Q3 Outlook: managing through the frustratingly slow recovery

After an extremely strong first quarter, the second quarter also finished in positive territory thus confirming a strong first half of the year for global markets. In our second quarter outlook we highlighted that markets would be ‘desperately seeking reassurance’ on three fronts, namely –Geopolitics; Macro outlook and earnings outlook from companies.

In reality, 3 months on, sentiment remained volatile and markets remain uncertain on all three fronts. However, what has changed to support markets and THE change since April is that the ‘markets friend’, namely central banks have returned to center stage and the dramatic reversal in monetary expectations around the globe has again proven supportive. This is most evident in the US, where expectations of continued rate hikes at the beginning of the year have given way to expectations of rate cuts beginning in July. In addition, the belief that interest rates globally are now tethered close to historic lows for a prolonged period has also hardened into a ‘lower for longer’ mindset.

We continue to believe that fears of a global recession are overblown at this point, not least making bond markets especially vulnerable from current historic low levels of yield. It is reasonable to argue that we are currently experiencing a pause in economic growth globally but from our perspective its a pause that refreshes. We expect some mild reacceleration of economic activity globally through the second half of 2019 and into next year.

Our central view is that historically low (and negative) cash and bond yields and further reassurance on fundamentals over coming months can further support global equity markets and pressure bond yields higher but we expect absolute returns from here to be more modest. After the strong gains in the first half of the year, it is reasonable to expect that markets will tread water in a narrow trading range in the near term to allow fundamentals to ‘catch up’.

Markets will continue to ‘desperately seek reassurance’ but have a back-stop support from the actions of global central banks. THE key risk remains the future path of China-US trade relations which is currently priced for a fudge/benign outcome.

While our core expectation remains that a gradually reassuring outlook will support further market gains, we continue to monitor the various downside risks. From trade tensions to Brexit related wobbles to potential currency wars these may well inject renewed volatility over coming months.

Asset class outlook: Equities

While central banks continue to inject abundant liquidity and support market confidence at all time highs, we continue to focus on fundamentals which is what ultimately matters. If anything, there is more downside than upside from here from central bank expectations. Therefore the support from equities will be dependent on fundamentals more than sentiment from here,.

Earnings growth expectations have been reduced for 2019, so its important that we also see this bottom out and a more positive expectation emerge into 2020

We continue to argue that overall valuations are at fair value levels and in some cases cheap (e.g. Emerging Markets and Europe to a lesser extent). Across sectors we are concerned by the extent of the over-valuation of pockets such as elements of the technology sector.

Asset class outlook: Bonds

Government bonds are fundamentally overvalued at historically low yield levels. An unexpected deep recession would certainly support government bonds and at current yield levels they are  priced more for a no-growth/no-inflation scenario than for a growth or inflationary one, hence extremely vulnerable.

Conclusion: We expect gains from here to be more modest and in a world short of growth, we do emphasise the importance of income and quality in our stock picking. Given the major change in expectations, Central banks may disappoint from here, highlighting the importance of good old fashioned fundamentals!

After a relatively torrid final quarter to 2018, equity market returns were extremely strong for the first months of 2019, reversing many of the losses of Q4. In a nutshell, the strong rally was predominantly a mirror reflection of what occurred during Q4. Positive sentiment winning out, helped by:

A de-escalation of fears for a global trade war as a result of ongoing US-China trade tensions.
Central banks turning more dovish, particularly the US’s Federal Reserve which significantly changed its interest rates outlook.  The European Central Bank also appeared set to remain very much in dovish mode.
An extension of the Brexit deadline, with a “no deal” exit not at all expected by markets
Within equity markets and across asset classes, riskier sectors and assets generally outperformed with very large US and Emerging Market tech stocks re-emerging as a winner for the quarter.

At KBI Global Investors, our central view is that fundamentals remain supportive for further gains in global equity markets but expect absolute returns from here to be more modest. After the strong gains in the first few months of this year, it is reasonable to expect that markets will tread water in a narrow trading range in the near term to allow fundamentals to ‘catch up’. Economic growth has been slowing but importantly the major world economies are still growing and patient policymakers are again very market friendly in the absence of any significant inflationary fears!

