Sector and style leadership in January was clearly ‘risk on’, with cyclical and small cap equities as well as companies with higher earnings variability leading the way. ‘Value’ also performed well, coinciding with some steepening of the yield curve and better than expected US economic data (rising surprise indices). In contrast, quality stocks underperformed last month, even though they gained in absolute terms.
Importantly, despite mostly positive earnings announcements thus far in the Q4 reporting season, the January gains were mostly driven by a re-rating of equity multiples. Although some further advance is possible before average P/E levels return to their 2017 peaks, the committee feels the bulk of the valuation re-adjustment is probably over.
Full-year analyst earnings estimates continue to come under pressure. US consensus earnings are only expected to grow in the mid-single digits this year, well below the 20%-plus year-on-year numbers recorded in the middle two quarters of 2018. Earnings revisions will therefore be a probable headwind for equities this year and, indeed, a US earnings recession in 2019 cannot be ruled out if US and global growth weakens further.
Many of the risks that precipitated the Q4 2018 sell-off loom ahead. Late last week global equities stumbled as reports circulated that presidents Trump and Xi may not meet before the US-imposed 1 March deadline for hiking tariff rates on imports from China. Whether the UK can reach an agreement to avoid a ‘hard Brexit’ on 29 March remains up in the air. And although US data have, for the most part, been more reassuring thus far in 2019, the same cannot be said for Europe or China, where negative news predominates.
Our base case remains a global growth and earnings slowdown - ‘post-peak’ - rather than economic or earnings recession. In all major economic regions, consumer spending remains supported by steady increases in household income, courtesy of jobs growth and real (inflation-adjusted) wage gains. Inventory levels - always a problematic measure - do not appear to be excessive, suggesting the final demand will continue to lift global production.
Yet there are concerning trends in some of the detail. Although market measures of financial conditions remain supportive, eg rebounding equity and credit markets, loan officer surveys in the US and Europe suggest banks are beginning to tighten lending standards. In the US, activity in the housing and auto markets has weakened noticeably. In Europe, resilient household spending has not been enough to offset weakness from trade, production and investment. The same is true in China.
A backdrop of slowing economic and earnings growth makes risk assets more vulnerable to other forms of uncertainty. Absent a sudden and unexpected upturn in growth outside the US, therefore, the equity market recovery of January was always going to fade. Insofar as much of the slowing of global growth last year was the result of policy and political uncertainty, much now rides on the outcome of the US-China trade negotiations and Brexit outcomes. Yet, given their binary nature - either very positive or very negative for global growth - we anticipate that investors will begin to rein in their ‘risk-on’ positions. As we note below, we have done the same across most portfolios we manage.
Over the past few weeks, we have trimmed allocations to higher beta segments of global equity markets. Quality, minimum volatility and high / stable margin versus low / variable margin stocks are among our preferred positions. Against benchmarks (where applicable) we have reduced overall equity weightings. Among regions, we tend to prefer Japan, emerging markets and the US, relative to Europe, where the growth and earnings inflection point remains difficult to foresee. We continue to shy away from UK holdings, given the uncertainties surrounding Brexit.
In fixed income, our preference remains for specialty credit, shorter duration exposures and even cash. Unlike global equity markets, which recovered sharply from their 2018 lows, global bond yields continue to fall. If we are correct that growth has merely slowed, but recession risk remains low, investors are probably too sanguine about the end of the Fed tightening cycle or even ECB easing. In small steps, therefore, we have begun to re-establish short futures positions in Treasuries and Bunds, in anticipation that yields will eventually resume rising from today’s levels.
Across most strategies, we have reduced exposure to alternative managers and strategies, given poor track records, including in difficult market conditions when they ought to contribute most to portfolio performance. In some portfolios, however, we have increased our allocations to diversified non-directional approaches, such as target return and alternative risk premium strategies.