need now, is for an improvement in fundamentals to follow and eventually feed through to earnings.
Wide disparity in valuations no longer warranted
The first piece of the puzzle is a US-China trade deal. This is necessary for two reasons. First, because the start of negotiations has been an important pillar of the improved investor sentiment, and any negative news could reignite a bear market reaction. Second, because it would be a first step towards the reinvigoration of the weakened global economic activity. A good part of the global macro slowdown that we have witnessed in recent months has been due to the direct and indirect consequences of the trade dispute (as companies have either been directly impacted or have become more cautious with their spending plans).
Moreover, the trade deal does not need to be perfect, and it most likely won’t be. It just has to be good enough to scrap the tariffs that were imposed over the course of 2018. Any deal is likely to leave a lot of questions unanswered in the short term, whether they relate to the actual execution, the future of technology transfers, or any follow-through on a US-Europe trade deal. That said, none of those questions will have answers that could possibly be as bad for the global economy as the prospect of 25% tariffs on all goods traded between US and China.
Second, we need the world’s major central banks to continue to remain supportive, in other words, dovish. This is particularly important given the weak global macro backdrop. Take emerging markets, where equities have historically benefited from a strong growth outlook, regardless of the Fed’s stance (as was the case in the Fed tightening cycle of 2004-2006), but in a weak growth environment such as the current one, Fed support is a crucial element.
Third, we need the Chinese government to continue to gradually stimulate the domestic economy, managing the delicate balancing act between stimulus injection and debt management. We all understand that China’s economic growth will continue to weaken structurally, but as long as the government can manage the soft landing, investors will still be able to find compelling opportunities in the structural changes that are taking place in the country’s economy.
Of course, if the uncertainties surrounding the future of Europe, namely Brexit, the trade dispute between the EU and the US, and Italy’s woes were finally vanquished, that would be the icing on the cake. That said, we don’t want to be greedy and we feel that the markets should be able to cope with a bit more uncertainty on this end, as long as the other bigger boxes (China-US trade, central bank dovishness and China’s stimulus) are ticked.
We see all the required catalysts lining up for emerging markets, and some green shoots appearing. PMIs have started to improve in a few countries, namely China, Brazil and Indonesia, and earnings revisions seem to have reached a trough. Of course, we need to be mindful that emerging markets are not a homogeneous asset class, and some countries will fare better than others. China and Brazil are two that stand out in the current environment.
We believe Japan is next on the buy list, as some macro data is also taking a turn for the better, but earnings revisions remain weak. While we do find good investment opportunities in Europe and earnings revisions are also showing signs of having bottomed out, we see the risk of bouts of volatility ahead as markets look for clarity on Brexit, the US-EU trade talks and the trajectory of the Italian economy.
Based on the above, our investment team maintains its neutral outlook on developed markets, while its outlook on emerging markets has turned positive. In our five-factor framework, the emerging markets team has upgraded the sentiment indicator. This is owing to the change in the monetary situation in the US and the more constructive US-China relations, which, in turn, has led to a significant recovery of fund flows.
The global equities rally in the first quarter of 2019 was about realizing that the global economy was not heading off a cliff. For investor sentiment to remain upbeat, markets now have to show signs of improving fundamentals. If the pace of improvement is not limited to the US and other markets manage to maintain at least the same momentum, valuations in emerging markets, Japan and Europe will offer more compelling opportunities. Then, this time it really will be different.
1 Total Return