We continue to believe that fears of a global recession are overblown at this point. Reassurance on fundamentals over coming months should continue to support higher global equity markets and pressure bond yields higher again. Returns available on cash and yields on fixed income are negligible and we note that global investor surveys show that investors are positioned very defensively with above-average cash holdings.

Markets are ‘desperately seeking reassurance’ on three fronts:

1) Geopolitical front: seeking positive deal-making between China and the USA and some further progress on Brexit

2) Macro: confirmation of a growing not slowing global economy

3) Micro: despite negative earnings revisions of late, investors will look to companies to provide comfort on the outlook for their earnings

With markets far from complacent we continue to monitor the various downside risks with our core expectation remaining that a gradually reassuring outlook will support further market gains.

Asset class outlook: Equities

The support from equities will be dependent on fundamentals more than sentiment from here, with sentiment having been the predominant driver of the flip-flop between Q4 and Q1.

Earnings growth will be most crucial driver from here, helped by a continuation of the global economic expansion, albeit at a slower pace.

Overall valuations are at fair value levels and in some cases cheap (e.g. Emerging Markets and Europe to a lesser extent). Across sectors we are concerned by the extent of the over-valuation of pockets such as elements of the technology sector.

It is also crucial that we see signs of a stabilisation of the European economy led by Germany and France, and we expect to see corporate leadership via increased M&A activity.  Buybacks and higher dividends will also support stocks

Asset class outlook: Bonds

Government bonds should continue to be avoided as we believe that they are fundamentally overvalued. An unexpected recession would certainly support government bonds and at current yield levels they are arguably priced more for a no-growth scenario than a growth or inflationary one

Conclusion: markets have been strong year to date at a time when many investors have been quite defensively positioned.

We expect gains from here to be positive but more modest. In a world looking for growth, we do emphasise the importance of income and quality in our stock picking. A strong and growing dividend will be increasingly an important source of total return from here.

The final quarter of 2018 proved to be a challenging one for global equity markets with the bulls of the previous decade’s strong equity markets over-run by a combination of fears, notably focused on geopolitical concerns re US-China trade and Brexit, and in parallel a sudden hyped-up fear of an imminent and earlier than expected global recession. The market returns were negative, the more cyclical sectors performed poorly, and the negative market also proved a catalyst for the ‘bursting’ of the FANG bubble with many of the previously high-flying technology names falling sharply back to earth. The final quarter proved to be a battle between fundamentals and sentiment with the latter proving victorious.

So where to from here? At KBI Global Investors, we believe that fears of a global recession are overblown at this point and that fundamentals will prove constructive for further gains in global equity markets. That said, the bull market is quite mature by now, so expect more modest returns from here. Central banks - who for the previous decade have been the prime drivers of markets through their quantitative easing and easy monetary policy – have notably changed their policy stance, starting with substantially higher interest rates in the US, and this has rightly put some focus on some of the more extremely overvalued sectors or stocks within equity markets – a trend that is likely to continue. The ‘easy money’ days are over.

Over coming months, it is likely that markets will struggle to make much positive progress. A key area of focus will be the geopolitical issues of Brexit and US-Chinese trade negotiations. Globally, the latter is a far more significant issue for markets and it is noteworthy that investors appear to be positioning for a more positive resolution so far in 2019, but we caution that such sentiment may prove unfounded and the negotiations may drag on for much longer than many might hope for. In Europe, the Brexit negotiations remain as perplexing as ever with even the most knowledgeable experts being very uncertain as to how this may play out. From a fundamentals perspective, while we believe recession fears are overblown, it is reasonable to conclude that the global GDP growth rates of early 2018 have moderated and we will see more modest growth rates that will likely see some earnings downgrades during the first quarter reporting season. Much of this should already be in stock prices but there may be some vulnerability to downgrades depending on market sentiment at the time.

