Market Overview
We believe fundamentals drive long-term returns. Although global growth may slow in 2019, we think fundamentals are still supportive and valuations are more attractive now than a year ago: yields have risen and equity valuations have fallen. That creates opportunities. Stay positive and keep long-term prospective!
US and Global Economics
Despite the recent pessimism in the market, we think the 4th quarter selloff was overdone. Although US growth has started to moderate from the exceptionally strong pace earlier in 2018, momentum remains solid with Q4 GDP growth to be about 2.5% per Blue Chip (major 50 world financial institutions) consensus. Moreover, there are a few things which should support the US economy in the near future. According to WSJ, the US holiday sales are the strongest in 6 years. Consumption (roughly 70% of GDP) should be smoothed by a healthy personal saving rate, and strong real income growth thanks to rising wages and weak oil prices. The recent selloff suggests that investors have substantially lowered their growth expectations. The flattening of the yield curve has added to the concerns about future recession. Recent weakness in non-manufacturing and manufacturing and moderated job growth in November also didn’t boost enthusiasm. Nevertheless, the yield curve is not inverted yet (and after inversion it usually takes 18 months before recession). Moreover, next year Blue Chip consensus forecast doesn’t point to a recession but rather to a slower growing economy. Investors worry about things going wrong, but some developments could surprise on the upside:
A. Corporate profits might not peak in 2018. According to JP Morgan, earnings remain in an uptrend. Margins could stall, but revenue growth is likely to be robust. Specifically, for the US, earnings don’t typically peak for the cycle before they overshoot the trend by 20-30%, according to JPM, which may indicate there is more to go.
B. The Fed could raise interest rates at a slower pace next year. They already indicated a much more cautious approach to raising interest rates. Per JP Morgan Policy, rates are still accommodative, with US real rates near zero. None of the last eight downturns started with real rates lower than 2%. The current yield curve shape is consistent with double-digit S&P500 returns over the next 12 months. One typically doesn’t see a slowdown without High Yield credit spreads widening 300-400bp. Their widening of late is much smaller than this. The Fed turning incrementally more dovish should not lead to falling 10-year yields, as is the current knee-jerk market response. The risk of “policy mistake” is reducing, and the curve should steepen, according to JPM.
C. The Administration could take a step back from its stance with China and there is a good chance the sides will come to an agreement. China already feels the impact of tariffs and is not interested in a prolonged standoff. They already started taking first steps to opening their markets and reducing forced technology transfer.
D. Global Economy might not slow down dramatically. According to Goldman Sachs, Euro area growth is returning to above-trend growth in Q4. And the sharp drop in oil prices should provide a welcome boost to consumers in Europe and Japan. A few green shoots are also emerging in some EM economies. China has continued to slow, but Chinese policymakers are making efforts to boost credit growth and fiscal activity, and the détente in the trade row between the US and China has (for now) provided some relief. Moreover, they are seeing tentative signs that growth in EM countries outside of China are bouncing off of the 2018 lows. Their EM economists’ forecasts of moderately higher growth in 2019 and therefore still see decent global growth of around 3½% in 2019—that is, a stabilization at the current sequential pace with a modest slowdown in the US and slightly faster growth elsewhere, especially EM.
E. Equities have become cheaper and we see early signs of fundamentals getting back into the game. For the first time in more than 8 months we see fundamentals playing out the way they usually do in the long-run. We think this may positively impact our actively managed strategies.
Equities
In the fourth quarter investors doubted the health of the global economy and reacted swiftly. Per Empirical Research Partners, the trailing P/E multiple of S&P 500 has contracted by 19%, which is the 14th biggest decline in the last 372 quarters or 92 years, the correlation of Big Growers spiked to 62%, a level never seen before, the utilities sector became the momentum leadership and the relative price to sale ratio of metal and mining stocks fell to all time low. Utilities sell at 75% P/E premium to the banks, which is a top 2% reading by the standards of the last 55 years. When the market’s multiple declined by an amount like that we’ve just seen, it has recovered in the next year in 15 out of 20 episodes, according to Empirical. Judging by our Valuation Spreads Chart below, we have broken 1 standard deviation above the 20-year mean in November. This means more expensive companies in their sectors have become even more expensive relative to lower valuation stocks. We think it makes sense to own equities with reasonable valuations as well as other attractive fundamental characteristics in anticipation of this spread reverting to more normal levels overtime. If the yield curve steepens, we believe banks could advance meaningfully. If there is a truce between US and China, metals and mining will probably go up substantially along with some industrials and technology. If the Fed slows down with interest rate increases, housing markets could perk up. More importantly, no matter what happens in the near term – in the long-run fundamentals influence returns more than anything else. We believe returns should mainly come from stocks with strong fundamentals trading at reasonable valuations. This process has served our clients well over time. This is why we don’t deviate from our process of investing in fundamentally well-rounded companies during periods of extreme markets.
Valuation Spreads (Source: Signet FM, Compustat) through November 2018:
