Q3 Review & Outlook for 2019

Volatility has been elevated over the summer months, prompted by a fluid mix of dislocated policy maker talk, geopolitical pressures and Central Bank narrative. The backdrop for investors has been somewhat puzzling given the myriad of conflicting messages and the ever-increasing short termism of market participants that seem to continue to be impatient and reactionary to headlines. Trade pressures have had a negative effect on global growth and whilst Trump is particularly sensitive to market weakness, we have noted that historically the blame for market corrections were aimed towards the Fed. But now with the pivot towards lower rates blame will no doubt be shifted elsewhere, and we have seen some signs other factors being “responsible”. We await the outcome of other macro developments – namely Brexit, US/China and latterly China/Hong Kong but as yet have no definitive confirmation on any. Into the end of Q4 we anticipate de-escalation of these macro headwinds and earnings growth to bottom out and stabilise. The juxtaposition of negative geopolitical tensions and supportive global policy action (with increasing scope for employment of fiscal tools) continues but we take a constructive view that global expansion can recover.

With heightened geopolitical tension on the horizon it had started to feed through into safe havens assets such as Gold and Fixed Income with yields moving to all-time lows across the German Bund Yield curve and then followed by action from some European Banks offering negative yields cash deposits. This highlights investor optimism is still on the low side amid weaker macro and corporate data which could continue to fester without resolution until the year end. On a headline basis this does make for grim reading, but we look through the noise and focus on our disciplined investment process and filtering out short term volatility. With the Central Banks back in accommodative move, a US election approaching and more easing in China the market looks to have backstop support to continue to make more headway into the end of the year. Overall the main assumptions and risks revolve on;

  • Geopolitics
  • US recession
  • Credit Cycle
  • EM imbalances
  • Ageing business cycle

Whereas on the basis that we continue higher into the end of Q4 the market will focus on;

  • Trade Resolution
  • Domestic activity picking up in Europe & the US
  • Fiscal Stimulus
  • Dovish Central Banks – Fed to cut 50bps by year end, BoE to cut under a no deal, ECB to cut again Q1 20, BoJ: On hold, no changes in target yields on YCC (Yield Curve Control), possibly well into 2020 & India cut 25bp and reduced corporate tax rate.

We are entering the busiest part of the Q3 reporting season. Nearly a third of companies have reported in the US and in Europe so far, and 10% in Japan. Initial results point to a positive earnings surprise in both the US and Europe, to the tune of 5% and 2%, respectively. This follows a significant reduction in earnings expectations going into the quarter, in particular for the S&P500, with consensus having moved to an outright negative y-o-y EPS growth projection of -4%, down from +5% at the start of the year. Following persistent downgrades (-10% over 12 months for the S&P 500), Q3 earnings are beating at a slightly above average historical rate. Muted reactions to misses but strong reactions to beats suggests the slowdown was well priced in. Elsewhere the earnings season is not as far advanced, but the early read is similar. Global growth could indeed slow to down to 3.1% in 2019, the US could avoid a recession but drop in global growth momentum has slowed and China could continue to maintain targeted stimulus in Q4 to offset weak macro data.

These mixed messages can make the current environment confusing but overall Global Markets have scope to recover, albeit with more frequent bouts of sharp short-term corrections. The S&P 500 Index, although flat year over year, was up strongly year to date and near an all-time high. In the US, economic growth has slowed since the first quarter, but remains in the positive range of the past decade whilst GDP growth in Japan and Europe is also steady, albeit at the lower end. This is where we can look to be proactive and use short-term risk off sessions as a key time to look to add to exposure to our key themes.
Investors remain nervous about the outlook for global markets in a low growth environment. Granted, volatility will continue, but leveraged balance sheets coupled with an inverted yield curve do not always signal the beginning of a global recession especially when set against a backdrop of accommodative central bank action as rate cuts and further QE keep borrowing costs low and make equity valuations against bonds look attractive.

Fixed Income

Trade developments continue to be the key driver for the outlook in fixed income and the driver for bond yields. The prolonged dispute has continued to force yields lower as macro indicators and consumer confidence data points start to weaken. Market uncertainty moved money into safe government bonds, even those paying a negative rate. Remarkably, Italy and Greece once more offer yields in USD which are attractive for USD investors and has been a contrarian trade in Q3 but has performed well. Greece and Italy are the only European governments that are offering any positive yields.

