One constant in the ever-changing investment profession is that the task of making predictions for the New Year is a tricky one; sometimes it can feel almost futile. Given what markets have experienced in 2018, that seems especially true. Are the prevailing dynamics of the last decade no longer with us, or has 2018 just been an aberration? Since the Great Recession – a starting point now experienced by less than half of our industry’s current buy-side practitioners – the market has grown on the back of abundant liquidity pushing asset values ever higher. But that, perhaps, is behind us.
Investors are now grappling with the notion that growth is undoubtedly softening across the globe, despite the 113-month economic expansion in the US. How this slowdown develops is the most crucial variable in determining equity market direction and shape over the next few months. Whispers of an inverting US yield curve are concerning bears that a recession approaches. Our base case is one of a measured slowdown scenario in the near term; we do not expect an imminent recession.
Upward pressure on the cost of doing business, especially with respect to labour, transport and other key input prices, is arguably a more troubling recent change. No economic recession does not necessarily mean no earnings “recession”, and given corporate profitability is already high in a historical context these pressures are of concern. Optimistic margin forecasts are vulnerable and we could be in for a period of consistently negative net earnings revisions. Downgrades for all major markets actually started in October and comparatives will get progressively tougher through 2019. Whilst the great de-rating of market multiples in 2018 (the third largest fall in global price-earnings ratios for over 40 years) has to some extent priced-in this risk, there is a possibility that equity valuations suffer further as economic and earnings forecasts grind slowly lower. And, as in 2018, exacerbating this trend will be more “quantitative tightening”, as central banks continue to draw liquidity from the system. The derating challenge will likely be the strongest headwind to share prices again this year.
Market direction in the very near term is likely to remain opaque. However there is clearly merit in giving consideration to regional preferences at this stage. Each year we are “advised” to switch out of “expensive” US equities into the “cheap” markets of Europe and Japan. That has been uniformly wrong in recent years and we expect it to be wrong again in 2019. Rating differentials are hard earned and should be respected, not feared. The persistent US outperformance has been about relative earnings delivery, and given it has the most flexible economy with the most innovative corporate culture that outperformance is set to continue. Europe and Japan are essentially value cyclicals, will inevitably underperform in a downgrade cycle and remain a relative avoid. Emerging markets and the UK hold the surprise factor in 2019. The former have already fallen heavily so with a possible peak US dollar twinned with tentative signs that investment flows are returning, dipping a toe or even toes in emerging market waters could be a smart strategy. Due to the Brexit fiasco international investors have rightly taken to the sidelines of the UK market. This is creating a number of extreme valuation anomalies however as the likelihood of a very difficult outcome becomes ever discounted. If some form of agreement resembling anything near sensible can be reached then there could be outsized relative gains on offer here in the coming months, combined with the right bottom up approach.
Opinions and views from the Equities team at Kames Capital are not an investment recommendation, research or advice and should not be considered as such. Content discussing investment strategies and stocks is derived from and solely relates to the investment management activities of Kames Capital.
About the author
Mark Peden is the architect of our global equity income strategy and has been the lead manager of the Kames Global Equity Income Strategy since its inception in 2011. European equities are his main area of research expertise where he has been analysing companies since joining the firm in 1992. Over his tenure Mark has held a number of positions and managed a range of both International and European equity funds. He graduated from the University of York and the University of California (Santa Barbara) with a BSc honours degree in Economics with Politics. He a CFA charterholder and is also an Associate member of the UK Society of Investment Professionals (ASIP). He has 26 years ’industry experience.*
*As at 30 November 2018.