Q2 Review & Outlook for 2019

As we approach the end of Q2 much of the price action that has propelled the US indices to new highs has been driven by a combination of stabilising fundamentals but more meaningfully by Central Bank action. This policy pivot should extend the long expansion, we believe, and has already triggered easier financial conditions. Having approached close to a bear market, global equity markets have subsequently staged a strong ‘V’ shaped recovery, however valuation gaps between US and non-US assets remain. Non-US markets have yet to follow the rally in the US but with China taking action to stabilise growth (led by macro and Central Bank policy actions), the ECB having a dovish stance and Japan showing evidence of corporate recovery coupled with a dovish BoJ, the outlook is more stable. The U.S. and China have entered into a strategic competition that we see as structural and persistent. Moves to further erode the benefits (lower inflation and expanded company profit margins) of decades-long globalisation trends with potential to deliver a supply shock and inhibit trend growth remains the headline threat to the decade-long bull market.

Q2 2019 Perfromance Chart (2)

The value of investments and the income from them can go down as well as up and you may not get back the amount  invested.

Central banks (and political influences) have again intervened to mitigate against further political and/or market instability (such as Q4 ’18) and to prevent the pressure resulting in large downside market shocks. In addition to Trumps protectionist push the US market has managed to shrug off increasing geo-political tensions/threats e.g. Mexico tariffs (likely to be resolved by tightening the Southern Mexican border), Iranian sanctions and threat of war. Investors have taken comfort from the dovish tones being touted by both the ECB and the Fed and on the potential deal/truce from the G20 meeting between Trump & Xi.

On a high-level macro basis, the continued rally in risk assets has been driven by the following;

  • Brexit Delay – 29 March to 31st October & new leadership candidate for PM.
  • Powell Put – December rate hike to now pricing in two cuts by April 2020. Confirming that the market is dependent on accommodative monetary policy through this bull market and for the avoidance of volatility when things start to turn.
  • China / US Trade Deal – Trump’s aggressive tone now reigned in to being more angled towards the positive progress being made. In an election year Trump will focus on political victories and given his focus on financial markets and continual reassurance commentary his focus on achieving a great deal will be key. We have noted this previously that his tone vs actual action are two very different beasts and believes the intent narrative should be enough to gather votes and increase his popularity in the polls, classic game theory tactics.
  • Italian Budget – Another delay having been in the headlines on a regular basis regarding the violation of the EU Budgetary rules. GDP has steadily risen in Q2 but still below the growth rate to hit budget targets. Into the end of Q2 the risk (albeit not mentioned in the press of late) remains grave as it still has the 6th worst debt to GDP ratio globally and remains a systemic risk.
  • China Easing – in the midst of US trade tensions China has continued to ease using both traditional and non-traditional methods to stave off a drop-in growth. Credit expansion and easing of conditions by stepping into equity markets has, in the short term, eased domestic pressures.

What the above highlights is that as macro data started to weaken this has led to pre-emptive moves by Central Banks to avoid downside risks. The effect of this has resulted in a move back into equities as investors continue to search for yield and income higher up the risk spectrum. Based on 12-month forward PE, US equities are trading close to the 30-year average, whilst Global (ex US) stocks continue to trade at a discount which again highlights the impact of dovish Central Bank Policy.

Europe

Dovish ECB commentary towards the latter part of June was unexpected but failed to ignite a sustained equity rally like we have witnessed in the US confirming that investor sentiment remains cautious. The EuroStoxx 600 Index is up 10% (in GBP) over the last quarter and is now in a consolidation phase. Italy has been one of main beneficiaries of the rally (where as early as 2 months ago there was more concern on the contagion effect of Italy failing),  in conjunction with the economic outlook in Spain which has been improving over the last few quarters, in addition the Euro has rallied (linked to a combination of Fed rate cut expectations and ECB safety net promise).  The main risk for the Eurozone is a protracted trade war as European manufacturing activity and capital spending are closely correlated with export orders from China, as we have previously shown.

With almost half of European corporate revenues generated from outside Europe any hint of a global slowdown also adds downside pressure, perhaps explaining the lack of market reaction to Draghi’s dovish stance. Pressure in the European market has continued through most of Q1 led by uncertainty and largely discounted valuations exacerbated by the prospects of a no Tariff deal witnessed through weaker corporate earnings as a result. Autos and other cyclical sectors with high Emerging Market (EM) sales have been negatively impacted, along with Banks as rate expectations shift out. At a sector level there is a wide spread between large implied cuts to earnings for some of the “structurally challenged” sectors (such as Autos, Telecoms and Tobacco) and double-digit implied upgrades for Beverages, Food Producers and Chemicals. European cyclical sectors carrying exposure to EM’s (inc China) such as Semiconductors, Mining and Tech Hardware have been particularly sensitive to trade news flow. The EM sales exposure of Autos is likely understated as many do not consolidate their joint ventures meaning that on the back of any positive news this could result in merger and enhanced corporate activity. Names with high exposure to the trade war have already materially cut growth expectations. With such pessimism priced in should a deal be confirmed then earnings momentum should experience a sharp reversal.

European Earnings data in Q1 has been cautiously downgraded however, the key headlines that should bring discounted valuations and forward-looking guidance back to historical averages will be focused on;

  • De-escalation of the trade wars.
  • Pick up in Chinese data.
  • Stability in EU Macro Eurozone macro backdrop.

US

The US market has traded up at near all-time highs led by more dovish action from the Fed and on the back of a strong earnings season. The one-off impact of tax cuts and fiscal stimulus has faded and filtered into earnings projections however, the outlook remains positive. So far 40% of companies have raised 2019 guidance which has led to a meaningful rebound in 2019 EPS expectations. In the midst of trade tensions this is seen as positive and if resolved should push the market higher. Perhaps the surprise in Q2 was the change of the dot plot for the Fed outlook with the board now taking a dovish stance leading to two rate cuts being priced in. Powell noted that even the FOMC participants who did not call for a cut say that the case for a cut has risen.

Powell did re-emphasise in the press release that they want to react to trends, not single data points hence having the flexibility to remain fluid. With the market now pricing in a 40% probability of a cut in July and a 67% probability in September there is still scope for some upside risk to equities which could start to consolidate and push higher on a trade deal.

  • As a precautionary cut in response to challenging external conditions, akin to 1995 and 1998, or –
  • The start of easing at the end of the cycle

History shows us that since the 1960s the Fed has undertaken 14 easing cycles (5 of which retrospectively were outside official NBER (National Bureau of Economic Research) recessions) but throughout these periods’ – equities rallied significantly over the proceeding 12-month period following led by PE multiple expansions. If this does indeed turn out to be a soft patch and not a recessionary environment then we see the same pattern being repeated.

Given that US equities towards the end of Q2 are at all-time highs, we see the following as main catalysts to support this move and allow equities to continue for the region to push higher.

  • Trade tensions decline.
  • Fed moves to ease aggressively (evident by Fed Fund Futures dots).
  • The slight industrial slowdown is only a soft patch and not a recessionary pre cursor.

China

Headlines through Q1 chiefly consisted of Trade concerns that continued to drive asset performance but even in the midst of macro pressures the MSCI China Index has delivered a 20% return YTD. The recent increase of tariffs to 25% from 10% on USD200bn of Chinese products, if permanent, could cut growth of China’s total real exports by 1.7-2.8ppt in the next 12 months, lowering China’s real GDP growth by 0.3-0.5ppt. If the 25% tariff is extended to the rest of China’s exports to the US (USD300bn), as threatened, its impact would be much bigger, around 6.3-6.8ppt on total real exports and 1.1-1.2ppt on real GDP. In short, there is the risk of GDP growth dipping below 6%.

China data remains very important as investors try to find evidence of the effectiveness of the policy stimulus programme. Policymakers have acted to provide stability in credit growth and have allowed fiscal policy easing to near 2% of GDP. Chinese nominal GDP has slowed to 7.8% in Q1 from 9.8% in Q1 2018 but we expect that this could be closer to the trough namely due to the following factors.

SME -Domestic SME have received better funding and financing allowing credit pressures to ease. With the PBOC implementing a new mandate to push commercial banks loan growth to over 30% this should lead to less funding pressures and loan book growth.

  • Money Supply stabilising.
  • Fiscal Easing – China continuing to experience strong fiscal and credit momentum.
  • Property Prices stable – this is a key metric as China property represents about 23% of local government revenue, about half of household wealth and banks collateral, as well as around 10% of GDP.

Japan

Japan continues to trade at a substantial discount with valuations still near a decade low and trading at a near 35% discount to EV/EBITDA to global markets. With recent changes in corporate governance and Central Banks policy changes, we see scope for this discount to narrow as employment starts to pick up and GDP expectations for the next 6 months remains strong. Any further easing in China will also allow the historical pressures in Japanese corporates and the economy to ease. Some corporates are now achieving near 5% mkt cap share buybacks and with Bank of Japan (BoJ) remaining active in QE (Equities and Fixed Income), the historical discount should start to narrow.

