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Improving outlook for risk assets

The downturn in industrial output is bottoming out and corporate earnings – powered by rate cuts in the US and Europe – are about to accelerate.

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Neil Robson

Neil Robson

Global Equity Columbia Threadneedle

  • The Fed’s shift in stance, with more monetary policy easing than expected, delivered a surprise to markets at the start of 2019.
  • The outlook for risk assets in 2020 is stronger than expected due to the scale of global monetary easing.
  • Earnings growth for the S&P 500 is expected to accelerate to more than 10% by the end of 2020.
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Unlike many others, we never believed a recession was imminent in early 2019. After the 10-year US Treasury yield spiked above 3% in September 2018, worries about the escalating US-China trade war and industrial inventories drove world equity markets sharply lower. But the economic data remained positive. US and European consumers were not showing signs of stress and demand from this sector has remained robust throughout the year. So we were not surprised that the major economies continued to expand.

2019’s big surprises

Other developments did surprise us, however, the Fed’s rapid shift of stance between late 2018 and early 2019, signalled by chairman Jay Powell in January, was followed by far more monetary easing than we expected. For the first time, the US central bank was stimulating the economy during a period of full employment with no apparent impact on inflation. After its initial rate cut in July, the US 10-year yield fell to a low of 1.5% by the end of August and, along with renewed easing in the eurozone, delivered a huge cut in the cost of capital for corporations.

The other surprise, given our view on the likelihood of a recession, were the deep cuts to earnings forecasts we have seen through 2019. In the US, these fell by 8%-9% during the year, discounting a much worse economic situation that we had predicted. As we near the end of 2019, the S&P 500 is delivering earnings growth of 2%-3% year-on-year.

Fears grow of industrial recession

However, concerns over a turn in the inventory cycle leading to an industrial recession intensified in August and have dominated the second half. Germany’s export-focused industrial sector has been particularly weak, with production down as much as 5% year-on-year in recent months, driven by the escalating trade war between the US and China, and a significant slowdown in the auto sector.

From an equity market perspective, this year’s sharp reverse in interest rate expectations has created market conditions that were very favourable for “bond-like” equities such as utilities as well as for the growth stocks that we focus on. 

Tilt towards quality cyclicals

In terms of positioning, we have added some exposure to high-quality cyclical stocks through the year, initially in semiconductors, where we believe we are close to the bottom of the inventory cycle in some important segments. More recently, we have bought quality names in areas such as paper and chemicals. With capacity expansion in the US Gulf Coast chemical industry largely complete and an improving outlook for industrial production, we expect leading chemicals players to produce a big increase in free cash flow through 2020.

We believe the outlook for risk assets in 2020 is much stronger than many people realise, mainly due to the scale of this year’s global monetary easing.

Central banks covering two thirds of the world economy have been cutting rates in 2019, creating a very benign environment for equities, supporting consumer confidence and significantly reducing the likelihood of a recession. As a rule of thumb, taking 100 basis points off the 10-year Treasury yield can add about 15% to the S&P 500. This year the 10-year yield has dropped 150bps and the S&P is up around 23% at the time of writing. With the effects of this year’s rate cuts still feeding through, it would take a sharp increase in bond yields to put the brakes back on equity markets.

Earnings to gain momentum

Consequently, we expect earnings growth for the S&P 500 to accelerate to more than 10% by the end of 2020, especially given there is little prospect that the US Fed will tighten in an election year. In Europe, we expect German industrial production to recover, with growth in the low single digit percentage points for 2020. 

US election race and Democratic Primaries

The prospects for US-China trade is obviously bound up with the unfolding US presidential race, with the Democratic Primaries in February and March representing the next major milestone on the road to November. If the radical Democrat Elizabeth Warren wins the nomination and is elected, we expect equity markets to drop sharply. Although we believe President Trump has been motivated to reach some kind of deal to help his re-election prospects, fundamentally we see trade as a bipartisan issue for Washington.

Also note that there is less space between Trump and his likely Democrat opponents on trade with China than on many other issues. This points to a longer-term issue for world trade, as global supply chains increasingly fracture into regional spheres of influence. The same bipartisan backdrop applies, to some extent, to big tech, where both Democrats and Republicans are talking about more aggressive regulation.

However, we think major change is unlikely in the near term and so look for names such as Alphabet, with 20% revenue and earnings growth, to re-rate significantly.

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