Sunil Krishnan discusses the conditions for a continued rise in global equities, the potential of Japanese and US equities to outperform from a regional perspective, and some attractive features of emerging markets – particularly Brazil – which may have been overlooked.
5 minute read
All told, 2019 was a great year for equity investors. For example, the US equity market returned 31.5 per cent in dollar terms.1 The idea such strong performance could continue in 2020 seems too good to be true, especially given the January headlines on the US conflict with Iran and worldwide health fears over the coronavirus. Yet the right longer-term conditions remain in place, which is why we are overweight global equities.
Many global concerns have lifted
Last year, there were serious concerns over corporate profitability. In the US, for example, these centred on the health of the economy and domestic demand, particularly from consumers. In September, markets – and our own House View – were pricing in a material risk of recession.
US unemployment remains low and is trending lower; consumer spending also seems solid
Yet given how low investor expectations had fallen, the subsequent stabilisation of the economy was enough for equities to recover. Today, US unemployment remains low and is trending lower; consumer spending also seems solid. For instance, credit-card data suggests reasonably strong US holiday spending.
Figure 1: US unemployment rate (SA, per cent)
At a company level, while it is too early to call a significant turn in investment intentions, a more stable capital market environment, the continuation of accommodative monetary policy and tentative signs of a durable trade truce create scope for businesses to start making investments they had previously delayed.
Following the phase-one trade deal, US and China relations are now on a more stable footing
US and China trade tensions concerned investors as well as businesses. Following the phase-one deal signed in January, although a comprehensive phase-two deal is not on the immediate horizon, relations are now on a more stable footing, which may last until the US presidential election.2
Significant headwinds for equities have therefore abated; inflation remains subdued and US Federal Reserve (Fed) communications indicate the central bank is in no hurry to raise interest rates.3 The Fed also showed itself willing to support financial stability by providing substantial liquidity when funding markets came under pressure in the autumn and in late December.4
Figure 2: Inflation placing little pressure on rates
Finally, investor sentiment has improved but is nowhere near the euphoria of, for example, the beginning of 2018. Retail investors appear to be largely on the side-lines – in 2019, flows into bond funds were much stronger than into equity funds. Periods of realised gains tend to attract retail investors back into the equity market, so this demand dynamic could change in 2020.
Figure 3: Investment Company Institute cumulative fund flows (USDm)
The combination of a reasonable economic backdrop, supportive monetary policy and positive investor sentiment should create the conditions for a continued rise in global equities. In addition to our overall overweight for the asset class, we have some regional preferences, in Japan, the US and emerging markets (EM).
Two developed markets stand out
With low investor expectations reflected in valuations, there is an opportunity for Japanese equities to play catch-up to other markets (see Multi-asset allocation views: Could Japan outperform other equity markets?).
US sales are marginally better than anticipated, while earnings are tracking around five per cent ahead of expectations
The US market remains supported by strong earnings power. With 40 per cent of the S&P500 having posted fourth-quarter profits as of 30 January, reported sales are marginally better than anticipated, while earnings are tracking around five per cent ahead of expectations (source: Bloomberg). Positive earnings surprises are spread across industries, including the critical technology sector.
EM looks attractive
Emerging markets have underperformed in terms of earnings as much as price for a decade. And while current expectations for earnings growth have reduced significantly, this could be bottoming.
Figure 4: MSCI EM relative performance vs. MSCI ACWI
Figure 5: MSCI EM relative earnings vs. MSCI ACWI
The asset class should benefit from the turn in the global semiconductor cycle, the US-China trade truce and a stable global monetary policy environment – particularly for US interest rates and the dollar. Furthermore, although global earnings momentum remains (broadly) in a downgrade cycle, there are signs it is beginning to ease in emerging markets faster than in other regions.
For Asia in particular, the outlook will depend on efforts to contain the effects of coronavirus
For Asia in particular, the outlook will depend on efforts to contain the effects of coronavirus. The human impact cannot be reversed, but on the economic side, history suggests that, while restrictions on normal activity will put a short-term brake on economies, the eventual unwinding of emergency measures could bring about a strong pickup in activity.
Brazil has been a volatile market in recent months, primarily due to its domestic political cycle – with uncertainty on who would be president, then on the economic credentials and intentions of the new administration, and finally on its ability to execute key economic reforms (for example in pensions). This has made investors reluctant to price in the genuine improvement in Brazilian companies’ return on equity.
The market is also changing. While commodity producers remain an important component of the Brazilian equity market, domestic sectors – such as financials – are gaining traction. As a result, the domestic economy is now a bigger influence than ten years ago, particularly as it can be reflected both through improving corporate profitability and a stronger currency.
Investors do not appear to have fully appreciated the improvement in domestic economic conditions that, combined with stronger earnings potential, creates an opportunity.