Blue sky thinking

20 November 2019

5 minute read

Global equities continue to rally. The S&P 500 is up more than 25% (total return) year to date, closely followed by European equities. At the same time volatility is hovering close to an all-time low, see Chart of the Week. There is a clear sense of optimism with investors expecting global economic growth to rebound, a “phase one” trade agreement to be signed imminently and a smooth Brexit. With equity markets pricing in what seems to be a “blue sky” scenario, we believe that one should be aware of the key risks surrounding the outlook.

It’s not a done deal

The main risk facing financial markets lies with US-China trade negotiations that could underwhelm (or collapse). At this point, investors are anticipating a healthy “phase one” agreement (including the avoidance of December tariffs and rescinding the September ones). However, it isn’t clear when a formal announcement will arrive by.

In fact, the Asia Pacific Economic Cooperation summit, which was supposed to serve as the setting for a “phase one” US-China signing agreement, has long passed. Although press reports suggest consensus hasn’t yet been reached on a many issues, investors remain impervious to these red flags. Even if both sides deliver on high expectations, we believe the market may be willing to “sell the news”.

Economic momentum yet to rebound

The second risk we highlight has to do with economic momentum. The consensus overwhelmingly anticipates improving manufacturing economic data over the coming months and the attendant outperformance in “cyclical” and “value” stocks, a popular trade recently. We fail to see hard data pointing in that direction. In fact, Citi’s global economic surprise index turned negative earlier in November, indicating that data is coming in below expectations (see chart). If data stays tepid (and the lack of agreement on trade isn’t helping) and Treasuries rally, it could severely undercut market positioning.

Global economic data is worse than expected

Optimistic earnings expectations

The final major downside risk for equities pertains to 2020 earnings expectations. While companies have not provided much guidance during the third-quarter earnings season, consensus earnings per share forecasts in the US have continued to bleed lower with 2020 growth now expected to be +10% (versus +11% six weeks ago). We believe this remains too high and anticipate further downgrades down the road, making the market ever more “pricey”. The fourth-quarter earnings season won’t start until 14 January 2020 but we would expect some negative pre-announcements in the coming weeks.

Other potential flash points

This list is not exhaustive as we see several other potential flash points including the unrest in Hong Kong, the lingering impeachment procedure in the US and the lack of clarity around possible auto tariffs on Europe. Yet, underexposed investors appear more fearful about missing a year-end melt-up in equities than being caught long should things take a turn for the worse.

We are not bearish, just pragmatic

We are certainly not advocating selling equities indiscriminately. Indeed, although the market may have gone ahead of itself in the short term, our 2020 outlook points to further (modest) gains for equities. Our message is that investors should make sure their exposure takes into account the numerous risks we see and the market seems to ignore for now.

Diversification, active management and volatility

In the current environment it is paramount that investors ensure they have appropriate levels of risk in their portfolios and maximise diversification. It’s easy to get caught in the prevalent optimism among investors. But sticking to long-term objectives and relevant asset allocation is key. We also think that active management can help better cushion drawdowns than passive exposure. Finally, volatility is unlikely to stay this low for much longer. We believe that investors should prepare for a rise in uncertainty and volatility.

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