Market valuations in early 2020 have quickly become stretched, while the recent coronavirus outbreak in central China has likely delayed our more constructive outlook into mid-year. Signs the outbreak is being contained should encourage some stabilisation in markets and a refocusing of investors’ attention on medium-term fundamentals.
Two key developments have seen international and domestic equity markets reach new highs in early 2020, while bond yields have moved above their cycle lows.
Firstly, the past two months have seen a significant easing in geopolitical tension, in mid-December, Boris Johnson’s UK Conservative Party secured a larger than forecast majority and Brexit occurred at the end of January. In mid-January, the US and China signed a phase one trade deal, and both sides also agreed to delay a phase two deal until after November’s US election.
Secondly, we’ve seen signs of stabilising growth as 2019 drew to a close. Activity picked up solidly in China in December. And in January, key leading indicators across the UK, Japan and Europe also moved higher. In Australia, while business and consumer confidence remain subdued, late 2019 saw jobs growth accelerate, the unemployment rate fall to a nine-month low and consumer spending lift.
Nor does 2020 appear to hold an imminent end to the cycle. Absent a new array of geopolitical shocks, the world’s current “new normal” of moderate growth, low inflation and relatively stable rates look set to persist for now. Of course, there are risks, most notably a re-escalation in the US-China trade dispute, uncertainty around the US presidential election and the outbreak of the coronavirus in China, which according to the US, appears to be more contagious than SARS.
It took SARS four months for 1,000 cases to be recorded, versus less than 25 days for the coronavirus. China’s economy is also a larger contributor to global activity than it was in 2002-2003. However, a significantly lower mortality rate (around 2 per cent, compared with 10 per cent for SARS) suggests the disease may be less severe (although fatalities have now exceeded SARS, albeit largely contained to China). Like previous outbreaks these events have the potential to significantly impact activity and dent market sentiments in the short term before activity bounces back. It’s likely forecasts for growth in China, Australia and other regions may be revised lower for Q1 2020. The most significant impact of these type of events typically falls on sectors such as retail, travel and entertainment. For Australia, export sectors linked to China, such as resources and tourism, are also vulnerable.
Despite this, for now, our key macro and market risk signals have also started 2020 in a more positive light. Risks around geopolitics, inflation and medium-term growth have eased.
And while equity indices were up strongly in 2019, average gains look less threatening when the late 2018 correction is included. Indeed, world equity markets rose by around 25 per cent in 2019, led by a rise of 29 per cent in the US. In Europe, the UK and Australia, equity indices gained more than 20 per cent. However, when we include the sharp (near-bear market) correction in late 2018, average per annum returns look far less breathtaking. Indeed, global equities have risen by just 6 per cent pa over the past two years. The US market is the stand-out with gains of about 10 per cent per annum.
Notwithstanding only moderate gains on average over two years, earnings growth has slowed, and valuations have risen from arguably fully valued levels in early December to be well above their 10-year averages. As such, we continue to hold only a tactically neutral position in equities (though overweight relative to fixed income). But we are overweight in those markets where valuations are closer to their long-term averages, such as the UK and emerging markets. In contrast, we maintain underweight in Australia where the index is now trading on 18.1 times calendar year 2020 earnings, its highest level in over 15 years.
The past couple of years have been dominated by geopolitical volatility and ongoing geopolitical skirmishes are likely to be a feature of the “new normal” investment horizon.
Behind the scenes, the preconditions for moderate global growth remain in play, including strong jobs markets, low inflation and accommodative monetary and fiscal policy. Valuations are arguably fully valued in traditional assets. Alternative investments continue to look attractive, reflecting end-of-cycle risks, as well as better risk-adjusted returns.
Overall, the potential for some stabilisation of global growth that underpins an improved earnings outlook in the wake of only moderate equity gains over the past two years, argues that the cycle’s end is far from imminent.
Diversified portfolios provide the best defence to an uncertain outlook. Despite the elongated macro cycle, conditions do not support being disengaged or disinvesting from markets. As recently highlighted in the American Association of Individual Investors Journal, since 1871, the average time for the US equity market to fully recover is 7.9 months. Indeed, 50 per cent of market downturns recover within two months and 80 per cent of market downturns recover within one year.
Scott Haslem, chief operating officer, Crestone Wealth Management
