Our baseline call entering 2019 was to be long risk assets, expressed by an overweight to equities, due to positive drivers such as supportive macro policies (monetary and fiscal) and still-contained inflation. Equities went on to have a strong first half of the year, despite slower global growth, rebounding quickly from the sharp sell-off in the final quarter of 2018 back to their previous levels. However, much of this was driven by earnings-per-share (EPS) multiple expansion (see Figure 1) and improving sentiment after the US Federal Reserve (Fed) put rates on hold, rather than by a broad upturn in the earnings outlook for the next 12 months. Therefore, investors need to be cautious, especially as volatility was unexpectedly low until late 2018 and could easily spike, given the significant geopolitical and growth risks facing the global economy.
More from the Mid-Year 2019 GMO
Given where we are in the market cycle –now the longest on record –and the increasing likelihood of volatility, it is questionable whether such a strong rally is sustainable over the remainder of the year without a significant improvement in the earnings outlook. An expansion in earnings yield (driven by higher earnings or lower share prices) is consistent with a dovish outlook on bond yields, and the current level of the yield gap between equities and bonds globally is slightly lower than its 10-year average.
Figure 2 illustrates the disconnect between prices and fundamentals for the MSCI World Index, where we have seen a significant gap emerge between multiple expansion and earnings growth. In the first half of the year, this manifested itself in poorer performance for companies with negative earnings surprises relative to those with positive surprises; S&P 500 companies delivering negative surprises lost 4% on average over the five days following their earnings releases, while those with positive surprises delivered +1%.
Much depends on how earnings develop over the next six months and whether the Fed, having switched gears abruptly at the end of 2018, maintains a dovish stance. Earnings revisions and expectations globally were mostly negative at the start of 2019, but seem to have stabilized in the second quarter. Overall, consensus expectations are for higher earnings from the eurozone and emerging markets (EMs) relative to the US.
With volatility flirting with 2018 lows in the face of very real geopolitical risks (e.g.,the US-China trade dispute and Brexit), we are cautious on equities overall and are focused on building positions in markets that may offer value. In our view, although emerging markets are more exposed to risk-off sentiment and a stronger US dollar as the trade dispute escalates, we continue to see better value there in aggregate than in Europe or the US, given how far US markets have come and the fact that Europe continues to disappoint. We will seek to take advantage of any increases in short-term volatility around the trade conflict to find attractive entry points into EMs.
Emerging Markets Offer Value
EMs still trade at a deep discount to developed markets (see Figure 3), despite the fact that GDP1 and earnings growth are likely to be stronger in EMs than in developed markets (DMs) (see Figure 4). Valuations in the MSCI EM index still look attractive relative to the S&P 500 index (see Figure 3). The price-to-book (PB) discount for MSCI EM versus the S&P 500 currently stands at about 51%; the price-to-earnings (PE) discount is about 28%. At the same time, the difference in return-on-equity (ROE) for MSCI EM versus the S&P 500 is only about 15%.2 This is notable because the discount in valuation multiples like PB and PE often roughly corresponds with the ROE gap–valuations, in other words, usually correspond with return on equity. In this case, however, the discount in valuations is much deeper than differences in ROE would ordinarily justify.
Consensus analyst estimates suggest that growth in earnings-per-share (EPS) is currently around 8.2% for EMs and around 6.8% for DMs (see Figure 4). These figures are particularly meaningful when viewed in context with consensus estimates for sales growth, which suggest expected sales growth among EM firms of around 5.3%, compared with expected sales growth for DM companies of only around 2.8%. Unlike EPS, which is a measure of profitability and reflected cost savings and other efficiencies, sales growth focuses exclusively on top-line revenues. Substantially stronger estimates for sales growth in emerging markets therefore suggest that robust demand is a primary driver of EM growth –less so in developed markets.
China Stimulus Should Have Positive Impact on EMs
China too should have a positive impact on EMs as a whole thanks to its fiscal stimulus. Typically EPS upgrades lag this kind of stimulus by six to 12 months. Recent economic data from China (industrial production up 6.5% vs. 5.6% expected, Q1 GDP at 6.4% vs. 6.3% expected)3 suggests the stimulus is already having a positive impact on growth and there should be more to come. Our economists continue to forecast 6.2% growth in China in 2019, as they did at the start of this year, despite trade risks. This means that the growth differential between EMs and DMs is likely to widen; typically, this is a strong positive for EM equities and debt.
At the macro level, the US dollar is looking expensive on most of our metrics, and cyclical indicators (oil, industrial growth, dovish central banks) all look much better than they did at the beginning of the year. This indicates that there should be room for P/E multiples to expand, as long as some accommodation is reached on trade in the next few months. Finally, the ongoing inclusion of China A securities in the MSCI EM index (with a weighting of around 3.4% by the end of 2019) should provide further support for EM assets. Analysts expect US$69 billion of flows into China as a result of this expanded inclusion. (For a closer look at emerging markets, see Emerging-Market Giants Drive Growth Despite Trade Risk.)
Concerns about Europe Keep Us on the Side Lines for Now
Despite European valuations appearing attractive relative to the US and elsewhere, political instability persists, not least uncertainty over the exact shape of Brexit, which will now not be known until October, and the increased presence of populist parties in the European Parliament. A sharp drop in economic growth (our economics team has cut its forecast for Europe’s GDP growth by 0.6% for 2019) and concerns about financial-sector equities keep us on the side lines for now.
While investors have become more optimistic about European equity markets on the back of the longer extension of the Brexit deadline, further dovish sentiment from the European Central Bank and the likelihood of better growth in EMs (which may feed through to better European equity market performance), we believe there is insufficient compensation offered relative to the US to justify a market weight position in the region. Some indicators like GBPUSD and EURUSD risk reversals4 (both trading at 2017 levels) seem too optimistic in relation to the potential resolution of political uncertainty, given the longstanding structural imbalances that persist in the eurozone.
Equity valuation multiples relative to the length of the current cycle (the longest on record) and past cycles should prove justified if trade risks moderate and earnings growth improves towards the latter part of 2019. Despite all the noise around the US-China stand-off, investors need to take into account the extraordinary support from monetary and fiscal policy, which can effectively extend this cycle even further. Moreover, trade risks aside, we are starting to see the evolution of local political risk in some of the bigger EMs, with countries such as India and South Africa now through their election cycles. Other macroeconomic factors should support global growth, including low unemployment, fiscal stimulus in China, and a strong consumer sector in developed markets. Given that markets remain acutely aware of being late in the cycle, however, investors should expect a bumpy ride.
1For additional information on potential GDP growth, see Simona Mocuta, Policy Uncertainty Weighs on Global Economic Growth Prospects(State Street Global Advisors,June 2019).
2Source for PB discount, PE discount, and ROE gap: Worldscope, State Street Global Advisors, as of 6 June 2019.
3Source: State Street Global Advisors Economics
4“Risk reversal” is a concept in foreign-exchange (FX) trading that can be used to gauge FX-market positions and to make trading decisions. Risk reversal technically refers to the difference between the implied volatility of one category of options –so-called “out-of-the-money” call options –and another category –“out of the money”put options. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means that calls are more volatile than similar puts –which in turn implies that more market participants are betting on a rise in the currency’s value than are betting on a drop in its value. (The opposite is true if the risk reversal is negative.) In this case, we might expect the risk reversals for the sterling versus the US dollar and for the euro versus the US dollar to be trading at levels that would indicate a greater anticipation for a drop in value –in line with the political imbalances and structural uncertainty we’re observing –than actual risk-reversal values indicate.
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