Defying a wall of worry

8 minute read

12 November 2019

By Julien Lafargue, CFA, London UK, Head of Equity Strategy

While the spectre of a US presidential election and recessionary fears cloud the outlook for many investors, prospects for a diversified global equity portfolio remain bright.

Going into 2020, fundamentals point to some upside in equities, justifying staying invested. Yet, uncertainty is high and market participants remain torn between fears of recession and hopes that the cycle extends. In what is likely to be another volatile year, it makes sense to focus on ways to diversify and improve the risk/reward profile of portfolios.

Earnings likely to be lowered

After just 1% growth in 2019, bottom-up analysts expect global equities to deliver around 10% earnings growth in 2020 and 2021. However, most of the investor community - us included - believes that from a top-down perspective 10% growth is unrealistic. Indeed, we pencil in 6% growth in 2020.

Our cautiousness on earnings is based on the following factors. First, we believe that global economic growth will remain at, or below, trend. After a difficult 2019, growth could reaccelerate modestly, particularly in emerging markets. However, most of the developed world is likely to remain stuck with sub-par growth. This means that top-line growth should not surpass +4% in 2020, only slightly better than 2019’s +3.5% growth. Second, from a margins perspective, we see limited scope for expansion given limited slack in labour markets, tougher raw materials comparables and slow productivity growth (see chart).

2020 earnings expectations appear too elevated

We see limited scope for (margins) expansion given limited slack in labour markets, tougher comparables on raw materials and slow productivity growth.

Limited room for valuations to expand

In terms of valuations, global equities trade at a price to 2020 earnings multiple of around 15 times, using current consensus figures. This compares to 15 and 5-year averages of 13.8 and 15.2 times, respectively.

Assuming earnings only grow by 6% in 2020, valuations appear even more stretched at 15.6 times. Easy monetary policy and low interest rates are likely to support valuations, but further multiple expansion would require investor sentiment to improve substantially. We don’t see this happening unless there is a positive shock such as broad-based fiscal stimulus.

While we will certainly see swings in valuations in the next twelve months, on a trend basis we expect multiples to remain unchanged.

What could go right?

It is difficult to see how either earnings growth or multiples could go higher. The former would require global growth to pick up or some one-off boosts, such as the tax break US companies received in 2018.

While neither earnings growth nor valuations appear set to rise, pressure has been mounting on governments to take advantage of the low interest rate environment and increase spending. In particular, infrastructure spending, mostly geared toward energy efficiency, has been a popular topic. Should this occur in a meaningful way, we could expect earnings to pick up.

On the valuation side of the equation, we would need to see investors becoming euphoric once again in order for multiples to expand. This could be achieved if both economic and geopolitical risks shrink significantly. This is unlikely but possible assuming that trade discussions move to “phase 2”, allowing existing tariffs to be rolled back. In a blue sky scenario, assuming that earnings grow by 10% and that multiples expand further, we believe that global equities could generate mid-teens returns.

Significant multiple extention seems unlikely

What could go wrong?

After the last twelve months, the “wall of worry” is high and the list of things that could hit sentiment is long. Among these, we see two main potential risks.

First, an economic slowdown that is worse than anticipated. While global growth has slowed, an outright recession seems unlikely. Yet, even if the global economy avoids two consecutive quarters of negative growth, or recession, if investors believe a recession is near, equity markets could suffer. This was the case in December 2018 and we can’t rule out it won’t happen again.

Second, ultra-accommodative central banks, coupled with market expectations for further stimulus, could pose a dual risk to the markets. On one hand, investors could lose faith in central banks’ ability to save the day as they run out of effective ammunitions. On the other, markets could be wrong-footed if central banks start tightening monetary policy again, causing another “taper tantrum” episode. While downside risk would be significant, we would expect a quick recovery, as this scenario would only occur if economic activity was gaining momentum.

Equities still attractive

From a fundamental point of view, the risk/reward for investors appears challenging. Yet, in the context of a global economy that is slowing, but growing, with low interest rates and light investor positioning, we believe equities offer modest upside and significant relative value.

Volatility on the rise

As relevant as fundamentals may be, they are often overridden by sentiment in the short term. On that front, we expect 2020 to be another volatile year as investors’ perception swings between recession fears and recovery hopes. Over each of the past 40 years, global equities have experienced a median annual drawdown of -11.5% (see chart).

We believe 2020 will be more akin to the norm than to 2017, when markets never pulled back more than 2%. As such, investors should be able to take advantage of volatility spikes as the year progresses.


