Over the past decade Wall Street set a cracking pace versus the rest of the world, with US stocks up 190 per cent.
Traders are now expecting a rebound in global economic activity in January, spurred by a recovery in business sentiment and investment. Central bank policy easing over the past 12 months has helped counter the drag inflicted by a trade war and a moderating Chinese economy on global activity. In the wake of the recent trade detente between Washington and Beijing, investors need to gauge the extent of any recovery and whether it translates into stronger earnings growth, which is a key driver of long-term equity performance.
A strategy to counter the slumbering government bond yields of the past decade entails that equities remain a prime source of income for investors, along with corporate debt. This approach is driven by the expanding balance sheets and easy money policies of central banks. As to whether fiscal policy spurs higher bond yields, many point to the experience of Japan, where big spending by the government has failed to boost growth and inflation down the decades.
In global terms, the MSCI All-World equity index only recently eclipsed its early January peak from 2018. That shows how the bruising two-year trade battle between the US and China, alongside political drama in the eurozone and UK, has essentially been accompanied by global equities trading sideways. But this is not the full picture. The S&P 500 has risen more than 10 per cent beyond its early-2018 peak, reflecting the dominance of its tech titans. Europe is next, with the Stoxx 600 having taken out its 2015 record high, while the MSCI Emerging Market equity index loiters about 15 per cent below where it was trading two years ago.
The S&P 500’s current 12-month forward price-to-earnings ratio of 18.2 times is about 15 per cent above its long-run average. In contrast, this measure for non-US equity markets sits well below long-run averages.
Such a contrast between regions explains why many believe in a rotation from expensive US shares towards cheaper global areas, such as the UK, Europe, Japan and emerging countries. A global recovery that favours the emerging world while US activity moderates would be one driver. Others anticipate that fiscal stimulus in Japan, the UK, and even the eurozone could provide a fillip while the US focuses on the presidential and congressional contests this November.
Investors looking at the generally cheaper valuations of EM equities must weigh whether lower bond yields and fiscal stimulus during 2019 have set the scene for a rebound in economic activity. The strong performance of EM bonds in both US dollar and local-currency terms last year is a reflection of central banks’ efforts to ease policy against a backdrop of slowing inflation.
“Japanese and EM equities are among those set to benefit most from a global manufacturing recovery and a lull in US-China trade tensions,’’ say strategists at BlackRock. “And EM central banks outside of China are likely to stay on their easing paths, supporting growth and equity markets.”
The performance of China’s economy will play an important role for investor sentiment, particularly across Asia. A trade war thaw that sustains a stable renminbi and a period of US dollar weakness could power a strong performance for EM equities, as was the case in 2017.
Another stumbling block that has held back recent investment sentiment has been Beijing’s reluctance for the kind of sweeping debt-funded stimulus that boosted global activity in the past. Moreover, China’s transition towards a more domestic-oriented consumer economy is bad news for its neighbours.
“The change in China’s growth model is a serious structural problem because a consumption-driven China is EM unfriendly,” argue economists at Citi, who believe that “EM potential growth rates are falling”. They add: “While EM has a bit of space to respond with looser fiscal policy, public debt stocks are already high.”
Also weighing on the performance of EM equities in 2019 was the financials sector, reflecting a tough operating environment and a warning sign that credit stress still lurks beneath the surface for many economies. As banks account for a quarter of the weighting of the MSCI EM equity index, this is one group that must experience an uplift or it will drag down the broader market.
This highlights another important aspect about 2020: just how investors navigate the divergence in equity valuations amid a patchy economic recovery. Equities are priced for an extended economic cycle that restores double-digit earnings growth and stronger corporate margins in the coming quarters. That is certainly the expectation among analysts for multinational companies in the S&P 500, where the gap between valuations and profits looks stretched.
JPMorgan’s analysts highlight the stakes for investors: “While it’s normal for markets to anticipate the next phase of the business cycle, the current overshoot is large enough to imply about 10 per cent drawdown should fundamentals fail to turn.”
For readers looking to 2020 and beyond, the best of success in navigating the market currents.