It’s all about earnings and growth in 2020


[0.27] Looking at the year just passed, it has been a very strong year for equities, what has been driving the market?

  • Unusually its not earnings
  • If you decompose the returns of global equity markets, so far this year – the first 11 months, we find that actually only 17% of the returns are generated by earnings
  • Remainder has been generated by valuation expansion, that can be traced back to a number of factors including, much easier central bank liquidity, The Fed has cut interest rates three times, ECB has cut rates, The Fed has increased its asset purchases, People’s Bank of China cutting rate. So a lot of these easing of liquidities has helped the markets recover
  • Starting to see signs of trade protection easing between China and US
  • Combination of these factors that has driven up the equities which has contributed to the returns this year

[1.30] Can we see this changing next year? Will the market start to get more discriminating on earnings and start to differentiate between different types of company?

  • Absolutely, if you look at what is going to happen in 2020, we envisage a complete reverse of those returns being generated more by earnings generation rather than valuation expansion
  • we know looking at the future market that The Fed is likely to cut rates just once, if at all
  • probably expect a rate cuts coming from the ECB
  • key here will be whether there's delivery of the earnings expectations for 2020 and currently they're about 10% (Thomson Reuters Datastream)
  • we think some of the underlying fundamentals behind that are actually
  • quite conservative, for example if you want to look at sales per share, the top-line sales growth of companies, it's only expected to grow by four and a half percent and that's equivalent to nominal GDP for the global economy and that's roughly in line with it
  • so I think that's a fairly conservative estimate, the risk here of course would be that if we have profit margins start to be eroded by say higher labour costs, then that would be a net negative on earnings and there may be a risk that companies fail to deliver on those earnings expectations
  • our base case is that 10% earnings (Thomson Reuters Datastream) growth next year it seems fairly conservative and achievable

[2.54] Looking more domestically now, obviously we've got an election coming up now, labour has come out with its manifesto and clearly there are some risks in there for them equity market. How do you view it, and then to what extent of those risks priced in what do you say?

  • I don't think those risks are entirely priced, even for the risk of a Labour government
  • to give you an outline of what the Labour government has set what they're going to do in their manifesto, the first thing is it's going to be a lot more spending going on
  • from the current level of spending which is both day to day spending and capital investment, it's 40% of GDP (Resolution Foundation)
  • over the five-year term, labour they expect that to rise to 45 percent of GDP which would be the biggest increase in fact since the 1970s
  • if we look at what the Tories would say, that's a comparison, there you expect on one percentage point increase from 40 to 41% (Resolution Foundation) over the term of their Parliament
  • saying that, that's still quite a large increase for the Tories, the largest increase going all the way back to Harold Macmillan in the early 1960s
  • but apart from looking at the increased government spending and the risk of what that would entail or how it's going to be funded, I think the bigger issue about the UK market is that within the late manifesto, they basically talk about expropriation of assets
  • what we're talking about is something called inclusive ownership funds and this is basically every year the state will take 1 percent shareholder capital or dilution or shareholder capital every year for 10 years on companies on more than 250 employees, that's going to completely spook foreign investors and domestic investors
  • on top of that they have some other policies, for example if companies are not seen by the labour party as being green enough, they can indeed find themselves being deselected from the London Stock Exchange, again that will have an underlining impact on confidence in the UK stock market
  • so I think instead of just looking at the overall spending which looks
  • unaffordable, we should also look at some of these expropriations and I think
  • that's a bit scarier for investors and the bigger risk.

Okay so it could be ramifications for the bond market from the debt side and for the equity market?

  •  exactly from both angles

[5.20] To your mind that's not sort of fully priced and I mean the market does still seem to be expecting a Tory majority?

  •  the UK market is quite cheap at the moment, but it has been recovering certainly sterling has been coming on the expectations that you'll get a Tory majority government
  • the risk here is that Boris Johnson and the Tories actually might end up with a minority government
  • it's worth bearing in mind that the weather forecasters are forecasting that we're going to have snow on the election day, that may effect their own Tory voters
  • there is a risk here, if Boris doesn't get his so-called majority, then Jeremy Corbyn would have a next stab at trying to form a government, he’d have to probably get into bed with the SN and the LibDems to form his government, that may force you to water down some of this policies, some of the extreme policies
  • but then nevertheless Jeremy Corbyn wants to be able to form a government even in its fragile
  • he would have implications to the market because people would have or investors have a lot of uncertainty about what exactly Jeremy Corbyn John McDonald Head of Chancellor would actually impose - those are key risks

[6.30] Some of the data that coming out of China has looks quite weak but I understand you have a slightly different interpretation on that. Give me an idea of what the data’s look like and you're seeing it.

