What's Ahead in 2019

Global investing

What's Ahead in 2019

A look ahead to what else may be in store in a year that's already defied many investor expectations.

Our focus for the remainder of 2019 (and beyond)

Unsurprisingly given our long-term time horizon, our focus remains on long-term trends that will shape economies and markets, centered around three mega-trends: demographic change, the future of technology and resource scarcity.

Demographic change remains an important focus for us, both in terms of ageing population trends, urbanisation drivers, ongoing growth in the emerging markets middle-class, healthy living and vanity. All of these trends are very apparent, and there are exciting ways to gain exposure to them for the long term.

The future of technology is a fascinating trend, one that is showing some explosive under-currents, both in terms of cyber security, outsourcing, gaming and bespoke healthcare opportunities – specifically robotics and AI (artificial intelligence) deployed to the healthcare industry at large. We have been focusing some of our research work on continuing to analyse disruptive threats coming from adjacencies of some of the U.S. technology giants, as they keep deploying their substantial cash piles on future areas of growth. One interesting development that has come to the forefront of these U.S. tech giants has been the ongoing regulatory scrutiny, which has stepped up this year, and which is worth following closely given the long-term risk to their business model, even if developments will likely be slow to come through. We have developed a new analytical framework to analyse the technological platforms, to help us navigate around the various companies, and assess all risk exposures.

Finally, resource scarcity remains an important focus both for us, and for the broader market, given the increasing political focus and the popular concerns emanating from this mega-trend. We have continued to work on finding attractive companies that can harness some of the long-term trends, in particular, in robotisation and electric vehicles.

 

The risks in 2019

Geopolitical risks are increasing

On the macroeconomic front, since our 2019 outlook piece, things have become more uncertain on the outcome of trade tensions between the U.S. and other trading partners – not just China, but also Europe, Mexico and Vietnam among others. We believe the outcomes of such trade tensions are more difficult to predict than we initially projected, notably in relation to the U.S.-China tensions, which have taken more than just a trade dimension, becoming political and strategic: the Huawei issue, for instance, is at the heart of such escalation.

The Brexit path remains unclear as we write, fuelling more uncertainty and continuing to impact the UK economy negatively. The change in political leadership further increases the risks of a disorderly Brexit; we re-ran a Brexit stress-test on our portfolios at the start of the year and we are comfortable with our current positioning. The situation is fluid, and the final outcome is still highly uncertain, both in terms of shape and timing, despite the 31 October 2019 deadline.

To add to the geopolitical uncertainty of Brexit and trade tensions, Iran and the U.S. have come close to armed conflict in the past two months, which although didn’t materialise, has heightened the temperature in the region and needs careful monitoring.

Macroeconomic momentum is weakening, but monetary policies are supportive for markets

Global macroeconomic momentum has been weakening, leading central banks to either

  • back-track on their hawkish intentions from late last year, as per the U,S, Federal Reserve turning more dovish at the start of 2019 or;
  • reiterate their dovish stance as per the European Central Bank and the Bank of Japan.

Looking at leading indicators generally, the trends remain soggy, and direction of travel uncertain on aggregate, and somewhat dependent on the trade tensions outcome.

Purchasing Managers’ index (PMI) Manufacturing

Sources: Martin Currie, OECD and FactSet as at 31 August 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Purchasing Managers’ index (PMI) Services

Sources: Martin Currie, OECD and FactSet as at 31 August 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

While central banks’ support is welcome for equity markets, it highlights the fact that the global economic recovery remains fragile, and the strong deflationary undercurrents we have discussed previously remain an important risk for investors. Government bond yields remain very low as a result.

U.S. versus Eurozone bond yield

Sources: Martin Currie, OECD and FactSet as at 31 August 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The weaker economic backdrop is likely to put pressure on consensus earnings estimates globally, which some short-term investors will be particularly sensitive to. We think the downward revisions to earnings could actually be quite substantial in some of the more cyclically exposed names.

Forecast EPS growth – next 12 months

Sources: Martin Currie and FactSet as at 31 August 2019. Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Style rotation likely to become a key talking point

A final area of uncertainty and risk for the remainder of 2019 is around investment styles. The valuation spread between ‘quality’ and ‘value’ is very extended and has reached historic extremes – as shown in the chart below. In the short term, there is a risk of a snapback and rotation out of quality into value.

Price earnings spread extended: Global – growth versus value

Sources: Martin Currie and FactSet as at 31 August 2019. Spread is MSCI ACWI Growth versus MSCI ACWI Value. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

However, we believe that it is very difficult to predict the timing of any style rotation, and such a rotation will be driven in part by monetary policy direction. Indeed, the valuation spread of quality-value has been strongly correlated with bond yields, as the chart below shows. Furthermore, our style is persistently anchored in the ‘quality growth’ space, something that provides an assurance to our investors. As such, we do not spend any time worrying about the short-term style rotation risk. But given that the market is going to spend time discussing this at length, we think it is worth highlighting it as an intra-market risk that investors should be aware of.

Value spread correlates to bond yields (MSCI ACWI)

Sources: Martin Currie and FactSet as at 31 August 2019. Spread is MSCI ACWI Growth versus MSCI ACWI Value. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

What the market has been missing

 
Pricing power remains a key focus

Inflationary pressures have been short lived, and there is growing concern about the lack of inflationary pick up, as shown from central bank actions. Underlying deflationary trends kindled by technological developments highlight the ongoing need to focus on companies with strong pricing power. The market has increasingly been coming to the same conclusion, with many of these companies re-rating since the start of the year.

