Financial conditions, (a proxy for the cost of capital) have been looser and supportive to growth particularly in the US and China.
Inflationary pressures remain subdued; a resolution in the trade war between China and the US significantly reduces the main risk to inflation. However, President Donald Trump has shown his willingness to use the threats of tariffs as his preferred foreign policy tool, which can be reignited at any time.
Given the risks to inflation are lower, central banks and governments have made it clear that they are still more concerned about a weaker growth outlook, as growth remains close to stall speed. They are heavily biased to provide additional policy support should that be needed.
This significantly reduces the chances of a policy error-induced recession. However, we are not as excited about the potential for a burst in corporate investment spending as a result of the easing in trade tensions and more clarity regarding Brexit, as some analysts have suggested. Two factors prevent us from getting overexcited:
1) Geopolitical risks remain. In particular, the US presidential election in 2020 will keep US trade policy at the forefront as it is one of the few areas of policy where President Trump can act with a degree of freedom and remains an electoral positive with his voter base.
2) High and expanding profit margins provide a key backdrop where corporates are able to plan investment decisions with a higher level of confidence. Unfortunately margins have exhibited a declining trend in recent years; in addition margin growth in the current cycle has been primarily driven by cost control rather than revenue growth and is a key reason why the labour share of growth has declined, resulting in lower consumption growth. The good news is that our analysis suggests that the pace and extent of this decline in margin growth are unlikely to prompt a sharp change in corporate behaviour that could trigger recession in 2020.
So whilst the growth outlook remains subdued, recession risk is low.
As for the market, given the strength of risk assets in 2019 our immediate question is to what extent have the markets already moved ahead of the economic reality of continued subdued economic growth? From an equity market perspective the primary driver of returns in 2019 was multiple expansion rather than earnings growth. The key driver of the multiple expansion was the decline in bond yields reflecting the accommodative central bank policy settings. Logically, this tempers likely returns from equities in 2020 unless growth and earnings surprise meaningfully to the upside. So what are the chances of an upside surprise to earnings?
The current consensus EPS expectations for 2020 already appear high at 9 per cent for the world index given the tepid growth outlook and the more limited scope for margin improvement. In addition, consensus forecasts for EPS growth have historically been a particularly poor guide; over the last 30 years the average growth forecast has been 15 per cent while actual has averaged 6 per cent. In the second half of 2019 global equities moved into a zone we refer to as “market hope”, characterised by positive valuations (the 12-month change on forward price earnings multiple) and negative EPS growth. The reduction in recessionary risk was a necessary condition for this rerating in equities, but now earnings need to validate the market expectations. For equities to break significantly higher, we will need to see evidence of a rebound in EPS growth by Q2.
Given the improving outlook and low probability of recession, our multi-asset strategy currently has a medium term preference for equities and credit relative to government bonds.
Adam Kibble, investment specialist, Insight Investment
