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We sold Goldilocks in the last quarter of 2018. It is now
time to buy Armageddon.
When we wrote our last Quarterly, in early October 2018,
the US equity market had just had its longest losing streak
since the start of the Trump presidency. The key question
at the time was if US Equities would enter a bear market
and drag other equity markets further down with them.
Our answer was and remains: no. This is because the
Market Watcher Supreme is President Trump himself, the
same individual who holds the keys to the trade disputes
which, in our opinion, played a significant part in the
weakness of equity markets. We believed that any
continuation of a meltdown could be followed by pledges
for more stimulus or maybe, just maybe, a more
conciliatory tone versus China.
Lo and behold, President Trump did make an overture to
President Xi at the G20 meeting, that started on
November 30 in Buenos Aires. The two sides agreed to
postpone by 90 days the planned tariff increase on
January 1 and to initiate talks. Granted, not everything
ran smoothly from the get-go. It hardly ever does. The
arrest of the CFO of one of China’s most prominent
technology companies, Huawei, kept markets doubting
that a deal would ever be possible. Also, a solution to the
trade disputes would be more of a truce, in what will most
likely be a long-term ideologically driven conflict between
China and the US. That said, talks at the time of writing are proceeding and a solution will be a key overhang to
be lifted for equity markets.
EM outperformed US Equities by a wide margin
We have maintained for a while that any positive news on
the trade disputes could ignite a rally, more so in those
markets that had been heavily battered, such as Emerging Market Equities. Even in the doldrums of last December’s
market volatility, with still a significant lack of clarity on
the trade disputes and all major regional markets posting
negative returns, EM outperformed US Equities by a wide
margin, followed by Europe and Japan. This was no
surprise to us.
Of course, the trade wars were not the only issue that
affected equities outside the US, over the better part of
2018. The Fed tightening at a time when global growth
was potentially being affected by protectionism,
geopolitical concerns in Emerging Markets and Europe,
and the dollar strength that ensued all contributed to a
perfect storm of potential threats. Eventually, when
investors realized that this conjuncture of events, which is
not good for equities markets outside of the US, is
actually not that great for US Equities either, US Equities
also started to nosedive. Investors began selling the
Goldilocks scenario, where US Equities risk premium had
reached an historical low versus all other major equity
markets, because it simply was too good to be true that
US earnings would be unscathed by all the ills that would
affect the rest of the world.
Time to turn to markets outside the US
Well, it is now time to turn to markets outside the US. EM,
Europe and Japan have all underperformed the S&P500 over the course of 2018 (in USD terms). Even with the
outperformance last December, they still all closed the
year about 10% behind the US. While geopolitical risk and
some European countries playing with the odds of a
recession are likely to keep volatility high in European
Equities for the time being, there is less uncertainty on the
horizon for Japan and EM Equities, as most of the
potentially negative catalysts ahead appear to be already
expected and discounted by markets.
Take Emerging Markets, for example, where investors
have been discounting an Armageddon scenario with a
17% underperformance against US Equities in the 11
months to November 2018.
Not that everything is perfect in EM. Earnings growth is
slowing down and economic growth in China continues to
weaken. For one, we are likely to have more earnings
disappointments in the near term. Yet, earnings growth
for 2019 is still estimated at 9% and a good part of the
negative revisions that we have seen in recent months
were due to direct and indirect consequences of the trade
disputes (as companies have either been directly
impacted or have become more cautious with their
spending plans). While a “deal” between Trump and Xi
would not fully reverse the earnings outlook, it would
certainly eliminate a significant overhang. China’s
economic growth will structurally continue to weaken, but
the government can still manage the soft landing with
stimulus measures and our investment team expects
more of these later in the year.
At the same time, every other issue that was dogging EM
Equities in 2018, while it has not disappeared, has started to relieve the pressure. For one, the FED’s recent language is more dovish hinting to a pause in rate increases. While
the balance sheet shrinkage at this stage will most likely
continue, the fact that the Fed is moving more cautiously
indicates that, if the macro outlook would warrant it, a
pause in quantitative tightening could also be in the
cards. With a more dovish Fed, and a less buoyant US
macro backdrop, the US dollar is also likely to pause its
ascent. In the meanwhile, a number of the geopolitical
concerns that characterized EM besides the trade disputes
(such as elections in Brazil and Mexico) are now behind
us.
Risks remain high
Don’t get me wrong, nothing is ever straigthforward, and
the risks remain high. Yet, the odds have turned. Those
Damocles swords that were hanging over EM are slowly
being pulled back: the Fed has become more dovish, Xi
and Trump are talking, and the Trump administration
seems more willing to ink ‘the deal’, and geopolitical
concerns have dissipated. If all this also means a
normalized dollar, as the US economy cools off and the
Fed errs on the side of caution, this is the recipe that we
have all hoped for: we sold a false sense of Goldilocks,
now we should buy a misplaced fear of Armageddon.
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