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Investment Outlook January 2020

20th January, 2020

After a strong rebound in asset prices in 2019, which has taken equity market valuations back towards the highs of this cycle, the market appears to be pricing in an improved environment. While there have been some major developments recently in the trade war, Brexit, and global monetary policy, can they drive the earnings recovery the market expects?

Introduction

2019 was a good year for asset owners. Global bonds, according to the JP Morgan Global Bond Index, rose by 4.6% in response to low inflation and dovish guidance from many central banks, notably the ECB and Fed, while Global equity markets delivered the strongest calendar-year return of the current cycle. Equities rose by 30.0% as measured by the MSCI World Index in euro terms. Much of this return was a recovery of 2018’s losses – in fact it took until August 2019 for the index to break convincingly above the old 2018 high.

Figure 1: MSCI World Index performance (January 2018 to December 2019)

MSCI World Index

Source Bloomberg and MSCI as at 31st December 2019

Nevertheless, last year’s equity return is remarkable for having been achieved against a backdrop of faltering economic activity and little or no earnings growth for companies. Global economic growth was impacted negatively by the trade dispute between the US and China and the uncertainties around Brexit. It is expected that after the fourth quarter earnings are tallied in the coming weeks, the outturn for earnings growth in 2019 will have been close to zero.

Strong price appreciation coupled with little or no earnings growth has taken equity valuations back to the highs for this cycle. This suggests that the equity market has moved to price in an improved earnings environment in 2020. With much at stake, can the global economy support the earnings expectations in 2020?

Driving an earnings rebound

The market currently expects around 10% earnings growth from global equities this year. That outturn, if achieved, would take the 12m forward P/E of the MSCI World Index from a cycle-high of 17x at end 2019 back down to 15.5x by year-end. While the political and economic environment is undoubtedly risky, investors have some reason to believe that earnings growth can improve in 2020.

There is no doubt that corporate confidence took a battering in 2019, driven to a large extent by the twin shadows of the trade war and Brexit. The trade dispute between the US and China has been cited by many central bankers and company managements alike as a key driver of the global economic slowdown in 2019. The dispute has stunted global trade and investment according to the OECD. Economies which have a greater exposure to trade, such as Germany’s and Japan’s, have felt this economic slowdown more than most.

Though less exposed to trade than others, the US has also seen the effects. Manufacturing activity for December was at its lowest level since the financial crisis. While the recently signed phase-one deal between the US and China has averted any immediate escalation in tensions and reduced some existing tariff rates, the deal will leave tariffs on $360bn of Chinese goods. These tariffs were a drag on the earnings of US companies during 2019, as many of them found it impossible to pass on the extra cost of importing Chinese goods and parts on to their customers. The hope now is that corporate confidence and business investment will pick up following the phase-one settlement.

The president says the remaining tariffs will give the US leverage during a phase-two deal that will seek address the more intractable issues such as unfair state subsidies to Chinese companies.

Figure 2: ISM Manufacturing Index (June 2006 to December 2019)

ISM Manufacturing Index

Source: Institute for Supply Management as at 31st December 2019

As the November election approaches, President Trump ought to be keen to have made some progress on a phase-two deal that rows back further on tariffs and supports the economy. Given how poor manufacturing sentiment is right now, this may improve confidence and encourage investment, which should feed into improved earnings for companies. Combine improved manufacturing sentiment with a solid consumer and the US economy may yet outperform expectations in 2020.

Figure 3: Consumer Confidence Remains High (2014 to 2019)

Consumer Confidence

Source: Conference Board as at 31st December 2019

The future relationship

European companies have had to contend with slowing trade and the uncertainties created by the Brexit process. An improvement in global trade may occur in 2020, but Brexit risk remains. The Conservative Party’s emphatic UK election victory may have removed the threat of a “no-deal” cliff edge, but there is no clarity yet on what sort of future relationship Johnson’s government wants with the EU. Recent comments from the chancellor on the degree of alignment with EU have been contradictory.

The prime minister’s decision to limit the transition period to the end of this year has surely restricted the scope of any possible deal and created a new cliff edge at year-end. It would seem that only a basic trade deal could be negotiated in the eleven months left after the UK’s departure at the end of January.

That decision may have been taken to keep the pressure on the EU to “get Brexit done”, but the hard yards are ahead of the negotiation teams, with difficult issues such as goods trade, fishing rights and security arrangements said to be among the EU’s priorities. As the negotiations proceed, we would expect overt lobbying from industrialists on both sides to try to force the negotiations towards a close relationship. It is possible that we will start to get the clarity that companies need to plan investment within the first few months, but it is more likely that we will head to the wire yet again.

Our often-repeated view has been that self-interest will steer the future relationship towards “zero tariffs, zero quotas, and zero dumping”. We will stick with that optimistic view for now.

Bond market support

Rising interest rates were partially responsible for the Q4 2018 equity selloff that spooked policy makers and prompted a reversal of tack by the Federal Reserve. In recent months both the European Central Bank (ECB) and the Federal Reserve have indicated that interest rate increases are unlikely during this year. The ECB has said it will not raise rates until at least the middle of 2020, while no Fed officials currently expect a US interest rate increase in 2020.

While the change in central bank policy was very supportive of bond returns during 2019, that effect had been priced in by last summer and yields have drifted higher since. Now that this support is in the price, it is the trajectory of the trade war that will be the key driver of bond returns in 2020. A sustainable resolution to hostilities will support growth and reduce recession risk. This should allow yields to continue to drift higher in spite of the fact that inflationary pressures remain under control.

With the trade situation set to improve and industrial sentiment already low, our expected return from bonds for 2020 is low single digits. However, we recommend that investors have a position in bonds in a balanced portfolio because, although the expected return in bonds is only marginally better than as cash, bonds will diversify equity returns in the event of an equity market correction, while cash will not.

Conclusion

Investors have had to contend with a heightened level of political risk in recent years and 2020 will be no different. US-Iran tensions in the Middle-East, both an impeachment inquiry and a presidential election in the US, and ongoing Brexit negotiations will all generate headlines and volatility. And yet, what has driven markets in recent years has been global central bank policy and trade war developments. On both fronts we believe there is scope for optimism.

We have more visibility on monetary policy now than we had last year, and it looks like it will be supportive through this year. The extent of the likely improvement in corporate earnings and global growth from the US-China phase-one trade deal is far less certain and probably weighted towards the end of the year. This leaves the scope for a correction from current levels if investors lose patience. Return expectations must also be tempered by current valuation levels. But the issues that we have highlighted above which have weighed on the economy in the past year are being resolved and this should improve the earnings outlook for the market.

When building equity portfolios, we focus on our definition of Quality*. Using this philosophy, we invest in profitable companies that deliver consistent results in the long run, allocate capital wisely and are best positioned to manage their longer term Environmental, Social and Governance (ESG) risks. In the current environment, we also believe that bonds will continue to play a diversifying role in balanced portfolios while being complemented by the asymmetric return profile of high-quality equities.

 

*Davy Asset Management - “Quality Matters” White Paper – Chantal Brennan, Paraic Ryan, Hannah Cooney: 2016.

 

 

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