Welcome to a new world. The trade deal was not reached, earnings revisions have worsened, and the world’s central banks have become even more dovish than in the last quarter. Our outlook for developed markets remains neutral, we stay positive on emerging markets.
We are in a 50:50 world. When the Robeco Fundamental Equities team decided just over a year ago to launch a regular market outlook, we at first debated if it even made sense to write a quarterly. After all, some of the team members argued, we are long-term investors; how can our views change on a quarterly basis? Fast forward just over a year, and, in the age of tweets, market conditions are now changing month by month, let alone quarter by quarter. We are in a world where a trade deal seems imminent one minute, and is then off the table the next, thereby turning the macro outlook around by 180 degrees.
In our previous quarterly we argued that – after the 1Q19 rally – for equity markets to rise further we needed an improvement in fundamentals to follow and to feed through to earnings. Three elements were needed to support those fundamentals. First, a US-China trade deal. At the time, it did look like the risk of a US-China trade war had diminished, and that the US and China would come to some sort of agreement.
Second, the world’s major central banks had to continue to remain supportive. At the time, the prevailing expectation was for the Fed to be on hold. Third, we needed the Chinese government to continue to gradually stimulate the domestic economy. As we were writing the 2Q19 quarterly, we were seeing the first green shoots appearing, with earnings revisions seemingly having reached a trough in the US, Europe and emerging markets, and with PMIs starting to improve in a number of emerging countries.
Now, forget all of the above and welcome to a new world. On May 5, President Trump de facto broke the trade talks with China with his weapon of choice, a tweet. This was followed by an additional tariff increase, from 10% to 25%, on USD 200bn in Chinese exports to the US, and the threat of 25% on the remaining USD 300bn in exports. Global equity markets reacted negatively and slid for a couple of weeks.
It took some very dovish remarks from Fed officials and other central banks around the world to prop markets back up and return them to pre-May 5 levels. The G20 summit at the end of June, where Presidents Trump and Xi agreed to resume trade talks (and delay tariffs on the extra USD 300bn), gave equity markets an extra push. In all of this, the US and Europe led, while emerging markets and Japan lagged.
The Fed and most central banks around the world have become even more dovish, which has helped market sentiment
More importantly, we saw a new bout of deterioration in fundamentals, with earnings revisions worsening in all major equity markets and PMIs back on a declining path across emerging markets, driven by the new-orders component. It was a sign that corporates are back to getting more concerned and, hence, cautious. We believe the uncertainty surrounding the trade conflict, not only between the US and China but to a large degree between the US and the rest of the world, together with the intellectual property disputes in information technology, are having either a direct (through higher costs and lower revenues) or indirect (as companies refrain from spending or investing more) impact across the globe.
In the meanwhile, the Fed and most central banks around the world have become even more dovish (we now expect the Fed to cut by 75 to 100 bps during the remainder of 2019 and 2020), and the Chinese government has continued to support the economy (we expect more stimulus in Q3), which has helped market sentiment. That said, more easing can only cushion, not avoid, the impact on earnings of a trade war escalation, and earnings remain a key driver of stocks, especially in emerging markets.
The key question becomes: how do we manage investments in a 50:50 world, in a world of binary outcomes where the macro backdrop can turn by 180 degrees in the time that it takes to flip a coin – or to type 140 characters? Let’s be clear, it is not only a matter of news flow changing. For those of us who have managed money long enough, particularly in emerging markets, dealing with a volatile news flow has been a recurring part of our jobs. The issue now is that it is not only that the news flow is volatile, but that actually the outlook for fundamentals, such as those driven by global trade, can change erratically.
Our answer is: look for structural changes, look at what is likely to change or not to change, no matter what the vagaries of President Trump’s tweets and the reactions to them imply. This is easier said than done, but not impossible. In China, our portfolio managers have been outperforming the market by investing in areas that will benefit from the Chinese government stimulus. Whether we have a trade war or not, the Chinese government will have to continue stimulating its weakening economy. It will just be a matter of how far they have to go, depending on what happens to global trade and macroeconomy.