Beyond these short-term hurdles that may hold markets at bay, we believe fundamentals do remain supportive for equity market progress based on:

• a continuation of the global economic expansion, albeit likely moderated
• continued earnings and dividend growth
• valuations that are at fair value levels and in some cases cheap (e.g. Emerging Markets)
• relatively muted inflation, which will limit central bank tightening  
• progress in trade talks between China and the US
• eventual clarity on the nature of the UK’s exit from the EU
• signs of a stabilisation of the European economy led by Germany and France
• corporate leadership manifest by increased M&A activity, buybacks and higher dividends

As we have written about previously, the bull market has been characterised by investors continuously worried about some ‘issue or other’ for a decade. We always get asked what the next market crisis will be or when the next recession will occur. From our perspective, there are currently no major market or valuation extremes such as characterised and predated other market crashes, and we therefore expect that this bull market and economic expansion will remain a slower and more moderate cycle, without the global crisis of 2008 or indeed the market crash of the early 2000s.

Ten years on from the Global Financial Crisis, the global bull market continues and is now one of the longest bull markets in history with one constant being investors’ constant penchant to be ‘worried’ about something! For ten years the financial headlines have tended to be on the gloomy side and 2018 is proving no exception, yet the market continues to climb apart from some recent days in October! 2018 is proving to be a year which is resulting in material performance divergence between the ‘haves and have-nots’.  We can see a large divergence between the strength of the US equity market and the weakness in Europe and Emerging Markets in particular.  The relatively poor performance of Europe and EM reflects some slowdown in growth, as well as concerns over US trade policy and European politics, while the US market has sailed on merrily.

At KBIGI, our central scenario is constructive, and we forecast a more balanced and positive outlook for the global economy into 2019. The US economy will continue to grow strongly above trend, and European economy will grow at or above trend – though at a somewhat slower pace than earlier this year. We expect that Emerging Markets in general will be solid – while there may be ‘accidents’ in particular, smaller, emerging market economies, as is fairly typical. In the US, the Federal Reserve will continue to raise its key interest rate, with inflation in the world economy generally trending higher but not at an alarming rate.

Of course, the greatest risk to this scenario would be a material escalation of the trade war between the US and China.

For equity investors what is reassuring is to point out that fundamentals of earnings growth, dividend growth, corporate activity etc have been strong during 2018 and certainly not as unbalanced as divergent market returns suggest. From our analysis, it is predominantly investor sentiment that has driven this divergence. At this juncture the US is ‘priced for perfection’ while others such as Europe or Emerging Markets increasingly are priced for a quite pessimistic scenario.

Our base scenario is not bearish on the US equity market, as we expect further gains in equities over coming quarters.  But we do expect to see better returns outside the US. Relative valuations, positive earnings growth and undervalued currencies are key fundamental supports to this with improved sentiment the most likely catalyst for developed markets, while for emerging markets a clear resolution of trade wars will be required.

Looking to the short-term, there are a number of key events or issues in the coming weeks that bear close watching:

• a final decision on the nature of the UK’s exit from the EU
• results of the US mid-term elections in November
• progress – or not – in trade talks between China and the US
• corporate profit growth during the forthcoming earnings season
• the outcome from Italian budgetary negotiations

We will continue to monitor these and other issues but for now we remain reasonably constructive on equity markets though we continue to favour non-US markets.  We are encouraged by the fact that so many market participants worry about when this economic cycle will end – this itself shows that markets are not ignoring important risks. 

Asset class outlook: Equities

Our central scenario is as outlined. As per our Q3 update, a material deterioration in US-Sino relations on trade remains the largest equity market risk event we believe.

Apart from relative attractiveness of many non-US developed and Emerging Market markets the same can be said across industry sectors and investment styles. For some time, we have cautioned on the valuation levels of growth and momentum driven styles and highlight the attractiveness of many more value-oriented sectors. Growth has been driven to extreme levels of outperformance by the cheerleading and momentum investing for FAANG stocks in the US and similar names in other markets such as Emerging Markets. Many value-oriented stocks and sectors are much more attractive investments we believe. For these names, stock prices have not reflected the strong underlying fundamentals of earnings, cash flow and dividend growth. For non-growth/momentum stocks poor sentiment rather than underlying strong fundamentals has been the winner, we expect this to reverse.

