What a difference a quarter has made. When our equity investors met in late September, the mood of the group was more subdued than usual, and when asked about likely equity market returns over the next 18–24 months, “below average” was the most popular response. Two concerns were weigh¬ing on us: first, the risks to profits growth posed by higher interest rates and growing trade frictions, and second, signs of froth in the technology sector, which had been leading the markets higher.
Three months later, we are again feeling better about the outlook for equities, and we also see some interesting opportunities to add value within markets. True, the prospects for corporate profits growth have been fading and earnings forecasts have been slipping around the world. But profits are still increasing, and the modest deterioration in the outlook is, in our minds, more than offset by the significant drop in stock prices since early October. When that decline is set against the backdrop of reasonable growth, it takes equity valuations to a much more interesting place for longer-term investors. If 2018 began with complacency and even euphoria, the year ended on a very pessimistic note, and we think this dramatic shift in mood has created opportunities (EXHIBIT 1). Growth stocks have been as hard-hit as markets overall and look much less frothy these days, although the bigger opportunity may well be ahead for value investors, with the gap between the two styles still at historically very wide levels. And international markets have finally started to perform better on a relative basis. At the time of writing, markets have quickly recovered almost a third of the ground lost in Q4, but the risk-reward picture still looks better to us than it did back in September.
The world is, of course, not free of worry, and we do think that profit expectations are still a little too optimistic in the near term. In the technology sector, for example, the semiconductor cycle has rolled over, and the trend toward longer smartphone replacement cycles is becoming more obvious, although, importantly, enterprise technology spending is still robust. In the energy sector, market expectations haven’t yet caught up with the dramatic collapse in oil prices during the second half of the year. More broadly, with global growth cooling down and inventories built up last year in anticipation of tariff increases, business will be slow for many industrial companies in 2019. But we think enough bad news is now discounted for investors to start thinking about what could go right. Modest interest rate increases and healthy consumer demand could prolong the U.S. economic cycle for some time to come. Most importantly for us, our work suggests that the level of opportunity in many areas of the global equity market is now clearly above average.
Profits growth will clearly decelerate this year, and market expectations are probably still too high, but we don’t see a meaningful downturn developing any time soon. This year looks to be one of mid-single-digit profits growth globally, with the U.S. once again outperforming the global average, but by less than during 2018. Looking out beyond 2019, our research indicates that profits are now modestly above trend in the more cyclical sectors, including industrial/commodities, automobiles and parts of technology. As a result, profit declines in these groups should be expected (and, indeed, current low multiples suggest that they are).
EXHIBIT 2 presents a snapshot of our outlook.
In 2018 earnings grew, but lower multiples led to negative returns
EXHIBIT 1: SOURCES OF TOTAL RETURN IN 2018
Source: J.P. Morgan Asset Management; data as of December 31, 2018.
Views from our Global Equity Investors Quarterly, January 2019
A subset of survey results are shown for Global Equity Investors Quarterly participants, taken in January 2019. These responses are taken from a quarterly survey, representing 35 CIOs and senior portfolio managers across global equities.
After a long wait, the opportunities for value investors are finally much more interesting. Many of our portfolio managers want to see how the current economic slowdown plays out before they take a lot more risk, but in the value space there are already plenty of opportunities. Financial stocks have performed poorly throughout the last year even as profits and dividends have continued to grow in many instances. While we would pay close attention to quality in this group after a long period of benign credit conditions, we think that many banks and insurance companies have been treated unreasonably and now look interesting. Many small cap names appear more attractive to some of our value investors; in particular, leveraged small cap companies are in certain cases trading at levels not seen since the 2008 financial crisis. At current valuations, we reckon that small caps look more attractive than they have about three-quarters of the time over the past 28 years. With significant pessimism priced in at these levels, small caps may present some compelling opportunities.
By region, our U.S. equity investors are the most optimistic as we enter 2019. U.S. stocks sold off as hard as any late last year, and valuations based on profitability look very reasonable again. Meanwhile the near-term trends in profits growth look more dependable than other regions, with the U.S. economy continuing to outperform, although we are expecting much less earnings growth this year after almost 20% in 2018. Both growth and value styles have merits, while defensive stocks look richly priced again after outperforming in the recent correction. While valuations are not as attractive as they had been before the recent rebound, we think that the balance of risk-reward still favors investing at these levels.
Looking back, 2018 was not just a poor year for markets but also a difficult one for many investment managers looking to beat the markets. Our International Behavioral Finance team found that returns from a classic combination of value, quality and momentum factors, for example, ranked in the 93rd percentile of experience over the last 23 years (EXHIBIT 3), with none of the three components faring well. Frustrating as this has been, it also very likely creates opportunity given the long-run success of these factors, and many of our investment teams see unusually good prospects for adding value from this starting point. In addition, our U.S. Core research team’s measure of dispersion between attractive and unattractive stocks is wider than we have seen 90% of the time over the past 32 years; this is typically a good indicator of better returns ahead.
Style factors did not perform well in 2018 - is this a sign of better opportunities ahead?
EXHIBIT3: ROLLING 12-MONTH GLOBAL STYLE FACTOR RETURNS (1995–2018)
Source: J.P. Morgan Asset Management; data as of December 31, 2018.
As U.S. profit margins have surged in recent years to record highs, we are watching carefully for signs of deterioration. Potential problems include rising wage costs (mostly a problem for low margin consumer discretionary companies, such as restaurant chains with large workforces) and, of course, the impact of new tariffs and trade restrictions on the highly globalized and fabulously profitable technology sector.
Indeed, we think that “trade and tariffs” still deserves a separate mention as a continued risk for equity markets. The expansion in manufacturing profitability, led by technology companies, over the last 20 years has had a large positive impact on overall market profits, and investors are correct, we think, to pay close attention to the impacts of any changes in trade policy, unpredictable as they are.