The market is pricing in lower US 10-year yields and higher US credit spreads whereas in Europe given the action of the ECB some tightening is expected. Greece auctioned negatively yielding T-bills, US auctioned record low-yielding (2.17%) 30-year government bonds this week – bond bubble delays global recession and encourages irrational contagion to stocks. The ECB is expected to restart net asset purchases at a monthly pace of €20bn from 1 November. We expect the BoJ to remain on hold barring meaningful currency moves. Recent changes in monetary policies of major central banks mean that net 12m CB asset purchases are expected at +$860bn by the end of next year. With global bank intervention the price action and focus on the yield curve has been well documented but taking a holistic approach is key. Although absolute valuations are not particularly compelling, equities are still good value when compared to fixed income. Global equities’ dividend yield is 2.5%, while global bonds yield just 0.6%.

Equities still yield more than bonds in all the major DM economies and recessionary concerns can be abated as the inverted curve has been manipulated by the Fed allowing flex to cut again to effectively un-invert therefore potentially avoiding a recession. A further distorting factor has come from overseas investors; many are turning to Treasury bonds to seek refuge from negative bond yields in countries such as Germany and Japan, and that is pushing down yields on long term Treasury bonds.

The European market has not been immune to geopolitical pressures and has additional volatility attributed to weaker auto sales, FX volatility and EM sensitivity. European equities appear to be relatively inexpensive however, as we have highlighted previously, there are large gaps under the headline index level between cyclicals vs defensives and value vs growth. With growth being over owned any hint of a slowdown could result in downside volatility. Value on the other hand should and has been better protected with increasing EPS margin and falling bond yields (pricing in monetary easing). The recent rebound in equities in Q3 was accompanied by a rapid style rotation with value strongly outperforming growth. The thesis is that the bulk of the market gains have been driven by growth/quality names so in the event of a downturn these could be the principal drivers of downside risk. In other words, wider de risking could lead to selling of growth first vs the less owned value names that would be under less selling pressure. This is relevant as the European market has greater exposure to sectors that are more cyclical in nature and although not absent of high-profile Technology names (such as SAP and Infineon) it does provide more value investing opportunities (with the caveat that discretion between structurally exposed names and those trading at a discount to NAV but with catalysts for recovery is required). Incoming ECB President-elect Madame Lagarde is expected to continue with the Fiscal remedy requests set by her predecessor alongside revitalised monetary support.

Tariff concerns still dominate the US headlines as other factors such as manufacturing and consumer spending also exhibit signs of weakening. Last year’s first round of tariffs happened when companies were still enjoying a massive profit/margin windfall from the tax cuts. With that windfall now gone, the ability to absorb the tariffs is much lower today. Equity market performance has been led by the Fed and valuations, whilst the dovish Fed has been driving price returns even though forward-looking earnings estimates have eased off, whilst some argue that earnings estimates are too high and unsustainable which could lead to disappointment. Technically lower interest rates are a positive for equity prices as a lower discount rate means a higher NPV of future cash flows, e.g. a higher multiple.

US indices have rebounded strongly from bouts of weakness accompanied by the Gold price peaking at $1550 oz whilst the VIX remains considerably below the elevated levels seen in Q418. There has been a divergence in investor positioning in the US as the argument, as referenced earlier, on Growth vs Value continues.

Growth stocks have broadly outperformed Value stocks for over 12 years now; in part driven by uncertainty, extreme low yields and general scarcity of economic growth. The Tech sector makes up 22% of the S&P 500, its earnings performance is an important determinant of index level growth. The recent leg down in yields has pushed performance of Value to new lows and the spread in valuations between Value and Growth stocks to new highs. A shift by investors into beaten-down stocks with attractive low valuations in September has caught some investors off-guard – principally those who were heavily invested in momentum stocks – rapidly expanding companies – but ahead of the results season value stocks are likely to be seen as a shelter, giving less of a shock if a company misses estimates. MSCI global basket of value stocks rose 4%, while the momentum stocks slipped 1% last month. Before the rotation, momentum stocks had surged 20% as of August-end, while value stocks were up just 7%. We continue to monitor to determine if this rotation can be established as a sustainable trend.

