Wade O’Brien
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Investors should expect more volatility in 2019, as many of the trends and political dynamics that have rattled confidence over the last few months seem unlikely to dissipate in the months ahead. Twelve months ago, world economic growth was synchronizing and central banks remained accommodating; recently, growth has slowed, geopolitical and trade tensions have risen, and US interest rates have increased. The better news is that equity valuations (in most markets) remain reasonable and earnings targets don’t appear overly ambitious; there is also upside if central banks exercise restraint or politics improve. Ultimately, we think risk assets will regain their poise in 2019, though the path may not be smooth and the level of returns may leave some disappointed.
2018 may have felt worse than it actually was (though the year is not over yet). After a strong start, global equities stumbled in October and never regained their footing, leaving the broad MSCI ACWI -5% (in USD terms) year-to-date through December 7. What happened? Despite strong earnings growth in the United States and emerging markets, investor confidence has crumbled due to the unfolding trade war between the United States and China, uncertainty over Italian debt and Brexit, and questions over whether plunging oil prices and a flattening yield curve are harbingers of the next recession.
Despite this unfavorable backdrop, a more positive case can be made for developed markets stocks. Negative 2018 returns, despite rising earnings, mean that valuation multiples for many equity markets have fallen below historical medians. Tax cuts in the United States have boosted earnings, and less discussed is that healthy economic growth has boosted top lines as well. US valuations (and margins) look stretched, but expected per share earnings growth of 9% will be supported by buybacks. Japanese and Eurozone stocks, while offering more limited prospects for earnings growth, offer a significant discount to US equivalents as compensation. Political tensions and low rates (a headwind for banks) may continue to weigh on multiples, but dividend yields (3.5% in the Eurozone, 2.3% in Japan) will bolster returns. UK equities are the dark horse, as a steep Brexit-related sell-off in 2018 has lowered multiples and cheapened the pound, benefiting multi-nationals listed in London.
Emerging markets stock valuations also seem to offer upside, though Chinese economic growth was already slowing before tensions erupted with the United States over trade. Profitability has steadily risen, and corporate balance sheets look healthy in most markets. Concerns over tighter US monetary policy and its impact on capital outflows may also ease should softer data or increased volatility curb the Federal Reserve’s aggressive policy-tightening stance. An imminent upturn for emerging markets equities is not guaranteed (or perhaps even a base case), but a P/E ratio near bottom quartile and a significant valuation discount relative to developed markets equivalents continues to argue for a (small) overweight.
Credit investors will need to climb a wall of worries for returns to improve next year, though weak 2018 returns have pushed yields and spreads higher, offering some cushion should the Fed carry on hiking rates or the expected slowdown in economic growth turn into something worse. Floating-rate structured credit such as CLO debt remains priced to (again) outperform, given steady borrower fundamentals and generous spreads versus corporate equivalents. Investors may also want to look at beaten-up bank capital securities, some of which may be over-discounting worries over growth, lower rates, and idiosyncratic issues like European bank exposure to troubled emerging markets. Finally, real assets may again prove volatile and subject to political and economic cross currents in 2019. Investors should not abandon the category entirely, but rather look to capture stable cash flows in assets such as infrastructure and secular growth in real estate categories including logistics and healthcare.
Summing up, we are more cautious heading into next year than we were 12 months ago. The economic backdrop looks less encouraging and we see little prospect that thorny issues—such as Brexit and trade tensions—will quickly resolve themselves. Valuations for many equity and credit categories offer some cushion for these tensions, though it might take time to reverse sentiment for especially beaten-up assets like emerging markets stocks. Given our expectation that market volatility will continue, it is worth asking whether out-of-favor active management might finally have its day. If nothing else, the opportunity cost of holding cash is far lower than it was just one year ago.
Read Outlook 2019: More Risk for Less Return? for more of our views on developed and emerging markets equities, credit, real assets, sovereign bonds, and currencies, as well as the advice of our chief investment strategist.
Wade O’Brien, Managing Director