Long-term equity returns are traditionally driven by Earnings per Share (EPS) and dividends. However, from our calculations, we find these fundamentals only explain around 17% of total global equity returns so far in 2019. Instead, equity performance has been driven by most of the major central banks easing monetary policy.
Since the futures market expects the Fed to cut interest rates just once in 2020, investors will be looking at company earnings and dividends to sustain the equity rally. On the positive side, after a sharp slowdown in global manufacturing activity in 2019, there are tentative signs of stabilisation. Economic conditions have improved a little amid thawing US-China trade tensions. Faster growth increases the probability that companies can deliver on consensus global EPS expectations of 10% in 2020.
In our view, the underlying assumptions behind EPS expectations seem conservative. For instance, consensus sales growth for companies of +4.5% is in line with the IMF’s 2020 nominal GDP projected rate estimate. That said, should profit margins be squeezed as the global economy moves to full employment, and this forces up labour costs, it could hinder the ability of companies to meet EPS expectations.
A risk for investors is the extent to which 2020 company earnings have already been priced into markets following the equity rally in 2019. Political issues - such as a potential progressive left-leaning US president (see our November Investment Outlook) or President Trump doubling-down on his trade protectionism rhetoric ahead of the November election - are risks worth monitoring. Similarly, equity performance could suffer should the Fed turn hawkish on interest rates in 2020. However, with US inflation benign, we see that as a low probability risk. Consequently, we continue to favour equities over bonds.
Markets risks from the Labour manifesto
According to the Resolution Foundation, the Labour party manifesto envisages government spending (day-to- day and capital investment) of 45% of GDP by 2023/24, up from 40% currently, and would be the largest expenditure (excluding the Global Financial Crisis in 2008) by any government since the mid-1970s.
UK bond and equity markets will be concerned over whether this rapid rise in public spending is sustainable and whether it will weigh on long-term growth expectations if it doesn’t deliver higher productivity rates.
Arguably, Labour plans on corporate governance are a greater risk for investors. For instance, companies that don’t meet climate change criteria could risk being deselected from the London Stock Exchange. Another example is the establishment of Inclusive Ownership Funds, which would require companies with more than 250 employees to set aside up to 10% of their shares into funds for employees (without compensation) over 10 years. Should the Tories fail to win a majority at the upcoming general election, the risk of a possible Labour government implementing its policies is likely to weigh on markets.
Looking beyond headline statistics to interpret China’s economic health
China’s latest round of monthly macro statistics have been greeted with some gloom. Certainly, on the surface, the data appears disappointing. While industrial production grew +4.7% in October from a year ago and retail sales expanded by +7.2%, both data points were below consensus expectations. For many, this has been taken as a sign of China’s ongoing weakness.
However, our interpretation of China’s economic health is a little different. Look beyond these headline statistics and domestic demand appears relatively healthy. Notably, Alibaba’s “Single’s Day” shopping sales on the 11th November, the world’s largest e-commerce event, reported revenues up 26% from 2018. This suggests far faster growth than that laid out by the main headline government retail sales figures.
Looking forward, China has stepped up the supply of bank loans and direct financing (e.g. equity and bond issuance) flowing through the financial system. Given that this credit is a typical lead indicator, this should act to stimulate the economy and deliver stronger growth. Not only is this good news for the Chinese economy, but also for the global outlook, as Mainland demand has been an important engine of growth for countries across the world.
There is already evidence of faster Chinese demand growth feeding through to the global economy. Germany, which has been hit hard by China weakness, appears to have turned a corner and – against many predictions - avoided recession in the third quarter of this year.
Chinese and Emerging Market equities have underperformed markets this year. Nevertheless, should Chinese growth begin to recover, and US and China dial back on trade protectionism rhetoric, then we believe this provides an opportunity for investing at current undemanding valuations. More generally, financial markets are beginning to discount the impact of accelerated Chinese credit stimulus. Global equities are up more than 20% year-to-date and continue to rally. Bonds are also beginning to sell-off somewhat recently, as the global economic recovery strengthens. In short, additional Chinese credit provides insurance that the global business cycle can continue and for the equity rally to be extended into 2020.