Fed comments coupled with tweets on US & China developments continue to be a driver of short-term volatility. During these tensions the market itself remained. US indices have scope to move higher led by re- ratings, cheap FCF yield and EPS momentum being positive. On top of this a weakening $ will also be a benefit.

US Bonds and Equity Flows

We highlight this as it brings up an interesting shift in flows. When the US yield curve alongside the steepening 2/30yr curve coincided with a big rotation back into risk, coincidentally it was one of the first shifts away from fixed income into equities. This shows that overly bearish positioning about the cycle seems to be reversing. US-China trade dispute news has improved while the jump in oil prices ought to alleviate concerns about an imminent deflationary threat. Risk aversion has been rife and position unwinding suggests a lot of room for high beta and cyclicals to perform and not forgetting that the continued confidence of the US consumer is pivotal and should be supported by consistent wage growth.

Structural change amid ongoing trade tensions has forced China to take action in modifying the outlook for the labour market and economic outlook. The prolonging of the deal with the US concerns over how this will impact manufacturing and export sectors has already prompted the implementation of Reserve Requirement Rate (RRR) cuts and other policy measures to support both the labour market and growth. This is in response to an IMF report indicating that higher tariffs would have a significant negative impact on value added, employment, and productivity for the economies involved and for others through value chain links. Support is likely to be in the form of more frequent monetary and fiscal easing to give a boost to infrastructure investment – which in turn can stabilise GDP growth, whilst an easing of fees and lower barriers to entry for SMEs and private companies to manage the labour market.

We continue to take the view that Japan remains unusually cheap vs other developed markets with TOPIX valuations at historical lows. Japanese equities have delivered double-digit returns YTD however, short-term concerns have centred on the consumption tax (VAT) rise (from 8% to 10%) that begins in October and whether this will prompt a recession. Japan’s job market continues to tighten with unemployment at a 26-year low and jobs per applicant at a 44-year high, companies competing for young talent have been promoting a more attractive corporate culture. Indeed, attitudes to work/life balance were already starting to shift well before Abe’s 2018 “work style” legislative reforms. However, Japan’s lack of workers is not its only problem. The country ranks only 20th out of 36 for labour productivity amongst its OECD1 peer group (based on GDP per hour worked). Long working hours have not helped, nor has the ageing population. In a perfect storm of poor productivity, insufficient manpower and the growing trend of automation, IT solutions pose a credible lifeline in some sectors. Since 2015, foreigners have sold 95% of what they bought during Abenomics. Over the same period, Topix EPS rose by 33%, the same as S&P 500, furthermore Japanese corporate profits have been growing on par with the US.

As we approach the end of Q3 we are still unclear regarding the outlook for Brexit. Brexit uncertainty continues to weigh on consumer confidence, house prices and employment expectations as we approach October’s Brexit deadline. 70% of the FTSE100 revenues come from overseas hence the sensitivity to global GDP shifts and the move in oil vs domestics names. As UK equities are export driven so we may see some headway on a big spike in GBP vs European names but given investor positioning is light and investor sentiment cautious, we could see a broad-based rally. UK domestically biased names continue to trade at a substantial discount to other non-UK sector names which has resulted in some more cross border M&A, prompted in part by cheap valuations. Recent examples of M&A activity that have concluded at significant equity price premiums include names such as Flutter, Entertainment One, Greene King and Charles Taylor.

The flipside of the delay and ongoing uncertainty has led to an increase of domestic profit warnings which is now close to a financial crisis high. EY’s latest profit warnings report highlighted an acceleration in the number of warnings throughout the year, with 77 profit warnings recorded in the past three months. This represents a rise from 69 profit warnings in the second quarter, as more than a third of warnings cited volatility in the economy. Contract delays and cancellations were also blamed for 30% of warnings. Meanwhile, 22% of profit warnings in the most recent quarter stated that Brexit was a factor ahead of the October 31 deadline. In the past 12 months, almost 18% of UK-listed firms have issued a profit warning, the highest proportion for almost 15 years. A significant number of profit warnings this year came in the retail sector as the high street continues to struggle, EY said. The number of profit warnings for FTSE retail firms hit an eight year, representing 28 different downbeat statements.