In conjunction with this there should now be much greater focus on Japanese equity governance. With the recent change in tax accounting leading to more friendly M&A terms (being able to defer tax on equity M&A until shares are sold) could contribute to more takeovers – confirmed by a 40% drop in firms having hostile bid safeguards removed. Corporates are also now increasingly (led by the Government Pension Investment Fund which is increasingly only allocating money to third parties to run if they vote at AGMs) becoming more efficient and transparent allowing activist investors to pay greater attention to undervalued cash rich names (20% of MSCI Japan market cap consists of corporate balance sheet cash).

Japan so far YTD and since the escalation of the trade war has been a continual underperformer but recently has started to (in local and dollar terms) mount a recovery. Japan does, however, remain vulnerable to a Chinese slowdown with a central bank that is still accommodative, but policy constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.

UK

The UK market has rallied since the end of Q1, but valuations continue to retain a Brexit discount due to more uncertainty around the outcome post October, lack of any concrete deal and the huge volatility in GBP. New leadership continues to make investors nervous given the lack of clarity from politicians and what the ultimate Brexit deal will consist of in terms of guideline or plan. Due to this, outflows have not stemmed but, given the international exposure of the FTSE 100 with near 80% of sales being international, at this juncture downside should be somewhat limited.

With Brexit uncertainty, the increased risk of a no deal Brexit and the polls suggesting a potential Labour Government, all adds towards a lack of appetite for UK equities. With the threat of a Labour government GBP upside looks limited even in the midst of a soft Brexit. The potential political outcomes appear to be converging on either the hard Brexiteer PM with the pro- Brexit parliament post a general election, or a Labour government, both of which suggest that things are still difficult to price and value in the UK.

UK equities are now the cheapest in nearly 20 years with this discount led by the move in GBP, Oil & Commodities. Due to commodity sensitivity (confirmed by the oil and mining weightings) we await some confirmation bias on a combination of factors that should allow fund inflows back into the UK. Like for like UK v global sector comparisons show the valuation UK discounts, hence why we see more corporate activity is likely to continue.

UK Sector Valuations Prem vs Disc

                                                                                                                                                                                         Source: FactSet

 

Private Equity is sitting on nearly $2.5tn and ready to deploy these funds to distressed and underperforming assets in the UK. Leveraged buyout activity is once again at its highest level since the financial crisis, but for the first time, activity in the first half of a year has eclipsed the pace seen in the boom year of 2006. Low discounted valuations have allowed more M&A to continue and in Q2 we have seem more of this theme with more takeovers such as BCA Marketplace, Millennium & Copthorne, RPC Group, Premier Technical Services, & Merlin Entertainments.

This must be put in context given the backdrop of an increase in profit warnings & CVAs continuing – some of which can be attributed to Brexit impacts and others the victims of structural change. Retail yet again was impacted and we have seen warnings from Dixons Carphone, Keller, Pendragon, Galliford Try, Saga, and Plus 500, Debenhams and other non-listed entities like Jamie’s Italian.  This highlights that Brexit impact is not sector specific but is affecting a wide variety of industries given a lack of Brexit detail severely affecting supply chain economics. Activist pressure has also increased, something we have not consistently seen for a few years but now change demanded in names such as De La Rue and FirstGroup.

Asset Allocation

We continue to favour asset allocation towards equities with a tilt towards US and Asia Pacific. Equities have historically performed well in the latter stages of the economic cycle — generating returns above the full-cycle average. We continue to favour themes providing exposure to long-term secular growth trends whilst increasingly incorporating portfolio stabilisers running low exposure to fixed income and sourcing attractive total (preferably inflation-linked) returns from alternatives.

The extension of the current bullish cycle has been boosted by a ramp up in corporate activity (M&A) coupled with Central Banks pivoting to a dovish stance have effectively revived the QE trade which has attracted inflows into US stocks, credit, EM and DM bonds. On the contrary this has made growth and trade sensitive EM & European equities remaining out of favour whilst tail risk hedges such as gold and oil ETFs being added into portfolios.

The short-term outlook for Fixed Income is skewed as the recent rebound in risk led by the Fed and ECB has widened the window for more policy easing leading to a divergence in bond yields, equities and credit performance.

