A look back at the last quarter
The final quarter of 2018 was an uncomfortable experience for equity investors. The MSCI World was down 12.5% after being up 5% in the prior three quarters and 2018 was the worst year ever for broad asset returns in US dollar terms, in that 90% of financial assets finished in negative territory.
According to historical analysis from Deutsche Bank, this was the worst ratio since 1901, beating the previous peak of 84% in 1920. Only wheat, T-bills (US$ cash) and bond markets in China, the US, South Korea, Japan and Thailand provided positive returns – not one equity market managed to qualify.
The story was less dramatic in local currency terms since the US dollar had a strong year but, even so, 2018 ranks as the third-worst year on this basis with 61% of assets in negative territory. Of note is that since 1901, there have only been three occasions when more than 50% of assets were negative (in US dollars) for two years or more in a row.
Examining whether any of the catalysts behind the correction will change materially for the worse or the better in the year ahead will help weigh up the prospects a little better. In simplified form these catalysts are listed below.
Themes of 2018
- A threat to free trade
- A tightening of credit conditions in China
- A tightening of monetary policy by the Federal Reserve
- Political upheaval and regulatory changes in the auto industry in Europe
While earnings estimates for the MSCI World (All-Country) equity index actually rose last year, the themes noted above combined to heighten concerns regarding the future path of GDP and earnings growth. The effect on markets was to undermine the confidence that supports the multiple that investors are prepared to pay for future earnings (see below chart).
MSCI World P/E multiple compression
Source: Bloomberg / MSCI
The price to earnings ratio (P/E) is a function of a discount rate, growth and the confidence that investors have in that growth. In the short term, confidence is often the most powerful driver of investment returns.
Investor confidence is fickle and as a result, the volatility of the P/E multiple is often higher than the volatility of earnings. The P/E tends to rise as investors become more confident and fall as visibility deteriorates. The P/E also has a tendency to overshoot at both ends of the scale as fear and complacency become reinforcing, creating opportunities for the contrarian.
The sources of returns chart below shows the effect that changes in P/E have had by decade compared to earnings, dividends and inflation. In the very long term ( more than 30 years), inflation and dividend yield are the principle components of returns but, as the chart shows, the change in the P/E multiple can frequently dominate as the driver of returns in any discreet 10-year period.
Therefore, considering the ‘known unknowns’ and anticipating whether investors will be more confident or nervous as the year progresses will help to form a view on whether returns will be helped by multiple expansion or hindered by contraction.
MSCI World – sources of return
Source: Tilney / MSCI
With this in mind, our expectations with regard to the change in the P/E multiple in 2019 lead to a broadly positive conclusion for investors. All the themes in 2018 noted above heightened investor concerns for global growth, and P/E multiples contracted as this uncertainty grew accordingly.
In the year ahead, we expect business activity and earnings to deteriorate and that analyst earnings at the beginning of the year will be revised down over time. However, negative earnings revisions are actually a more normal phenomena than positive revisions for investors.
The last two years, and particularly 2017 were unusual because in most years, equity analysts cut their numbers during the year as their expectations are proved to have been too optimistic. Investors anticipate these dynamic and modest negative revisions and they tend to have little impact on markets.
Therefore, although the positive change in 2019 is unlikely to be via earnings, we still expect decent investor returns through an expansion of the multiple that investors are willing to pay for those earnings, as sentiment improves and the principal negatives from 2018 moderate.
The US/China trade tariff dispute has undoubtedly negatively impacted business sentiment and is now beginning to show through in terms of new orders out of the US. Deteriorating new orders affect trade volumes, as reflected by shipping rates (see below chart), and weakness in new orders out of the US was one of the principal negative catalysts we highlighted in the October Market Pulse.
We expect the Chinese government to reach a compromise agreement with the US administration regarding trade tariffs relatively soon, and that this will improve investor expectations for growth, particularly in the Asia Pacific region.
While it would be a negative if these talks broke down and the US continued to pursue an aggressive isolationist stance, we would expect the Federal Reserve to react to this via a more dovish monetary policy stance in a damage limitation exercise.
New orders leads shipping rates (US$)
Credit growth in China
Credit growth in China leads the change in manufacturing output by approximately 6-8 months. We highlighted the risks of Politburo policy to tighten over-zealous credit growth in China at the end of 2017 and we still expect these measures to be a drag on growth through the first half of 2019.
However, the government has recently taken steps to counter the drag on GDP through multiple channels including corporate tax cuts, personal tax allowance increases and capital spending programmes. The People’s Bank of China also made the largest ever net liquidity injection (1.14 trillion renminbi) into financial markets in mid-January and announced intentions to cut the reserve rate requirement by a further 1%.
