This year managed to get off to a positive start with equity markets recovering some of the losses endured at the end of 2018. This recovery was largely due to the US Federal Reserve (Fed) taking a U-turn on monetary policy. After the sharp market falls in December, the Fed became fearful of tightening monetary policy faster than the markets can handle. Investors stopped pricing in further rate increases, and the Fed capitulated by putting policy on hold. As a result, investors have found themselves with some breathing space, for now.
Equity valuations fall back into line
We’ve been waiting some time for valuations to improve across equities – especially in the US. Our patience finally bore fruit as good quality stocks were deeply over-sold amid the panic at the end of last year, and opportunities started to present themselves. Going forward, our focus is on earnings growth. If companies can deliver moderate growth in the months ahead, we can look forward to reasonable returns, albeit not at the pace we’ve seen in recent years. If growth stagnates, then equities could struggle. We are therefore interested in businesses that can deliver growth relative to expectations.
Corporate bonds looking more attractive
While 2018 was a difficult year for fixed income investors, the outlook for 2019 is improving. In comparison to 12 months ago, corporate bond credit spreads have widened, meaning investors are being better compensated for the investment they are making in businesses. As a result, we’ve added to our allocation of high yield bonds.
US capital expenditure incentives have pulled forward spending from the future, financial conditions have become more restrictive, and banks are extending less credit. In the US and UK, core inflation is above target, and it’s possible that very low unemployment and continued inflation pressures will force interest rates to rise beyond normalisation – despite the best intentions of the central banks. As these risks to growth continue to increase, we will maintain a defensive position for the foreseeable future.
“The December sell-off in equity markets has improved valuations and improved the margin of safety. Earnings growth is critical for this asset class, but this could become harder to deliver as economic growth slows.
If companies can deliver moderate growth, then high single digit returns should be possible” – Philip Smeaton, Chief Investment Officer
Investment view: What growth outlook data tells us about the future of the economy
The outlook for business growth is of paramount importance to investors. Every quarter, as companies report their earnings, investors watch and listen very closely as they try to extrapolate the meaning of the results, and what the future holds. So, what is the growth data telling us right now?
Chart 1 shows the expected earnings per share in the next 12 months. As you can see, after surging in 2017 this started to dip towards the end of last year, albeit remaining high relative to its history, and way above where it was during the credit crisis.
At the same time, Chart 2 shows a noticeable slowdown in the Purchasing Managers’ Index (PMI), which is an indicator of the economic health for manufacturing and service sectors. The sudden fall from 59 to 54 for the US was partly responsible for the December sell-off as the US came down from its euphoric highs and joined the rest of the world in a slightly more subdued outlook.
These are just two measures we watch closely on a monthly basis. Other measures, such as capital expenditure and nonresidential investment, are painting a similar picture and giving us cause for concern.
While we may not feel the impact of slowing growth this year, we acknowledge the possibility of a significant economic slowdown in 2020, and we must therefore use this analysis and insight to position client portfolios accordingly.