With a recession to be avoided and earnings growth to return, we believe global equities have further to go. We see stock markets reaching new highs going forward. First, a macro environment in which GDP growth is below but close to trend suits global equities just fine. In addition, financial conditions remain loose as a result of the very accommodative stance of central banks.
Since the financial crisis in 2008, global markets have moved in tandem with central bank balance sheets, which will start rising again after a two-year break. With the US yield curve suggesting that a US recession is more likely after 2020, equities have room to extend the bull market.
Historically, stock prices kept rising for an extended period of time of almost a year after every instance of the yield curve inverting (except for 1973). Prices peaked on average less than six months prior to a recession.
Second, earnings growth is set to return in the first half of next year. Diminishing uncertainty with regard to economic policy, as well as better manufacturing PMIs, will enable earnings-per-share growth to turn positive again. Earnings revisions, which remain at subdued levels today, could revert strongly once the cycle turns. Unit labor cost growth, which is negatively correlated to profit margins, will stay muted.
Wage growth is still relatively benign and productivity growth is finally rising. The tailwind of buybacks on earnings per share will dwindle somewhat, partly because of stronger investment growth. We do not believe this will keep equities from rising, though. As long as bond yields stay low or negative, companies will be enticed to swap equity for debt.
Third, investor sentiment is far from exuberant. As John Templeton once put it, “Bull markets… die on euphoria”. Currently, we are far away from a euphoric state of equity markets. Cash positions of global fund managers remain significantly above average, which is a contrarian bullish signal for stocks. In general, investor positioning is defensive.
Credit spreads also remain well behaved, with the BBB-AAA spread just below average. If anything, exuberance seems to have skipped equities and moved to less liquid, alternative investments like leveraged loans and private equity.
Fourth, equities do not look expensive in a multi-asset world. The equity risk premium has been consistently high in recent years as global bond yields continued to fall. Today is no different, with the equity risk premium still firmly in the first quartile. Historically, on an annual basis, equities have realized the best returns when the equity risk premiums have been the highest.
From an absolute level and based on realized P/E, valuation does not look demanding. The realized P/E ratio for the MSCI World Index is somewhat below its long-term average, driven by discounts in Europe and Japan.
Our alternative scenario features a US recession. Political uncertainty will not decrease or may even worsen and global manufacturing PMIs will not improve, pushing earnings down further. As a result, capital expenditures will not increase, but more importantly, a default cycle will begin as low-rated companies cannot pay off their debt.
Unemployment will rise and consumer confidence will break down. Even though there are few excesses in the economy, corporate debt being the exception, the economy will slip into recession. With central banks having less room for recession-countering measures than in the past, stock markets are likely to decline more than 20% under this scenario.
We expect global GDP growth to continue at a pace that is below but close to trend. After a slow start of the year, growth will gradually pick up. Manufacturing PMIs will improve as the inventory overhang is left behind. Earnings growth will turn positive in the first half of the year, helping sentiment that is currently far from exuberant.
Together with an attractive valuation relative to other asset classes, global equities are bound to make new highs before perhaps struggling towards the end of the year as recession fears start all over again.