There has been recent debate around the growth v value argument. At present Quality and Growth stocks are expensive and remain a crowded trade whereas Value remains depressed. Flows in Growth and Quality sectors such as Personal & Household goods, staples and healthcare has seen the bulk of ETF inflows in Europe. Whereas value plays such as Utilities & Banks noted outflows. Over the long run current investor positioning in Quality/Growth looks stretched, while it is the opposite for Value sectors. Over the long-term Value has been a successful trade and tactically staying invested appears to be the sensible strategy regardless of the short-term market volatility. If equities were to fall ahead of a potential recession some of the well owned and expensive quality parts of the market, which are also similar to cyclicals, like Tech, Industrial and Luxury Goods could be at risk of some profit taking (as would value but to a lesser extent). However, if activity remains buoyant and bond yields find a floor, this could bring back investor appetite for Value.

Global equity markets are faced with short term growth constraints, yet forward-looking expectations are starting to improve. Emerging Markets that have been weak should rebound by Fed action (they benefit from a pause or cut in rates), continual reform in China and a trade resolution. Japan should benefit from China growth and further progress towards a trade deal and in Europe, a dovish ECB should allow corporate earnings to remain supportive and guide higher given the outlook now for more monetary and potential fiscal stimulus.

The volatility witnessed during Q2 and the recovery of the market from near bear territory to all-time highs confirms our thinking that market timing is difficult to predict. Experience allows us to take a long-term view, maintain our thorough investment process and avoid being diverted by sensationalist headlines that cause short term market panic. This is pivotal in constructing robust long-term thematically driven risk graded portfolios that can contend with periods of volatility but outside the noise the underlying investments should outperform.

Summary

We remain constructively bullish for the equity market outlook. The key differential now is that the Fed will be cutting rates, regardless of a spike in High Yield spreads and jobless claims which typically move the economy into a recessionary environment. The consequential result could prevent the US Yield curve flattening and move higher and USD to peak. With investor sentiment and positioning being bearish, the spread between Earnings Yields and Bond Yields should remain attractively priced. Should this process unfold over H2 led by new highs in the equity market then the extreme Value/Growth price differential rotation has more impetus to finally materialise.

As equity prices moved higher, investors reduced exposure towards Quality and Defensives and moved into Growth names. Given the negative positioning in an environment where YTD there has been strong equity and credit returns, should a recession and trade war escalation be avoided (or even postponed) the upside potential remains in what looks to be a further stretching of the cycle.

As global equity markets grasp the slow recovery in global growth, they have yet again been held back by the re-escalation of trade tensions. In Q2, as we appeared to be reaching a resolution, talks yet again broke down with the US raising tariffs to 25% from 10% on $200bn of Chinese imports (effective 1st June) and USTR (United States Trade Representative) releasing a list of $300bn products covering pretty much all remaining imports from China that could be subject to a 25% tariff. China has in turn retaliated with additional import tariffs of 25% on $60bn worth of US goods effective 1 June. Potentially China could also impose new tariffs on currently untaxed US goods however the scope is limited as they are close to having taxed all imports from the US. We are acutely aware and fully appreciate that the longer these delays occur then corporates require potentially costly contingency plans, which involve permanently higher inventories and more diversified supply chains.

The major changes on the horizon revolve around the possibility of sustained weaker growth and higher inflation that will increase macro uncertainty. With the market yet again trading on headlines and not purely fundamental company data we are faced with multi-polar outcomes and we are focusing on asset classes that should be well protected. Thus far we have not witnessed the relative outperformance of Trade tension exposed equities and this could lead to the market continuing to push higher if confirmed.

The global cycle is near its low: Global macro surprises (exc US) have been negative for the longest period on record, and PMI new orders minus inventories are already at their weakest level since 2009. Thus, should trade war worries abate we anticipate a positive response.

Factors that will be watched closely for developments are;

  • China Slowdown
  • Brexit Update
  • Cost Inflation
  • Margin Pressure
  • Oil Price volatility
  • Capex
  • Productivity demand in face of increase in digital advancement and automation

Constantly we are evaluating and questioning the investment landscape and analysing global thematic trends that will dictate the direction of future growth, both from a macro and underlying investment analysis. The ability to be able to adjust our thinking by utilising a combination of valuation metrics, macro inputs and technical indicators to adjust our positioning, means we can be flexible while retaining exposure to long-term secular growth themes. Experience through short term market shocks does not detract away from our long term thematic and fundamental views whilst minimising downside risk.