- A foundation has been laid for more fundamentally driven returns to emerge with the unwinding of premium valuations across asset classes in 4Q18
- Further downgrades to earnings expectations remain the key headwind to global equities in early-2019 while government bond yields appear overly compressed entering the new year
- US Investment Grade bonds, Japanese Equities and select US equities appear to have already priced in the prospect of a significant slowdown in global growth
- Chinese, emerging market and global industrial commodity-linked equities present good value opportunities but are likely to require more proactive Chinese stimulus as a catalyst
Framing the volatility of 4Q2018 and looking forward
With the 17% peak-to-trough decline in global equities in the 4th quarter of 2018 followed by a 7% rebound into the new year, investors have been on a harrowing ride over the past several months.
However, putting the falls into context, the decline in US equities is similar in magnitude to moves seen in previous, post-2008 corrections (Chart 1). Similarly, the widening in investment grade credit spreads has reached comparable proportions to moves seen in previous, post-2008 corrections (Chart 2) and earlier US recessions (excluding 2008-98).
As we highlighted in our October Spotlight, Five Triggers for a Market Bottom, December and January saw four of the five catalysts emerge in a relative short span of time to bring stability in late-2018 (see pull-out ).
An additional positive trigger emerged on January 4, 2019 with a surprisingly strong US non-farm payrolls report allaying (unfounded in our view) growing fears of an imminent US recession which had built during the market declines.
Thus, with important headwinds including a hawkish Federal Reserve, excessive valuations and overly optimistic sentiment unwound through end-December, we expect that a foundation has been laid for more fundamentally driven returns to emerge in the market.
However, volatility similar to that witnessed in 4Q18 will remain a feature of markets looking ahead, requiring risk management to remain an important characteristic of decision making going forward.
Look for opportunities in US IG credit, Japan equities and select US equities
While the sell-offs across asset classes have been broad-based, the emergence of fundamental value has been more selective.
In the fixed income sphere, US investment grade bonds have seen a widening in spreads that has been consistent with not only post-2008 market corrections but also comparable to the widenings seen during the 1990 and 2001-02 US recessions as well as the 1997-98 Asian Financial Crisis (Chart 2).
Admittedly, in absolute terms, US Investment Grade spreads have only returned to historical average (Chart 3). Despite this, US Investment Grade risk-reward is now more balanced than at any time since 2015.
Bond investors should still remain wary of excessive exposure to interest rate risk as compressed US 10-year yields leave them susceptible to a repricing especially as recent jobs data suggests few signs of an outright recession in the US economy.
Following weak performance in 2018, Japanese equity price in a dire outlook for 2019 as outlined in our 2019 Investment Outlook. Valuations in Japan sit at lows only seen during the depths of the Global Financial Crisis despite the fact that Japanese equities have earnings and dividend growth which has outpaced that of both their US and European counterparts over the past five years.
UBP’s strong yen outlook does pose a headwind for Japanese corporates. However, for non-JPY investors, we anticipate that the prospect for FX gains should serve as a positive contributor to total returns.
Opportunities awaiting a Catalyst – US, China/EM and Industrial Commodities
Valuations in US equities have begun to overprice the prospect of a dramatic slowdown in US economic growth, having seen P/E multiples fall below 15 times. Despite, downgrades in recent weeks, we continue to believe that earnings expectations remain overly optimistic for 2019 as evidenced by recent downgrades from high profile corporates in recent weeks. We expect this trend to continue moving into late-January’s earnings season and present a headwind for the new year rally. As earnings are revised to more sustainable levels, investors should look to stock selection as the key driver of returns in the broader US equity market.
Valuations in both China and broader emerging markets have long been attractive in both absolute terms and relative to developed market equities. The challenge has been that the slowing economic and earnings growth profile and an unsupportive macro policy backdrop left nothing in the way of catalysts to crystallise the value present in these markets.
Though a truce in the ongoing trade conflict between the US and China in the coming months may serve as a boon to sentiment in China and the broader emerging markets complex , a ceasefire alone without more stimulative domestic policies may serve only to stabilise the slowing trend in the Chinese economy. However, should the economic slowdown of 2018 continue unabated in 2019, China would need to increase its efforts to support the economy and provide the catalyst awaited by markets.
In the broader emerging markets complex, Brazil’s new government may seek to use its early days in office to replicate the ‘Start-Stop’ approach of US President Donald Trump (please see UBP Spotlight Navigating a Trump Presidency, February 2017) and seek pro-cyclical policy measures initially before pursuing the challenging reform issues outlined during the campaign. Similarly, in India, with elections scheduled for May, pro-cyclical policies may be on the cards to buoy the economy looking ahead.
Should such pro-cyclical policies begin to appear in the largest emerging economies, the valuation discounts in place for the EM asset class may begin to reverse both in absolute terms and relative to Western markets. Such pro-cyclical policies should also return focus to the growing supply-demand imbalances emerging in key industrial commodities around the world (Chart 4) and the opportunity these present for industrial commodities prices and European metals and mining firms over future months.
Group Chief Investment Officer
and Co-CEO Asset Management
Chief Investment Officer Private Banking
and Head of Asset Allocation
Deputy Head of Asset Allocation