  • I would use a lot of the government headline statistics with a huge pinch of salt
  • also the fact that a lot of the data is probably not actually measuring the
  • economy as a whole, for example; we saw industrial production growth which is extremely weak in October only to reform with 4.7% (Thomson Reuters Datastream) from a year ago, retail sales that grew at 7.2% (Thomson Reuters Datastream) from a year ago
  • both these figures were quite bleak and they suggest that there's an ongoing deceleration in China
  • however, if you were to look under the hood, there are signs that the consumer remains relatively upbeat
  • on the 11th November, they have something called ‘Single’s Day’ day, which is the biggest ecommerce sales daily sales in the world
  • what we find is that the sales on was up 26% (Thomson Reuters Datastream) on 2018 that particular day so it does show you that actually there is underlying consumer purchasing power coming from the consumers which remains fairly robust
  • on top of that, if you look at some of the policies that China is implemented, we're talking about increased credit into the overall economy and that traditionally is seen as a leading indicator of economic growth and that’s been steadily been improving
  • it's offsets some of the shadow deleveraging that we’ve seen, we've had more bank loans, which is much more transparent, we see it's much more positive growth going forward at least in terms of stabilizing growth

[8.22] So actually China can continue to be this sort of engine of global growth that it's been before?

  • Indeed, it'd be inevitable that Chinese growth will start to decelerate as the company economy gets bigger
  • it just gets bigger, more difficult to expect at that sort of rate once the economy gets a lot larger
  • we also got to take into account the demographics are not very supportive of long term growth in China, as the country gets older, the population starts to decline, we started to see the working age population start to fall in China this inevitably will lead to some deceleration growth
  • so it should be feared to some degree, the key question is, is it rebalanced and is it more sustainable?
  • what we're talking about is, is the growth derived more from consumption, which it is - an example of when sales growth is coming from and the fact that the government is implementing some counter secret policies to support the overall growth rate of the economy
  • what you see next lies statistics, one I think they're out of date and it's not taking into account the strong growth we've seen in the e-commerce market and two – yes it'd be inevitable have indicated by demographics that you should have some deceleration in growth

[9.35] Do you have a view on the outcome of the trade tensions for 2020?

  • I think as we get closer and closer to November the third 2020, when we have the US presidential election, I think it's increased likelihood that President Trump will probably not escalate the trade wars
  • we may not necessarily get a deal probably won’t, we will probably get a pause and that could be sufficient
  • I think a key question mark will happen on the 15th of December, whether President Trump actually goes ahead with more training terrors it's not clear what's going to happen there, but as I suspect how to get closer and closer towards November next year that some of the trade protection rhetoric will calm down
  • on top of that, if you look at the other side from China’s point of view, they already have a lot of problems on their hand, there's lots of unrest as we can see in Hong Kong, on the 11th of January we have another election in Taiwan - their presidential election
  • obviously, the Chinese are looking very closely to that one
  • taking into account the slowdown that seen in the economy, the last thing that Chinese want is to accelerate the trade protection war with the US
  • one final note to remember is that, if you look at the Democrats they sound a lot more hawkish in terms of trade protection with China , so for example Elizabeth Warren who's been one of the stars on the progressive left for the Democrats, she's talked about that any trade deal that China would include how to include human rights and also climate change that's going to be far more difficult for the Chinese to accept than the current deal that's on the table with President Trump
  • so with that in mind, I think we’ll probably see moves from both sides towards at least a pause, not necessarily a deal at least a pause and not an escalation in trade protections

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This episode was recorded on  4/12/2019

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Podcast information:

The Pulse from Smith & Williamson

Investment Show: It’s all about earnings and growth in 2020

Episode 4

Broadcast on Smith & Williamson at 09:00, 4th of DECEMBER 2019

Available online from 10:00 on the same day .

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