The US is our preferred region

From a regional perspective, the US still seems best positioned owing to its growth-oriented profile. US equities have outperformed strongly over the past five years (+7% annualised excess return compared with non-US equities). We see little reason for this to change.

From a regional perspective, the US still seems best positioned owing to its growth-oriented profile.

US valuations aren’t particularly appealing, but we believe this can be justified by the market’s added visibility. Even if the 2020 presidential election clouds the outlook, we doubt investors will be willing to switch out of US equities to say Europe or emerging markets in periods of uncertainty. This was not the case in 2019 and 2016, the year President Trump was elected, which saw US equities outperform by almost 10%.

Emerging markets require patience

Emerging markets (EM) have generated disappointing returns of late. Slowing growth, a stubbornly strong US dollar and idiosyncratic issues (such as protests in Hong Kong and political instability in Latin America) haven’t helped.

Going into 2020, the region’s attractive medium-term growth prospects are still not properly reflected in valuations, in our opinion. Yet, we believe outperformance may not materialise until it is clear that growth in EM is stabilising. Some green shoots have started to appear, but another quarter or two may be necessary to reassure investors.

Going into 2020, (EM’s) attractive medium-term growth prospects are still not properly reflected in valuations.

Eurozone as a value play

Eurozone equities have performed surprisingly well in the context of slowing global trade and challenged domestic economies. The European Central Bank has played its role in supporting the region. However, for eurozone equities to move higher, we believe that more is needed.

The eurozone remains a value play that investors like to buy as a proxy for an improving macroeconomic backdrop. Next year is set to see large swings in investors’ sentiment, creating potential opportunities for eurozone equities to outperform.

But without more profound reforms, fiscal stimulus and structural improvements in the banking sector, we believe the region overall remains a trading market. Instead, for long-term investors, we prefer to focus on specific opportunities at the sector and stock-specific levels.

UK’s time to shine

Over three years into the Brexit saga and most investors are significantly underweight UK equities. Assuming clarity finally emerges on whether, how and when the UK leaves the European Union, significant inflows could follow, driving outperformance of the regional indices which remain largely undervalued in light of strong earnings growth.

Hard, soft of no Brexit, UK companies, in particular large capitalisation ones, will be able to adapt in our opinion. As such, once the initial shocks – positive or negative – from both economic and exchange-rate fluctuations have passed, we believe that UK equities’ attractiveness will shine again. Timing this opportunity will be difficult, but investors should put the UK market back on their radar.

Despite Brexit, UK's earnings grwoth remains strong

Every year in the past decade, the moment came when “value” stocks were due to finally start outperforming again. The last twelve months were no exception, as the valuation spread between “cheap” and “growth” companies reached unprecedented levels.

We see limited investment merits in chasing value. We do expect the investment style to be a hot topic in 2020. That said, the style will outperform periodically, but in relatively short bursts and extremely hard to capture. As such, we maintain our preference for “quality” stocks over the medium term.

Maintain a barbell sector allocation

At the sector level, given our top-down view, we maintain a so-called barbell approach between cyclicals and defensives. Within that, we are reluctant to chase expensive bond-proxies, like utilities, and we believe that some of the early-cycle industries are unlikely to see a sustained rebound against a highly uncertain backdrop. As a result, consumer discretionary, communication services, industrials and healthcare are our preferred sectors.

At the sector level, given our top-down view, we maintain a so-called barbell approach between cyclicals and defensives.

Consumption to fare better

Although it would be wrong to assume that consumers can stay insulated indefinitely from an economic slowdown, we think consumption will remain resilient in the medium term. As such, we keep our positive stance on consumer discretionary in all regions. Similarly, we remain constructive on communication services in the US, although we favour content producers versus large-cap internet names.

Industrials as a growth play

While industrials may struggle should economic momentum stall, we believe the sector is gradually becoming less sensitive to the economic cycle, offering attractive long-term growth prospects. Indeed, with the increased use of technology, most industrial companies are morphing into services providers. We believe this will reduce the volatility of earnings and allow for higher valuations as visibility improves.

Healthcare to remain volatile

Investing in the healthcare space ahead of a US election is always a challenge. We believe that 2020 won’t be different, with healthcare likely to experience higher-than-usual volatility. Yet, the combination of attractive growth potential and undemanding valuations relative to defensive peers, should not be overlooked. As such, we see any election-related weakness as a possible entry point into a sector that we think could generate outperformance over time.


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