Turbulent adjustment to slower growth
In early December we argued that despite the increase in earnings, and the move in equity prices, the attractiveness of the equity market was somewhat ambiguous. While the earnings yield of equities increased through most of 2018, so did the return on cash, leaving the difference between the two virtually unchanged.
Market performance in December was worse than what the overwhelming majority of analysts and investors anticipated. As a result, cash performed better than every asset class in 2018. While this is understandably frustrating, it is important to recall that asset allocations are based on medium term return expectations, and associated risks. December was a brutal example of how short-term performance can deviate substantially from medium term expectations.
The market moved from pricing-in a modest deceleration in growth to pricing-in virtual certainty of a recession this year. There are a number of explanations for the market gyrations. Uncertainty regarding the future of the US-China trade relationship. A change in the nuances of statements by Fed officials. The softening of economic data in a number of major economies. The speed and magnitude of the sell-off may have also been magnified by the impact of algorithmic trading in equities. Whatever the explanation, there is a significant disconnect between economic reality and market performance.
We surveyed the views of 20 banks and asset managers who published their 2019 outlook. While their opinions diverged on certain asset classes, there was a considerable consensus on a number of key themes. For instance, they all agree that the growth rate of the American economy will decelerate in 2019 but that the risk of a recession is low. Other recurring themes were that of a weaker US dollar, a stubbornly flat yield curve, an oil price target above USD 70, a slowdown in US earnings growth, and continued equity market volatility throughout the year.
Equity valuations are attractive, especially in Europe and Japan, where many managers continue to favour an allocation. Views over the US equity market were, however, more mixed given the deceleration of earnings growth. This translates into most managers opting for an asset allocation with a slight preference for equities over fixed income. Emerging markets (EM) on the other hand, both fixed income and equities, have regained the interest of most analyst.
Our views are similar to majority views in some respects and different in others. Following the change in valuations seen in December, we now agree that equities are more attractive than bonds. Within equities we prefer US equities over European or Japanese ones. US earnings growth will certainly decelerate from the torrid pace of last year, which was artificially boosted by tax cuts. But underlying fundamentals suggest that some modest growth this year should be expected. The outlook for Japanese and European earnings is more complex, as both markets are export-dependent. A decelerating global growth environment (especially uncertainties in China) is likely to weigh export dependent markets. We therefore increase our allocation to US equities to Neutral and maintain an underweight in Europe and Japan.
We also increase our exposure to EM equities to Neutral with a tactical call on Latin America. A weaker US dollar coupled with a potentially more dovish Fed and stable commodity prices are all supportive of EM fundamentals. The change of the administration in Brazil has renewed impetus for reform. While we do not expect the new president to succeed in all forms, some changes to pensions can be expected, which will have a material impact on the long-term debt dynamics.
Finally, we reduce our exposure to US high yield (HY) as we expect spreads to widen further. High corporate leverage, more expensive refinancing rates and a slower pace of growth should add pressure on borrowing costs for lower quality companies.
While we see a disconnect between economic reality and market performance, we recognise that there are some risks. If policy uncertainties (US-China trade relations, US government shutdown) persist, financial conditions may remain tight. This, in turn, will take a toll on growth and earnings. There is merit in taking some inspiration from Pyrrho on the sailing ship, but there is no room for complacency.
