January 2019 - Premature Recession Fears
Global equities tanked in December, led by Japan and the U.S. The MSCI All-Country World Index dropped 7.3% on the month, a -2 standard deviation move and its worst monthly performance since May 2010. U.S. equities (-9.2%) underperformed the rest of the world (-5%), a reversal from the trend during most of 2018. The main catalysts behind the selloff were (1) expectations for a more dovish Fed that didn’t materialize at the FOMC meeting (2) concerns about the Fed’s independence and the U.S. government shutdown (3) weaker economic data in China and (4) lower oil prices. On the year, the MSCI ACWI index dropped 7.7% in local terms, its worst year since 2008.
Global earnings per share (EPS) profit expectations have started to come down given the weaker macro backdrop, with the earnings revision ratio turning negative. Bottom-up analyst consensus recommendations now forecast a 7% global EPS growth for 2019, down from 10% four months ago. But even as profit expectations have come down, price declines for major indices have surpassed these. The MSCI ACWI index is now trading at a forward price to earnings ratio (P/E) of 13.3x (11.8x ex-US), around one standard deviation cheaper than the 10-year average of 14.7x (13.6x ex-US). While there have certainly been signs of weaker economic growth, particularly in China and Europe, we don’t expect a major deceleration that justifies these price declines. Investor sentiment has been overly bearish in recent months, and the Bank of America Merrill Lynch Bull & Bear indicator now indicates a tactical buy, the first one since Brexit. We agree and think that the selloff in December was a bit overdone and driven by excessive fears that won’t all materialize. We think that deploying some cash to add to equity and US HY exposure at this juncture offers an attractive risk-reward.
U.S. equity markets were among the worst performers in December, driven by richer valuations, the overly dovish market expectations before the Federal Open Market Committee (FOMC) and political uncertainty. The energy and financial sectors underperformed (-13.3% and -11.7%) more defensive sectors such as utilities (-4.8%), due to the big drop in oil prices and lower U.S. Treasury yields. Although there have been signs of weaker economic data in the manufacturing sector of the economy (the ISM manufacturing index recorded the largest monthly drop since October 2008), the manufacturing sector only contributes 17% to GDP. This sector is sensitive to global growth uncertainty and oil prices, but the more important segment to monitor is the consumer (which accounts for 70% of GDP). On this front, the very strong job market and lower oil prices should continue to support strong consumer spending, as evidenced by the strong preliminary figures for December’s holiday spending. With some progress emerging on the China-U.S. talks and the Fed becoming more receptive to the market’s concerns, we see the potential for more stability in U.S. equities in the near-term. We therefore advocate adding to domestic sectors that have been hit the hardest, such as financials (trading at 9.7x forward P/E) and consumer discretionary (16.4x P/E).
In other equity markets, the MSCI Europe index ended December down -5.4% and -13.1% on the year. Given that economic data has been weak (Eurozone manufacturing index has dropped to 51.4 from 60.6 at the end of 2017) and inflation pressures remain subdued, we expect the ECB to remain accommodative and provide some support to risk assets. European equities are trading at 5.5-year P/E lows (11.9x), and we expect them to recover somewhat, but political risks and their high exposure to global trade will remain an overhang. Japanese equities were the worst performers last month and should bounce back if there is progress on corporate governance and trade wars. EM equities outperformed in December (-2.8% in local terms), with Asia underperforming other regions. We remain overall constructive on EM equities, given cheaper valuations and our expectation for a weaker dollar. While Chinese equities were the worst performers in 2018, we prefer to wait until there is signs of stabilization in the macro data before adding to our exposure there, and prefer diversifying away from Asia and towards Europe and Latin America.
In credit markets, spreads continued to widen amid the weaker macro backdrop as well as the sharp fall in U.S. Treasury yields (-31 bps). US HY spreads widened another 104 bps on the month and total returns were -2.2%, and there were no new issues on the month. The US HY energy sector was the worst performer as it lost another -3.9% in December and 10% in Q4. Although tighter financial conditions and the drop in oil prices will likely lead to a slightly higher default rate in the coming year, we think it is too early to call it the end of the credit cycle. US HY spreads are now trading above 500 bps (yield of 7.6%), the widest level since early 2016. We think that current levels more than compensate for the expected deterioration in fundamentals, and advocate tactically going overweight US HY. The risks are continued stock market volatility and lower oil prices.
US IG spreads widened another 14 bps on the month (to 159 bps), ending the year +60 bps wider and marking the worst year of excess returns since 2011. Reflecting the market volatility, supply volumes were only $9 bn in December, the slowest December since 1998, and fund outflows accelerated towards the end of the month (-$34 bn over last 6 weeks). European IG credit spreads only widened 5 bps on the month as they were less impacted by the turmoil in the U.S., and they now trade 5 bps tighter than U.S. IG for the first time since August. We think recent spread widening may have been overblown, and see the most value in BBB paper which is trading at a spread of 205 bps (yield to worst of 4.7%).
In Emerging Markets, currencies were flat vs. the USD in December, with a divergence in performance. The Mexican Peso appreciated 3.7% on the back of a more market-friendly stance by the Andres Manuel Lopez Obrador (AMLO) administration, while the Russian Ruble lost 3.9% on the back of lower oil prices. EM USD credit spreads widened 17 bps but returns were +1.4% on the back of lower U.S. Treasury yields while local currency bonds returned +1.2% in USD terms – led by Chinese government bonds. We continue to see more value in local currency debt vs. USD debt, given benign inflationary pressures and our expectation for a weaker dollar. Nonetheless, country and credit selection remain important.
Overall, we think the recent market selloff in risky assets has been overdone, and we are facing an interesting tactical buying opportunity. Our base case assumes a modest slowdown in economic growth and progress on U.S. – China trade talks. We still expect volatility to remain high, given the large number of risks and uncertainties the market is currently facing. In the medium-term (12-18 months) we prefer to gradually reduce our exposure to risky assets after strong rallies (>5%). As always, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance.