Author: Alastair George
We have been cautious of global equity markets since Q219, fearing that global equities had run ahead of a renewed downtrend in 2019 profits forecasts. In addition, political risks remained unresolved. The most recent data for September suggests that while economic activity remains muted the rate of decline has moderated and profits forecasts may have stabilised. As importantly, given the 12-18m lags, the effects of lower interest rates globally on the world economy will shortly begin to show in the data. We believe equity investors should be alert to improving economic momentum at this time. Notwithstanding the still outstanding political risks, with many large-cap companies now yielding well in excess of the new lows in long-dated government bond yields, we move up to a neutral position on equities.
Source: Refinitiv, Edison calculations
At the time of our shift to a cautious stance, equity valuations had rebounded strongly from the lows of December 2018 while economic momentum was declining and the US/China political dispute showed few signs of resolution. Central banks were shifting away from earlier policies of attempting to renormalize monetary policy, but there was still significant doubt as to the extent of any easing. There should be little doubt now that central banks are willing to act to counter the weakness in the outlook, with the US Fed cutting rates at its most recent meeting and the ECB restarting its QE program, albeit controversially.
The peak in interest rates at both the short and long end of the yield curve was in Q418. Furthermore, central banks on both sides of the Atlantic have since cut rates and lowered expectations for future interest rates, implying another extended period of very low rates – which is unusual at such a late stage in the cycle. Previous economic studies indicate that the impact of changes in interest rates on the real economy occurs with a lag in the region of 12-18 months. If these studies are a guide, we would expect market expectations of any rebound in activity to be discounted somewhat ahead of the data becoming visible in economic time-series in Q120.
There has already been a notable shift in measures of risk aversion since the start of September in fixed income and currency markets. For example, developed market government bond yields have risen sharply from their lows at the end of August while the Japanese Yen has given up its recent advance. We also note the recent surge in the oil price has had virtually no impact on other financial markets which indicates a degree of near-term equity investor resilience to events.
While recent survey data in the eurozone has been disappointing, purchasing managers’ indices for the eurozone have stabilised during the summer, albeit at levels indicative of contracting activity. The ECB’s recent decisions to cut interest rates, extend forward guidance and reintroduce QE has reportedly caused controversy at the ECB governing council, but these actions are positive for eurozone equity markets where the competing long-term assets are government bonds with a negative yield.
We share the concerns that such distortions in financial markets may be unhealthy for market economies in the long-run and in particular contribute to the rise inequality that has already led to some adverse political outcomes. However, the lesson for investors from the prior decade is clear – in the short-term a central bank determined to ease monetary policy to support the economy cannot be ignored, even if the underlying economic data remains weak.
In the US, the most recent industrial production report paints a somewhat more positive picture of the health of the US economy than the PMI survey data. It is too early to be sure that this is the start of a trend but as the positive economic surprises continue, this is no longer the time to be running an overtly cautious portfolio. While the US Fed may have delivered a modestly more hawkish message yesterday compared to market expectations, Fed Chair Powell clearly stated that policy would be adjusted in the event growth continued to weaken.
The bullish scenario is that the delayed impact of the easing of monetary policy will start to feed into the real economy by early 2020, leading to a substantial improvement in investor sentiment – where positioning amongst institutional fund managers remains for now still bearish, according to recent surveys.
Politically, while the US/China trade dispute and Brexit certainly remain unresolved it is also the case both US President Trump and the UK Prime Minister Johnson have good electoral reasons to attempt to bring these episodes to a conclusion. For the US, President Trump fully understands the importance of a cyclically strong economy during a Presidential election year and a tactical boost to his campaign by reaching at least a short-term trade détente with China is largely within his control.
There is also an electoral prize awaiting PM Johnson who in a post-Brexit scenario would be likely to consolidate the currently fragmented support for a traditional Conservative party agenda, given that the Brexit question would no longer be of relevance. It may be difficult emotionally to invest alongside this unusually high level of uncertainty but it is not exclusively negative scenarios which are possible over the next 6 months.
Finally, having underperformed relative to traditional 8% pa equity return benchmarks in recent years European and UK large-cap equities valuations have become increasingly undemanding in our view, especially compared to the US, even if this is partly offset by a relatively poor performance in terms of profits growth. This is particularly noticeable in respect of the UK where the median 1-year forward price/book multiple for large-cap equities of 1.7x is close to the lows of the past decade.
Source: Refinitiv, Edison calculations
We are not suggesting that at this stage in the cycle it would be appropriate to invest aggressively in equities. The improvements in the incoming data we have observed to date remain only tentative indications of better data ahead. Nevertheless, while the US/China and Brexit conflict narratives remain in the foreground, the declines in global interest rates since Q418 will by now be supporting economic activity. We suggest a neutral view for global equities, rather than our previous cautious outlook is now appropriate as profits forecasts stabilise. Furthermore, additional central bank liquidity is directly beneficial for asset prices while large-cap valuations in Europe and the UK at least are now undemanding in the context of still very low yields on government bonds.