We are ever conscious that we are at the mature stages of a long bull market and as such when building equity portfolios downside protection is more important than ever. To that end we continue to emphasize quality stocks in our portfolios and focus consistently on items such as not owning:

-Companies carrying excessive debt on their balance sheets

-Excesses of valuation e.g. certain technology stocks

-Companies funded by more expensive corporate credit

 Asset class outlook: Bonds

Government bonds should continue to be avoided as we believe they are fundamentally overvalued and remain vulnerable. An unexpected recession would certainly support government bonds

To conclude, the fundamentals remain supportive for further gains in global equity markets but absolute returns from here should be more modest as we are at the mature stage of a bull market. Within markets there is an extreme positioning between ‘haves and have-nots’ and this is something we expect to reverse. The potential for a trade war is the biggest risk.

After almost a decade of a relentless equity bull market, global markets are struggling to make any gains so far during 2018. We have for some time highlighted that a transition from a central bank liquidity driven to an earnings driven market would be tricky and likely volatile and indeed this has been the case. Markets have been further restrained with additional uncertainty arising from trade tensions continuously emanating from the USA.

Our central scenario remains that we are in a synchronised growth phase for the global economy and that this will last for a few more years. We do not believe we are at the end of the current economic cycle but do acknowledge that any risks to this view are skewed more to the downside, in particular factoring in the risk of trade wars. Despite strong earnings growth and resilient prospects for further growth, investors have over recent months been more risk adverse with markets remaining in the doldrums.

We expect further upside for equity markets over the next 12-18 months but equally highlight that there are short term challenges and markets may find it difficult to make much progress over coming months:

• Geopolitics, especially trade wars. A full blown trade war, while not our central expectation would be a major negative with nobody a winner. Emerging markets would be in focus.

• The politics of Brexit and also some political instability in Germany and Italy. US mid-term elections will be a focus also.

• Any signs of further increases in inflation will raise concerns about further interest rate rises and higher bond yields.

• The fact that the abundant liquidity of recent years will continue to diminish with quantitative tightening ongoing by the FED and the end of  quantitative easing forthcoming by the ECB.

In summary, a positive medium term outlook but reasons to expect little progress in coming months.

Asset class outlook: Equities

Our central scenario is as outlined. Absent a material trade war (as distinct to fears of same) we don’t expect an imminent material correction in equity markets nor a bear market.

The equity bull market has been strongly and increasingly  driven by a narrow list of growth and momentum stocks and sectors. The relative valuation argument has not mattered during this phase with growth trouncing value. We have seen this before and not least during the technology bubble of the early 2000’s.We believe that as confidence is restored in a synchronized global economic cycle, that a rotation within the equity market and more towards more economically sensitive sectors and style stocks will occur. This should lead the next upward phase of the equity market. It is also critical that companies continue to delivering earnings and dividend growth for this to happen. EM should benefit in this scenario.

A theme of ours over recent quarters in portfolio construction has been and will continue to be one of avoiding what we believe to be excesses that may have lots of associated downside potential such as:

• Companies carrying excessive debt on their balance sheets
• Excesses of valuation e.g. certain technology stocks
• Companies funded by more expensive corporate credit

Asset class outlook: Bonds

Government bonds should be avoided as we believe they are fundamentally overvalued and remain vulnerable. An unexpected recession would certainly support government bonds

To conclude, the fundamentals remain supportive for further gains in global equity markets but expect progress to be slow. A switch from liquidity to stronger earnings growth is where we will focus our stock picking and we stick with our view of rotation within the market. The potential for a trade war is the biggest risk

Global equity investors entered 2018 seemingly happier than at any stage since the bull market began during the first quarter of 2009. As investors, we are generally happier when the consensus is worried and we highlighted some concern about this very point at the beginning of the year. Now, after a volatile and tricky first quarter, investors are generally more concerned again with many geopolitical concerns dominating the headlines and markets exhibiting more volatility than they have for many years.