Recession risk still low for now

The market has been gyrating between fear and calm around the recession risk, although sentiment has recently deteriorated as trade tensions have escalated, yields have been pushed into ever lower levels and yield curves have been inverting across key developed markets. As reported previously, this has typically been a good lead predictor of a pending recession as far as the U.S. yield curve is concerned. This has increased the market fears around the macroeconomic picture. It is important to highlight two things on this topic: (i) equity markets can continue to perform for some time after an initial yield curve inversion, and (ii) there are potentially more technical currents at play pushing yields down into negative territory, which could somewhat muddy the predictability of such indicator. In any case, this is something that the market will be spending a lot of time focusing on, and commenting on. As we mentioned before, we find that a more productive debate should be on shape of any upcoming recession that might come our way in the next 2-3 years.

China is unlikely to hard land

We predicted a renewed pickup in economic momentum in the U,S, and China in 2019 as a potential positive surprise – on the basis of a constructive trade deal and easing of tensions. However, since then, the tensions instead flared up, so we believe this projection is less likely to come through at this stage, although it is still very much dependent on whatever outcome U.S.-China trade negotiations take. There is a lack of visibility on this front to say the least, and we note that both sides are digging their heels deep. To outweigh this less positive outcome, central banks have so far this year surprised the market positively in their shift to being more dovish, which ultimately could be somewhat supportive. In the meantime, the weakening economic momentum in the U.S. and China has been quite apparent. Regarding China specifically, we believe the measures taken by the authorities, both on tax cuts and government spending should ensure that the economy doesn’t hard land, i.e. it should ensure that the GDP growth is in the 6–7% range, although more likely to be at the bottom of that range this year.

M&A will continue to provide support

We mentioned in our original 2019 outlook that there would be a further pick up in M&A activity. This has indeed been the case so far, with M&A deals announced this year amounting to around US$1.4 trillion which is on track to surpass the US$2.35 trillion total in 20181. We estimate that if we annualise the 2019 deals so far, 2019 would end up being 31% higher than 2018 in terms of deal size. Our prediction remains unchanged here – M&A should remain supportive.

And finally, two predictions for the second half of 2019:

An earnings recession is already upon us and could further worsen – with consensus estimates currently standing in a range of +1–6%1 depending on the region, and likely to come down to close to 0% or below in our view, given the weaker economic momentum and the overly optimistic earnings expectations currently in consensus estimates. Further downgrades to be expected for the remainder of the year therefore, despite the already significant downgrades seen year-to-date (consensus earnings growth estimates on S&P 500 for example have gone from +8% at the start of the year, to +2% now, whilst the same figure for MSCI World has gone from +7% to +0%). And worth also highlighting that 2020 earnings estimates are looking demanding, currently sitting at +10% earnings growth for MSCI World.

Brexit delay whilst less likely, is a non-negligible probability still – we think Boris Johnson could potentially fail to follow through on his statement to take the UK out of the EU with no deal. This could be either because he is blocked to do so in some way (Parliament block, loss of snap election), or because it will not be rationally and feasibly possible to enact the threat without it being disorderly for the UK. However, we acknowledge that rationality might not be the focus of the current government, and therefore this prediction is uncertain to say the least.

Our focus remains on long term investing

Given our long-term approach, in a period of increased economic and geopolitical uncertainty, we continue to focus our fundamental research work on finding undervalued companies that have strong competitive advantages. Specifically, those that operate in industries with high barriers to entry, generate high returns, have a good growth profile, and importantly have strong pricing power in a world where there is likely to be a lack of growth for some time to come.

In this context, we maintain our focus on the core components of our investment process: the careful assessment of the risk-reward in choosing stocks, considered portfolio construction and constant risk monitoring to ensure the optimal outcome for our investors.


Footnotes:

1 Source: FactSet as at 31 August 2019.

Definitions:

The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.

Deflation refers to a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.

The European Union (EU) is an economic and political union established in 1993 by members of the European Community. The EU now comprises 28 countries after its expansion to include numerous Central and Eastern European nations.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

Growth refers to stocks of companies whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects.

A leading indicator is an economic or financial variable that tends to move ahead of and in the same direction as general economic activity.

Mergers and acquisitions (M&A) is a general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.

The MSCI All Country World Index (ACWI) is a market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices.

The MSCI ACWI Growth Index is a market capitalization weighted index of those companies in the MSCI ACWI chosen for their growth orientation.

The MSCI ACWI Value Index is a market capitalization weighted index of those companies in the MSCI ACWI chosen for their value orientation.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets countries

The price-to-earnings (P/E) ratio is a stock's (or index’s) price divided by its earnings per share (or index earnings).

Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms. PMI greater than 50 indicated economic expansion; below 50, contraction.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

Standard deviation is a statistic used as a measure of the dispersion or variation in a distribution, or dataset, from its mean, or average; it measures the volatility of an investment’s return over a particular time period; the greater the number, the greater the volatility.

Value refers to an investment approach that aims to select stocks that trade for less than their intrinsic values.

The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.