As we approach 2019, equity markets have experienced a bout of volatility of the type not seen for several years. Rising inflationary expectations prompted a widespread sell-off across the globe as investors priced in the prospects for monetary tightening. This carried with it implications for valuations of the long duration growth stocks that have dominated markets post-GFC and which have led to what some have termed as value’s lost decade.
The question is whether this marks the end of the current cycle, ushering in a change in market leadership. As discussed previously, we do not believe the end to be imminent. Corporate earnings growth continues to come through across the globe with valuations looking attractive compared to historic averages and economic data supportive. The recent market pullback, therefore, represents opportunity.
With the reset in the valuations of attractive, secular growth stories, this backdrop is an ideal hunting ground for bottom-up investors capable of identifying stocks trading at below their intrinsic value. Any widening in the dispersion of returns brought about by a sustained rise in volatility should further increase opportunities for active managers.
We continue to favour capital-light, high-return businesses capable of growing market share and sustaining pricing. While the technology sector has garnered much of the focus during in recent years, this phenomenon is present across industries, with the profit dispersion between the highest quality companies and the lowest becoming ever more pronounced. As value chains continue to evolve, traditional business models are challenged, and technology comes of age, those companies that are able to innovate should continue to grow.
Corporate profits are growing, companies are behaving in an equity-friendly way, valuations are supportive, and bond yields should not rise aggressively – in short, we can expect more of the same in 2019.
However, we remain aware of the potential risk to equity markets, whether it’s ongoing rhetoric around trade, inflationary concerns or the UK’s exit of the European Union. Investors should therefore be prepared for further equity volatility in 2019.
There is widespread belief that investing in bonds today carries a greater degree of risk than in prior years because we are ‘late in the cycle.’ That belief is not helpful from an investment perspective and is also inaccurate when we look closely across industries, sectors and regions. Monetary policy is diverging globally, US interest rates look more attractive as yields have risen meaningfully, and the Fed’s reaction function is likely to change. Meanwhile, we remain defensive on interest rates in other developed markets as the rate hiking cycle is just getting started. In corporate credit, we are concerned at the elevated level of leverage among US companies, but we are finding opportunities across the industry and regional divergence in corporate bonds.
The consumer credit cycle is a bright spot, and there are attractive opportunities to generate income in the structured products market. Sovereign credit – specifically emerging markets – presents an interesting opportunity in 2019 following a sharp rise in yields, but will likely see tremendous divergence across countries. So while 2018 was a bad year for bonds, 2019 is poised to produce much more attractive outcomes for investors who can navigate divergent monetary policy and credit cycles.
We believe there will be opportunities to generate attractive risk-adjusted returns in 2019 and these areas are best identified by understanding where markets are diverging in relation to monetary policy and credit cycles.
In the US, the Federal Open Market Committee is three years into an interest rate hiking cycle, and arguably five years into a tightening cycle that began with the tapering of asset purchases in 2013. With real (after inflation) yields the highest in the developed world, the Fed is now close to what it describes as a neutral rate. Thus, as we move into 2019 we expect the Fed to move from the framework of ‘forward guidance’ it has used in recent years (marked by predictable, quarterly rate increases) to a framework of ‘data dependence’ in which more recent developments in data will alter the path of policy. Barring an accelerating inflation backdrop, we expect the Fed to pause its quarterly rate hiking cycle in 2019 and take a wait-and-see approach.
The European Central Bank is likely to begin raising interest rates next year, while the Bank of England may reconsider its low interest rate policy should a reasonable Brexit outcome be reached. In emerging markets, there are several central banks already raising rates, and others are likely to join in next year as well.
As a result US interest rates look more attractive as yields have risen meaningfully and the Fed’s reaction function is likely to change. Meanwhile, we remain defensive on interest rates in other developed markets as the rate hiking cycle is only just getting started.
The corporate credit cycle is often cited as an area of concern, understandably so given aggregate levels of leverage are higher today than they were five years ago. However, while many companies increased leverage in recent years to fund strategic acquisitions, they are now reducing debt. The energy, metals, and mining industries endured a full credit cycle three years ago marked by declining prices, industrial slowdown, and rising defaults, but corporates in this space are now seeing a rebound in earnings along with declining leverage.
Credit metrics in Europe look somewhat healthier than in the US, while other areas, such as China, have more concerning debt loads. With credit spreads on the rich side of historical averages, it’s our belief that the better performers in 2019 will be those companies and industries committed to keeping balance sheets strong to withstand potential volatility ahead. Energy, telecom and food & beverage are industries that have previously increased leverage but now have a number of companies reducing their debt levels.
One of the notable characteristics of 2018 has been the degree to which growth has exceeded expectations in the US, yet growth in other developed markets and emerging markets has decelerated. We expect 2019 to be a year where this relationship normalises, leading to stability in Europe and a rebound in emerging markets. Countries that show a commitment to credible institutions and prudent fiscal policy will be rewarded. The growth and policy disappointments of recent years have pushed yields higher in many countries such as Brazil, Mexico, Turkey, Argentina, and even Italy. Many of these may prove to be sound investments if policymakers can put debt on a sustainable track.
There are a number of risks that we are watching for closely which could affect this outlook. An overstimulation of the US economy, in order to continue its strong growth, could become inflationary, causing the Fed to tighten monetary policy more aggressively than is currently expected, unsettling markets. Geopolitical concerns also continue, and this includes the escalation of the trade war, or rising tensions between the US and Saudi Arabia. Within Europe, a key risk is if the European Union fragments in some way, either due to Italian budget, the rise of Right-wing politics, or ripples from whatever Brexit deal is agreed.
While the uncertainty of the Brexit outcome poses risks, arguably a Corbyn-led Labour government would have a greater impact on the domestic UK market.
Finally, we continue to be concerned about the levels of debt in the world, particularly sovereign and corporate debt, with net debt to GDP in the likes of China looking increasingly unsustainable.