From a fundamental perspective, the global economy is experiencing a strong synchronised growth led by the US and with Europe hot on its heels. Despite a tricky first quarter for equities and bonds, we remain constructive for coming quarters. Global equity valuations, after the recent setback, are closer to fair value and supported by strong and broadening bottom-up earnings growth. This will be THE driver of equity returns we believe, with central banks now firmly in the back seat. Global earnings (boosted by large US tax cuts) are growing at a healthy pace.

While generally positive in our outlook we do expect that the next coming quarters for equity markets will be more volatile. There are many reasons to expect such volatility to remain:

• Geopolitics, including trade wars, Brexit, North Korea etc.

• We are later stage in the economic cycle so markets are much more sensitive to higher inflation data and stronger economic data.

• The fact that the abundant liquidity of recent years will diminish as central banks tighten policy and remove quantitative easing.

• It is also reasonable to anticipate a phase where perhaps economic growth slows for a quarter or two.

In summary, a positive outlook but expect more moderate returns than recent years.

Asset class outlook: Equities

Our central scenario is as outlined. While we do expect equity volatility to be more of a feature we do not expect an imminent material correction in equity markets nor a bear market.

We are in a new phase for the equity market cycle. The previous strong phase was best characterised by abundant liquidity and scarce economic growth, which led to the equity market itself rewarding a very narrow list of technology names-the FANG’s. The phase we are now in, should best be characterised as having growth that is expanding and liquidity that is shrinking. The consequences of this for us as investors is that we expect to see a more meaningful rotation from very expensive growth-type technology stocks to a broader more value-focused leadership. Indeed the technology sector itself may also be more vulnerable to regulatory oversight which is topical at present.

Later in the cycle we look increasingly to avoid excesses:

- Increased corporate leverage (funding share buybacks)

- Excesses of valuation within markets e.g. technology stocks

- Companies funded by more expensive corporate credit

- Speculative crazes e.g. bitcoin

Asset class outlook: Bonds

Government bonds should be avoided as we believe they are fundamentally overvalued and vulnerable . If incorrect in our view, it will be for example a political crisis or unexpected slowdown in growth which will be bond market positive.

To conclude, the fundamentals remain supportive for further gains in global equity markets but expect a trickier and more volatile path. Investors are less bullish today which we like. A switch from liquidity to stronger earnings growth is where we will focus our stock picking. We do anticipate more rapid style leadership change as the year progresses.

Noel O’Halloran
Chief Investment Officer

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. The views expressed in this document are expressions of opinion only and should not be construed as investment advice.

It’s not long since we wrote to you with our 2018 outlook, but already global equity markets have experienced a roller-coaster from reaching all-time highs barely a week ago to the dramatic pullback of recent days that is hitting the headlines. As such, we felt it appropriate to provide you with a summary perspective.

Up to recent days the US stock market had set a 90-year record for the longest period without experiencing a 5% or more setback, so to ourselves and many others a setback was not a surprise and was clearly overdue. The only question was always, what would cause it and when would it occur? To put this in context today (February 6th) equity markets are in or around where we started 2018.

Over recent days equity markets have tumbled and volatility has surged, sparked – apparently -  by concerns over rising US wage inflation and subsequent rising bond yields. The first phase of the sell-off in many ways was completely understandable, reacting to stronger economic fundamentals and was merely unwinding some of the equity markets euphoric gains of the first weeks of January. In our beginning of year outlook piece we highlighted the vulnerability of bond markets to higher inflation, so we were not particularly surprised by this development. Over recent days we have endured arguably a second phase of the drawdown which is very different and predominantly an equity event (with bond markets rallying over the past 24 hours). The cause is largely technical and the focus (and blame) is being squarely focused on the fact that the dramatic rise in equity volatility of recent days has impacted many popular equity strategies of recent years such as ‘Risk Parity’ or ‘Target control Volatility’ strategies that target a certain volatility level. These have had to react to the massive spike in market volatility which forced them to sell hundreds of billions of equities to ‘square up’ and rebalance to the target volatility objective of the strategy. While we appreciate this is very technical, it hopefully explains why the move appears to be so dramatic, and to put this in context the volatility spike of recent days was greater than that experienced during the Lehman/Bear Sterns collapses, the US Government debt downgrade in 2011, the Brexit referendum result or the Flash Crash of 2010. This will likely take a few more days to settle down.

