Analysts, consultants and asset managers have all been weighing in with their 2019 investment outlooks, forecasts and reports. Many are emphasizing the geopolitical and macro-economic risks that are bearing down on the market. Cambridge Associates shares those concerns. “But we also look at fundamentals and valuations, and the picture there is a little less gloomy for global equities, said Sean McLaughlin, head of capital market research at Cambridge Associates. The firm is predicting high single-digit level total returns for developed equities in 2019.
“Equity valuations in the U.S. are relatively high, but they are much more reasonable in Japan and in Europe,” McLaughlin said. In the developed markets, “we are starting out with dividends of 2.5% or so, so if you piece together chunky dividends yields and reasonable earnings growth expectation for 2019, you’d be looking at high single-digit returns.”
Forecasting returns for assets one year ahead is no easy task, “but looking at bootstrapped expectations (expected dividend and earnings growth) is one way to estimate,” he said. “While valuations are high in the U.S., they are not that high for developed markets, taken together as a full package, because they are low in parts of Europe,” McLaughlin explained.
“The other aspect that is important to keep in mind over a one-year time horizon is that starting valuations do not have a huge impact on subsequent returns. Over a short time horizon, the impact of starting valuations is often swamped by changes in investor sentiment or other factors; over a longer horizon, starting valuations are more closely tied to subsequent returns,” said McLaughlin.
According to the Cambridge report, Outlook 2019: More Risk for Less Return, investors in all types of asset classes should be looking at a combination of fundamentals and changes in earnings relative to expectations, as well as any changes in the macroeconomic environment relative to expectations. “We do have concerns about the macro-economic environment,” said McLaughlin. Many are the same that impacted investors in 2018, and political risks are elevated, he said. “It is well known that there is potential for further tariff expectations, you have the March Brexit deadline, the Italy budget stand-off with the EU (European Union) and other geopolitical head winds, together with slowing economic growth.”
Central banks play big role
Central banks maneuvers will continue to play an important role in the performance of emerging markets, bonds, real assets and developed market equities, McLaughlin said.
“On the Central bank side, there has been a reversal of the quantitative easing (QE) that boosted Central Bank assets by 60% from the end of 2013,” McLaughlin noted. “After peaking early this year, central bank balance sheets have shrunk by $800 billion already, and even if the Fed pauses this winter, it’s unlikely to be done with this rate-boosting cycle.” Future rate increases could put future pressure on developed and EM stocks for dollar-based investors, he cautioned.
Another way that Central bank tightening in the US will impact demand for bonds is that “if you think about interest rate differentials for the U.S. vs Europe, it makes it difficult for a currency hedged investor in Europe to buy Treasuries, after the impact of hedging costs, because they are not getting the 3% yield that a U.S. investor is getting in Treasuries,” said McLaughlin. “The currency hedge bakes in the substantial interest rate differential between the US and Europe, so investors outside the U.S. are going to be quite reluctant to buy Treasuries, and that is going to a be big headwind for the bond markets,” he said.
Preparing for the bear
Cambridge is also advising investors to develop a strategy to help navigate an eventual recession-related bear market. “It’s not our central view that it’s coming in 2019, however, it’s late in the cycle, and we think it’s important for developing a strategy to navigate the bear market,” McLaughlin said. “If you look at liquidity, the sources and the demand for liquidity will vary from one investor type to another, and one asset owner to another, but it’s important to evaluate the sources and uses for liquidity,” he advised. “It’s also important to ensure that the portfolio has exposure to a wider variety of compensated risk, not one or two economic drivers, so investors should also consider incorporating uncorrelated strategies into their portfolios.”
It’s also important to ensure that the portfolio has exposure to a wider variety of compensated risk, not one or two economic drivers, so investors should also consider incorporating uncorrelated strategies into their portfolios.
With the yield curve flat in the U.S., Cambridge is also recommending that U.S. investors consider holding some short-duration bonds and cash in place of long-duration bonds, if they hold bonds to provide a source of ballast against poor economic environments, rather than as a pension liability hedge. “The carry from the bond portfolio is similar at the short and long ends of the curve, but the interest rate exposure at the short end is much less. So consider positioning toward the front end of curve, because the yield curve is so flat,” he said.
Overweight emerging markets and underweight the expensive US market.
Current geopolitical challenges are significant for emerging market (EM) equities, as Central banks are pulling back on qualitative easing, the Cambridge report continued. “Until recently, they were rowing in the same direction as investors, and now they are rowing against investors, both in terms of raising rates in U.S. and in terms of the qualitative easing process being reserved,” McLaughlin said. An additional challenge for investors is that China’s growth is downshifting, while there is the prospect that that tariffs could increase at the same time, he said. “However, the strong fundamentals and attractive valuations may outweigh these well-known challenges over the medium-to-long term,” continued McLaughlin.
“Fundamentals of EM companies, overall, are in reasonable shape with return on equity being the highest it has been in four years. It’s above the return on equity in the EAFE landscape, or the developed markets ex-US.,” McLaughlin said. Earnings growth for EM companies is estimated to come in at 13% for 2018 and 10% growth for 2019. “While it doesn’t have a huge impact on next year returns, valuations for the EM are quite reasonable. We calculate the normalized PE ratio for EMs and compare it to its history and it’s in the 30th percentile ratio back to 1995, so higher than it is 70% of the time, so those are quite reasonable valuation levels,” McLaughlin contends.
China’s influence on the markets
China may be the most important market in the emerging markets, both in terms of its own weighting in the EM index, and it’s overall influence on the other markets, according to the report. It’s the market to focus on, as China growth is leveling off, said McLaughlin. “Chinse debt has increased dramatically since 2010, from 120% of GDP to 164% currently, but it has leveled off over the past two years. That curtailed debt growth is by design; but it has slowed economic growth in China this year to about 6.5%, and expectations are for about 6.3% growth in 2019, which is still robust growth, but below levels that China was seeing 7 or 8 years ago,” he said.
Challenging environment for commodities
Commodities related investments have done poorly this cycle and commodities futures, in particular, have suffered because of the roll yield. “The impact of rolling futures contracts into the next available contract (typically at an elevated price compared to spot prices, when commodities are in contango), has detracted from total returns substantially since commodity prices bottomed in 2009,” McLaughlin said. “We continue to see negative roll yields from contango as a headwind and would advise investors to consider natural resources equities as an alternative to commodities, as valuations there are reasonable,” he noted.
Potential for UK equities to shine in 2019?
UK equities may have been written off by institutional investors, because of significant political risk in the country, due to the Brexit vote. “At the same time, the nature of those risks is known to investors and their valuations are cheap, so if the Brexit outcome is better than anticipated, it could end up being an excellent year for UK assets,” McLaughlin surmised. “We characterize UK equities as being the dark horse of 2019,” he said. “But making that bet is not necessarily something we would advocate, given that it’s a political outcome that we don’t have an edge in predicting. Given valuations, a neutral weighting seems to make sense,” he advised.