These expansionary policies are very encouraging for investors who are worried about growth but will take time to feed through to the pace of economic momentum. The authorities may even need to do more of the same if the trade situation deteriorates since, with 260% total debt to GDP, the options for credit-driven expansion in China are limited.
Chinese credit leads manufacturing
US Federal Reserve policy
Faced with a slowing growth picture outside the US, the decision by the Federal Reserve (Fed) to raise interest rates for the fourth time in December was not taken well by the markets. Over the following four business days, the MSCI World USA equity index fell 7.7% and the MSCI AC World index fell by 5.1%.
By the beginning of the New Year, 10-year US government bond yields had fallen from 3% at the end of November to just 2.5% and gold had rallied by 3.3%. This verdict from investors clearly indicated that the Fed was in danger of a policy mistake, and at the beginning of January Governor Powell acknowledged as much in a verbal downgrade of Fed tightening for the year ahead.
We believe that the combination of higher rates, a strong US dollar, slower international growth, quantitative tightening (QT) and the sell-off in equity markets forced the shift in policy, with the latter being the final catalyst for the reaction from Governor Powell. Notably, the Fed reduced quantitative tightening in December from the usual US$50 billion to just US$28.5 billion and it will be interesting to see if this reduced rate continues in January.
Markets have rallied nicely since the change in the Fed stance and some Fed watchers are now speculating over whether the next step will be to suspend QT. The consensus is now that further interest rate increases are firmly on hold as the Fed rethinks policy normalisation within the context of a higher fiscal deficit and a global slowdown.
US market-implied policy rates indicate a policy error
It is possible that the Fed has underestimated ‘crowding out’ by the financing of the rising US budget deficit in its rate path forecast and will now have to reset the assumptions. Crowding out occurs when the funding of the deficit leads to a tightening of financial conditions elsewhere in the economy, brought about by a redirection of savings to the public purse. In this case, the tightening came in the form of equity market liquidations as investors sold stocks to buy bonds.
Since QT removes the Fed as the largest buyer in the Treasury market, the US$1 trillion additional financing required as part of the fiscal reforms of 2018 would have to be financed either externally through foreign direct investment flows or from domestic savings. Foreign financing for the deficit is less likely if there is a trade war that undermines recycling of trade surpluses and the problem with financing from domestic savings is that it drains liquidity from the economy or from alternative financial assets such as the stock market.
We believe that this transfer of savings out of the stock market into risk-free interest rate bonds was one of the factors that drove the market correction in the US in the fourth quarter and tightened financial conditions accordingly. The Fed, who to be fair have not had to consider the problem of crowding out for 20 years, appears to have not factored this dynamic into their models and hence the volte face in policy that has cheered the markets.
The conclusion is that in the face of a rising budget deficit and high total fiscal debt, the path of monetary normalisation in the US will need to be more incremental, with appropriate language from the policy committee being used to tweak policy rather than blunt interest rate increases. Resolution to the trade issues with China could help the Fed with the financing problem a little but our central assumption is that this avenue is limited by the likelihood that China will move to a trade deficit position this year.
The introduction of new European emissions regulations in 2018 had two major consequences. It brought forward sales into 2017 and caused the German auto export engine to hit a significant pothole in 2018. In contrast to the abrupt downshift from 2.8% annualised GDP growth in quarter four of 2017 to around 1.2% the following year, we expect 2019 to see a return to a more normal GDP growth and an improvement in European manufacturing overall.
Manufacturing aside, Brexit and the US/China trade war clearly contributed to slower growth and sentiment in Europe in 2018. ‘Brexit in name only’ remains the most likely outcome rather than a ‘no deal’ scenario which remains a tail risk. The normalisation of manufacturing output and a broadly expansionary fiscal outlook in Europe should reverse the negative momentum of 2019 and support the equity markets and sentiment in the year ahead.
Our central assumption is that many of the themes that drove down markets in 2018 will be more benign this year. Monetary policy, fiscal policy and valuation are our three pillars of investment strategy and they have improved in favour of risk assets versus perceived safe havens such as government bonds.
We have recently increased our exposure to equities in portfolios and have a bias toward the unloved emerging and UK markets. A moderate depreciation of the US dollar would add to the momentum in emerging markets, although we also acknowledge that the US economy and US interest rates have the strongest attraction for capital for now.
We expect growth in the US to slow in the first half of 2019, while the rest of the world will begin to turn the corner and this dynamic should be good for our portfolios. At the same time, the politics remain volatile and, like the Fed, we will remain vigilant!
For more information or if you have any questions, please get in touch by calling 020 7189 9999.
This article was previously published on Tilney prior to the launch of Evelyn Partners.