For your portfolios we remain very confident in the fundamental supports of strong economic and (in particular) earnings growth. We do expect inflation to pick up but importantly we do not forecast inflation rising to an “overheating” level this year such that it is a material challenge to central banks and therefore equity markets. As such, we do see this current ‘panic’ as a meaningful correction but not the end of the bull market. It is also a reminder that we are in the later stages of this extended economic cycle and that any excesses in the markets, such as excessive valuations, high debt levels, mispriced volatility etc are vulnerable to being exposed and punished by markets. We are ever mindful of this when constructing your portfolios and continue to emphasise better growth, better value and better quality when constructing your portfolio(s).

It is very early days in this correction to draw any discernible conclusions as to where safety is to be found within equity markets as to date the sell-off appears to be indiscriminate and those who are selling are primarily targeting liquidity rather than any particular sector and style preference. Over coming days and weeks this should become more evident and we in the meantime will continue to prudently manage your portfolios focusing on the strong fundamentals we currently like.

Noel O’Halloran
Chief Investment Officer

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. The views expressed in this document are expressions of opinion only and should not be construed as investment advice.

It’s not long since we wrote to you with our 2018 outlook, but already global equity markets have experienced a roller-coaster from reaching all-time highs barely a week ago to the dramatic pullback of recent days that is hitting the headlines. As such, we felt it appropriate to provide you with a summary perspective.

Up to recent days the US stock market had set a 90-year record for the longest period without experiencing a 5% or more setback, so to ourselves and many others a setback was not a surprise and was clearly overdue. The only question was always, what would cause it and when would it occur? To put this in context today (February 6th) equity markets are in or around where we started 2018.
 

Over recent days equity markets have tumbled and volatility has surged, sparked – apparently -  by concerns over rising US wage inflation and subsequent rising bond yields. The first phase of the sell-off in many ways was completely understandable, reacting to stronger economic fundamentals and was merely unwinding some of the equity markets euphoric gains of the first weeks of January. In our beginning of year outlook piece we highlighted the vulnerability of bond markets to higher inflation, so we were not particularly surprised by this development. Over recent days we have endured arguably a second phase of the drawdown which is very different and predominantly an equity event (with bond markets rallying over the past 24 hours). The cause is largely technical and the focus (and blame) is being squarely focused on the fact that the dramatic rise in equity volatility of recent days has impacted many popular equity strategies of recent years such as ‘Risk Parity’ or ‘Target control Volatility’ strategies that target a certain volatility level. These have had to react to the massive spike in market volatility which forced them to sell hundreds of billions of equities to ‘square up’ and rebalance to the target volatility objective of the strategy. While we appreciate this is very technical, it hopefully explains why the move appears to be so dramatic, and to put this in context the volatility spike of recent days was greater than that experienced during the Lehman/Bear Sterns collapses, the US Government debt downgrade in 2011, the Brexit referendum result or the Flash Crash of 2010. This will likely take a few more days to settle down.

For your portfolios we remain very confident in the fundamental supports of strong economic and (in particular) earnings growth. We do expect inflation to pick up but importantly we do not forecast inflation rising to an “overheating” level this year such that it is a material challenge to central banks and therefore equity markets. As such, we do see this current ‘panic’ as a meaningful correction but not the end of the bull market. It is also a reminder that we are in the later stages of this extended economic cycle and that any excesses in the markets, such as excessive valuations, high debt levels, mispriced volatility etc are vulnerable to being exposed and punished by markets. We are ever mindful of this when constructing your portfolios and continue to emphasise better growth, better value and better quality when constructing your portfolio(s).

It is very early days in this correction to draw any discernible conclusions as to where safety is to be found within equity markets as to date the sell-off appears to be indiscriminate and those who are selling are primarily targeting liquidity rather than any particular sector and style preference. Over coming days and weeks this should become more evident and we in the meantime will continue to prudently manage your portfolios focusing on the strong fundamentals we currently like.

Noel O’Halloran
Chief Investment Officer

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. The views expressed in this document are expressions of opinion only and should not be construed as investment advice.