Last year was spectacular, starting with peak euphoria and ending with violent December drama of a type not witnessed since 1931. There were several culprits, but the stand-off between the US and China, together with a relatively hawkish Federal Open Market Committee decision in December – seen by many market participants as a policy mistake – were likely the two biggest drivers. Our main message for investors is to stay defensive, favouring minimum volatility factor over pure equity exposure.
Japanese equities are a potentially interesting rebound case if China manages to stimulate its economy into growth and strike a deal with the US on trade issues. In addition, we highlight long-term constraints on economic growth and warn about emerging-market exposure.
Ignoring December could be costly
The S&P 500 declined 9.2% in December, which is a rare event. If markets were normally distributed, which they are not, it would translate into a 1.8 sigma move, and a loss of this magnitude or more would not happen more than 3.5% of the time. All information is in the tails with the rest just being noise. Ignoring the decline in December would be a grave mistake. Even Federal Reserve chair Jerome Powell acknowledged in an early January interview that he and his colleagues are indeed taking market signals seriously.
What do the history books tell us about such large declines? The steepest December drop ever in the S&P 500 happened in 1931 and was followed by an additional 45% decline over the following six months. Another sharp fall in December 1930 was followed by very negative performance during 1931. Similarly, a slide in December 1937 led to a series of declines before sentiment changed and transformed 1938 into a year of gains. The 6% decline in December 2002 signalled the beginning of a weak three-month period before equities switched into fierce rally mode.
After the dramatic plunge in equity markets at the end of 2018, investors should keep a defensive stance and seek low volatility as the risk-reward ratio for 2019 looks bad. Japanese stocks could rebound if China succeeds in stimulating its economy and reaches a trade deal with the US.
The three-month future return, after a month with a decline of 8% or more, has historically been substantially positive, with an average gain of 2.7%. But the positive expectation comes with great risk in the form of a 20.1% standard deviation. Whatever direction equity markets take from here – which depends on many factors such as the Fed, US-China relations and China’s response to its economic slowdown – the path will be very volatile. Traders and investors need to be prepared and more active than usual as US equities could easily be up or down by 20% or more over the next three to six months.
Our main thesis, presented in our Q4 2018 Outlook, remains unchanged: equities and the current expansion are entering their final act, so risk-reward is not attractive. We still believe that equities should be part of investors’ asset allocation, but with a low weighting of around 30%, and exposure should be mainly in defensive sectors (consumer staples and healthcare) and minimum-volatility stocks.
Japanese equities are our top tactical play in Q1
Our new relative equity market model, introduced in early December, identifies Japan as the most attractive market on a relative basis. Japanese equities were hit hard in the fourth quarter, down 17.5% in JPY terms as Japan is an export-driven economy that has much to lose from the US-China trade war. While it was a brutal quarter for Japanese equities, the momentum relative to other equity markets over the past 12 months is still high. Combined with a low valuation relative to historical terms, the Japanese equity market offers an attractive risk-reward ratio, especially if China manages to engineer a rebound in its economy and seal a deal with the US across market access, trade issues and intellectual property rights. Mainland Chinese equities remain underweight in our model together with other emerging markets such as India and South Africa.
US equities were expensive and unattractive as we wrote our Q4 Outlook, but the 14% decline in the fourth quarter has reduced the z-score on the S&P 500’s valuation from 0.72 in September to 0.10 in December. At this level, US equities have obviously become more attractive, with an expected 10-year annualised return of 5.8% and a predicted worst-case at around 2%. While investors have been accustomed to high equity returns over the past 30 years, this may change soon as the global economy will be constrained across multiple dimensions, which we will explain later in this equity outlook.
Value beat growth in Q4
Our Q4 Outlook highlighted value stocks as the preferred factor tilt (minimum is still preferred overall) over growth as higher interest rates discount future cashflows proportionally more, leading to downside pressure on assets with high duration. This includes equities in general, but more so for growth stocks that derive most of their present value from cashflows beyond the immediate five-year horizon.
US value stocks were down 10.8% in Q4, compared with a decline of 16.6% for growth stocks, so value stocks delivered 5.8 percentage points of outperformance. The tilt towards value stocks was based on higher interest-rate expectations driven by the Fed’s communicated trajectory. However, given the slowdown in Chinese growth and the Fed’s likely lower path for interest rates in 2019, the big case for value stocks may already be over. We side with the hypothesis that it comes down to debt saturation as well as combined industry concentration that are stopping productivity from rising.
Population growth has been one of main engines of growth for centuries. Across Europe, China and Japan, demographics will become a negative constraint for nominal growth. For large welfare states, negative demographics come with even larger risks as pension liabilities could become a systemic risk.
Rising healthcare costs
Healthcare costs are rising in almost every country. In the US, health expenditure has risen from 5% of GDP in 1960 to a projected 20% of GDP in 2020. This is essentially a tax on consumers and the economy that diverts resources from other problems. Excessive drug prices are largely driven by their patent protection, leading to excess profit. DEBT CYCLE The world was saturated in debt after the Second World War, and a long period of deleveraging began, ending only in the early 1970s. Since then, debt-to-GDP has exploded with only few periods of deleveraging – the latest being in the years after the great financial crisis in 2008; according to the Institute of International Finance, global debt to GDP now stands at around 325%. Excess debt creates hidden risks and exposes the economy to severe tail risks. The world has essentially borrowed growth from the future.
The escalating rivalry between the US and China started after the US became preoccupied for over a decade by the Middle East in the wake of the terrorist attacks in 2001. As China is not converging with Western values in terms of a globalised market economy, deeper integration is at risk. Nationalism is on the rise, driven by many factors, including wealth inequality and the downside effects of globalisation. Any meaningful degree of deglobalisation will be a constraint on global growth.
The world has returned to its second Gilded Age, with high income and wealth inequality changing political dynamics. Nationalism and populism are on the rise. Consequently, taxes on capital and income could rise, thereby constraining growth. With big political change comes uncertainty, which is likely to lower confidence and future equity returns.
Be wary of EM
In our previous Equity Outlook, we highlighted emerging markets as potential outperformance candidates, particularly Chinese equities. In the fourth quarter, Chinese equities were down 10.7% compared with a drop of 13.4%in the MSCI World Index (global equities). Other EMs contributed positively to performance, and the MSCI Emerging Market Index was only down 7.5%, delivering a 5.9 percentage point outperformance over developed market equities.
While it is tempting to remain positive towards EM, there are more paths to a negative outcome than positive. In the best-case scenario, China manages to kick-start its economy, pulling the global economy and EM countries out of the mud. However, we see signs of credit transmission being broken in China, so China’s ability to stimulate the economy, as it has done several times since 2007, is severely constrained.
In a worst-case scenario, the US economy stays strong, luring the Fed to keep hiking interest rates and disregarding market signals from abroad. In this scenario, we see tremendous stress for EM economies reliant on USD funding for their growth.
We remain defensive on equities as the risk-reward ratio for 2019 looks bad. Short term, we could see a rally if China succeeds in its stimulus of the economy and the country strikes a deal with the US on trade. Our equity model has Japanese equities as its top conviction on a relative basis. EMs look fragile, and only Brazil is favoured in our equity market model, so in general we recommend investors either to underweight or stay out of this space. A potential option play on an industry level is call options on semiconductors, which will likely rebound if China and the US reach a deal.