Asset Allocation

Throughout Q3 equities have remained unloved and global outflows were close to $66bn, which is the 4th straight quarter of outflows and the longest on record. This does rightly ask the question as to why we continue to favour this asset class; put simply, although most of the macro wobbles are down to the US/China tariff and concerns over a manufacturing slowdown, importantly the global economy seems to be doing better than what the bond market is discounting – given pre-emptive easing by central banks. Equity investors continue to be at the helm of investor short-term market movements. It is becoming somewhat normal to see daily high double-digit percentage changes on a regular basis – regardless of earnings. Currently as there is heightened volatility and both macro and geo-political headwinds the pricing anomalies present some opportune investment opportunities. Where we look to question the narrative is beyond pricing – we aim to focus by trying to evaluate the sectors that have already priced in a recession and those that are yet to. We have identified those can provide higher EPS growth than the market at cheaper valuations but are yet to have a repricing effect due to other factors. History tells us that these deep discounts, if a recession is avoided, represent a compelling investment case – which we are monitoring on a regular basis for confirmation bias.

Equities remain the preferred asset class even during what some strategists call the latter stage of the economic cycle, where Central Banks have yet gain turned on the taps for easing, resulting in greater mispricing opportunities. We remain confident that that the earnings trough should now start to stabilise and gradually pick up in Q4. Granted late cycle wage pressures are headwinds for profit margins, whilst pricing and outlook indicators point towards some weakness but on the basis that a trade deal is reached and the UK/EU agree on an orderly Brexit – macro expectations can receive a timely boost.

We are on the cusp of Q3 earnings season begin and will give some guidance as to the justification for the market rally against a backdrop of lacklustre earnings in Q2 and a refocus on bottom-up fundamentals. The market made multiple new highs in Q1 and Q2 through a period of weakening fundamentals and softening activity and earnings momentum. Our investment process is truly global and has scope able to adapt to thematic changes and look for names that can benefit from thematic shifts through a variety of economic cycles. Being able to focus on those that exhibit evidence of being able to grow whilst taking advantage and adapting to a change in demographics, investor trends, technology and geopolitical change.

Summary

October is a seasonally busy period for markets which should dictate the outlook for the performance in Q4. The key focal points will be if the decline in manufacturing data spills over into the services sector. With weaker manufacturing data and mixed business confidence, the focus has been shifting back to the consumer as the main source of support for an improved growth outlook. From our perspective, the biggest risk for the rest of 2019 for large, multinational growth companies is that the support of easing monetary policy will collapse and the global business slowdown already in place spreads to U.S. consumer spending. With continual delays in global trade and other Brexit negotiations the lack of a meaningful information makes it tricky for companies to forward plan. Companies have been communicating a lack of visibility on final demand for the last several months, with tariffs and an impending U.S. profits recession causing managements to delay capital spending (capex). This anecdotal evidence is now showing up in government data on manufacturing, with U.S. industrial activity contracting in August and September.

Careful asset allocation to equities should start to play out in Q4 as the rate cuts we are now seeing are starting to lay the foundation for a pickup in global growth next year. In times of social media policy announcements, the reaction is quick and sharp, and it remains prudent to avoid market timing to pick the lows and to continue to hold a well-diversified cross-asset portfolio that supports the investment thesis we have constructed. We continue to stick to our investment process that looks to include investments likely to profit from thematic changes and long term structural trends alongside holdings that offer attractive total return prospects (supported by sustainable income generation) in conjunction with a robust risk management discipline. With the current market being in a large volatile trading range (evidence by the S&P 500 having crossed either side of 2900 16x in this quarter) but over the last 12 months having returned a paltry 0.10% with realised volatility of 15.5.

The composition of major indices, led by huge shifts in technology, has continued to change at a much faster rate than previous years. We are witnessing an ageing population at a time where the working population is shrinking. As this trend continues the Emerging Markets (EM) space becomes more important to global growth as the middle-class uprising is very real – and they are using technology to jump forward quicker in their economic development. This rapid and increasingly affluent young population are vocal regarding sustainability and climate change – but the difference being they have the means to make change and be heard. Purely due to this shift change, the ability to be able to harvest both short term indicators (current economic cycle, outlook for interest rates/duration risk, questionable valuations and investment flows) alongside long-term thematic trends in a diversified global portfolio remains our focus. Put another way yesterday’s leaders are no longer today’s and those will not be the incumbents in years to come, which is what we account for as part of our investment process during portfolio construction.