Another decision that our teams have taken is to trim some areas of exposure to IT hardware. As indicated by the issues surrounding the placing of Huawei on the US Entity List, there is more to the US-China rift than trade. In our opinion, the intellectual property disputes between China and the US and concerns on technology security will be long-term issues. Even if there were a short-term reprieve packaged into a trade deal (and this is a big ‘’if’’), we believe that the IP battle is destined to continue.
To deal with the uncertainty, some companies are postponing orders and many are already taking steps to reorganize their supply chains. Companies will not only have to incur investments and costs to transfer their supply chains outside of China, but this will most likely imply the fragmentation of these supply chains. This is because there is hardly any other country that currently can offer the same degree of availability of workers and level of infrastructure as China. This will imply delayed investment cycles, higher costs, and – at the extreme – the creation of two IT ecosystems, one led by China and one by the US. The latter would have far-reaching implications for global IT development and – again – costs.
Our opinion on whether there will be a trade deal has not changed: there will eventually be one, given Trump’s concerns around losing constituencies and his obsession with US equity markets, and given China’s need for economic stability. We also continue to believe that the likelihood of a trade deal is a key catalyst for global equity markets, not only just simplistically from a sentiment viewpoint, but more concretely because of the impact of tariffs on company earnings.
However, we believe that a trade agreement will take longer to reach and, in the meantime, we could face bouts of market volatility as complacency is met with an unpredictable news flow. President Trump’s tweet on May 5, which de facto broke down the trade talks, was particularly ill-timed. It fell one day after the 100th anniversary of the May 4 protest against the Treaty of Versailles (which conferred on Japan political and economic rights over China’s Shandong Peninsula).
The celebration was a powerful symbol of China’s nationalism against Western imperialism. This has played into the hands of President Xi Jinping and created strong popular support for a harder stance against the US. It now seems, therefore, that the Chinese government is determined not to give in easily to what it believes is the US administration’s attempts to humiliate it – and is prepared to sacrifice economic growth in the process.
We also think that, unless we have a deal before December, we are probably not going to see one until after the Presidential elections. This would imply tariffs for longer, with all the likely negative effects on companies’ earnings and disruption in global economic activity that brings. While the decision to resume talks at the G20 is positive, we are still nowhere near a deal.
As long as a trade deal is reached (and hence there is no further pressure on earnings), our opinion remains that there will be more opportunities for outperformance outside of the US. Now that the impact of President Trump’s tax cuts is over, the earnings growth differential between the US and other markets no longer justifies the wide disparity in valuations.
While earnings expectations have been toned down across all markets, the differential remains, with 2019 EPS expected to be 3.7% for the US, versus 4.9% for EM, 4.4% for Europe and 5.1% for Japan. The valuation disparity remains high, with US equities trading at 17.3x CY2019, versus 12.2x for EM, 13.8x for Europe and 12.1x for Japan, respectively. Of course, this is provided that earnings expectations outside of the US do not fall from their current levels and that the differential is maintained.
This means that earnings revisions need to improve from current levels. For now, we are hanging in there by a thread. We need a macro improvement to support earnings.
Based on the above, in our five-factor framework our investment team has downgraded the earnings indicator from neutral to negative, as earnings revisions remain very weak around the globe, especially in Europe and Japan. Our overall outlook for developed markets remains neutral. In emerging markets, our team maintains a positive outlook. This is underpinned by a positive valuation and a positive sentiment factor, while other factors remain neutral. We debated whether to downgrade the sentiment factor. We upgraded it last time owing to a change in the monetary situation in the US and more constructive US-China relations, which, in turn, led to a significant recovery of fund flows. In the end, we decided to keep it positive, as the negative effects of the outflows we saw in Q2 2019 are being offset by the positive effects of likely monetary easing in the US. The on-off US-China relations, which were ‘on’ again after the G20, are too volatile to be included in the assessment.
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商号等： ロベコ・ジャパン株式会社 金融商品取引業者 関東財務局長（金商）第２７８０号
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