International equities: Subdued expectations may lead to positive surprises

As 2019 draws to a close, the year has seen a welcome rebound for global equities after the sharp sell-off seen in late 2018. This rally has occurred despite weakening indicators so a key question facing investors is whether stabilization in growth/activity is now close at hand.

The big picture: Earning and Valuations

Earnings

In late 2019, many activity indicators (e.g., Purchasing Managers’ Indexes, industrial production, gross domestic product growth (GDP), inflation, and earnings growth) have continued to be revised downwards. Consensus global real GDP is expected to grow slightly less than 3% in 2020, after gradual declines each year from 3.8% growth in 2017. Consensus earnings growth for the MSCI World Index in 2019 is now expected to come in below 2% but to rebound +10% next year. The latter appears optimistic and inconsistent with the subdued GDP growth expectations and still deteriorating leading economic indicators. Estimate downgrades have been concentrated in commodity and cyclical sectors and the only time we have seen larger negative net revisions has been in recessionary periods.¹ Increasingly, the data suggest accommodative fiscal policy will be necessary to underpin earnings growth expectations in the coming year. Key risks to growth include the outcome of the U.S.-China trade negotiations and the adequacy of monetary and fiscal policy. While monetary support has begun, the timing and magnitude of fiscal assistance is less clear.

Valuations 

The MSCI AC World Index has been trading on a forward P/E of 15x, in-line with the long-term average, supported by low inflation and stimulus from central bank policies. Underneath this headline number, two particular items stand out in our minds, namely (i) the valuation discount for international equities versus the U.S. market – represented by the MSCI AC World ex-U.S. Index and MSCI USA Index respectively –is close to a multi-decade high, and (ii) the premium being paid for growth over value areas of the market should give long-term investors pause.²

Regional highlights

Europe

• Macro and geopolitical uncertainty continue as hopes for a second half 2019 growth acceleration did not materialize. Estimates for Eurozone GDP growth in 2020 have eased to +1% and this weaker growth outlook is reflected in lower corporate earnings expectations.³
• The two main drivers of uncertainty in Europe remain Brexit (with the upcoming December 12, 2019 U.K. General Election and revised January 31, 2020 Brexit deadline) and the U.S.-China trade war (where Europe is not a primary actor, but its cyclical export industries are certainly feeling the headwinds).

• In response to the weaker growth trends outgoing European Central Bank (ECB) President, Mario Draghi, cut interest rates on bank reserves (the first rate cut since 2016), the ECB is restarting quantitative easing in November 2019, and Mr. Draghi campaigned for fiscal stimulus from Eurozone governments.⁴

China

• The pace of progress towards a meaningful and complete U.S.-China trade deal can drive the market but expectations remain low given the geopolitical nature of the tensions.
• From a macroeconomic perspective, these trade tensions have contributed to China’s overall weaker macro picture. China’s outlook may soften further as manufacturers diversify their supply chains to other countries.
• China continues to stimulate, and we expect to see more countercyclical spending in 2020. That said, without a trade deal forecasts for 2020 GDP may be trimmed to 6% or below.⁵

Emerging markets

• Emerging market equities as a whole have lagged the U.S. and international developed equity markets in 2019. Headwinds have included negative headlines on slowing economic growth and the trade wars.
• However, there has been large dispersion in returns, allowing careful stock selection to provide attractive returns (e.g., in China consumer stocks versus exporters).
• Valuations look attractive relative to other markets; we believe they offer attractive long-term risk/reward potential although the positive catalysts (e.g., on trade, interest rates, weaker USD) are currently difficult to predict or time.

Three points to consider

• In our view, perhaps the most relevant question facing investors is whether we are on the cusp of stabilization (or further deterioration) in growth and leading indicators. High-quality and defensive growth stocks have remained in favour in the uncertain environment where growth is scarce. We believe they are likely to continue to do well (versus more cyclical sectors and export-oriented businesses) until earnings trends start to improve. Given the strong increases in stock prices in 2019 year-to-date (despite muted earnings growth) it seems reasonable to assume that the key driver of stock returns in 2020 is more likely to be earnings growth (rather than valuation expansion).
• The valuation premium for growth stocks versus value stocks has risen to extended levels – this is a trend we are seeing globally and reflects investors’ search for companies with more confident growth outlooks in a period of low growth and uncertainty. However, macro-sensitive names could generate outperformance if we were to see higher than expected government stimulus or an improved macro-economic growth outlook.

• Key risks to growth include the outcome of the U.S.-China trade negotiations (as it was a year ago) and the adequacy of monetary and fiscal policy. These uncertainties can add volatility to the markets and provide opportunities for long-term investors like ourselves to buy high quality growth stocks at more attractive valuations.

In conclusion

• A sustainable shift in leadership remains heavily dependent on a rise in bond yields led by higher real growth and inflation. Surprises from trade or concerted fiscal policy may lead to stronger growth expectations which – if they were to emerge – could have positive implications for some emerging markets or non-U.S. stocks, where big valuation disconnects exist after an extended period of U.S. outperformance.
• Our team takes a long-term view of Earnings, Quality and Valuation (EQV), seeking to mitigate risk by owning a portfolio of high-quality businesses with sustainable growth potential, low levels of debt and by not overpaying for the strong fundamentals. The momentum environment of 2017 and the first half of 2018 was a challenging one for our balanced EQV approach, but it has returned to favour since mid-2018, providing a pleasant tailwind for performance.