Market Outlook: Global Equities

Liquidity is the Question

Earnings were the primary determinant of 2018 stock market performance, and it’s easy to extrapolate that to 2019, but we think liquidity will be the driving factor next year.

Key Takeaways

  •  We expect recent market weakness could continue, with stocks testing a low before rallying higher.
  •  We also believe markets have become too pessimistic on 2019 earnings growth.
  •  A step down in growth is to be expected given the front-loaded aspects of the 2017 tax cuts.
  • Interest rates will continue to climb, though at a somewhat subdued rate, while the Fed will also continue to shrink its balance sheet. Therefore, liquidity will continue to tighten and will remain a key variable to monitor.
  •  We expect strong cash flows and strong buybacks to support stocks and for quality-oriented stocks to outperform in 2019.

Key Driver in 2019

We think liquidity will be the driving factor next year. We look at liquidity in several ways. The strength of the U.S. dollar is one. The U.S. dollar continues to surge, and that’s a negative for liquidity. The nominal change in interest rates, which continue to rise as the Fed tightens monetary policy, also impacts liquidity. Perhaps the most important liquidity driver is credit spreads, which determine the cost of borrowing for consumers and businesses. Although spreads have only widened modestly recently, the biggest potential risk in 2019 is a curtailment of liquidity that creates the next bear market.  

A widening of spreads should have the effect of separating leveraged companies from those with less leverage. Spread widening should be positive for active management. As we get later in the economic cycle and spreads start to widen, some companies become more sensitive to market drawdowns or weakness. In some cases, you have perfectly good companies with high leverage and fine coverage ratios, but they’ll get caught up in a basket of so-called highly leveraged stocks and decline just as much as others. That can create opportunities for active managers to differentiate a quality company with a smarter debt structure that might get sold off indiscriminately.

The return of a more normalized volatility environment, which has been sparked by an increase in Treasury yields and the term premium for bonds, increased worries about China and some high-level earnings disappointments, also creates more opportunities for active investors to make changes. Periods of volatility allow us to ask very productive questions about the stocks we own and whether they should be let go, or if valuations have become attractive enough to warrant buying a stock that we have been researching for some time. A rise in the CBOE Volatility Index (or VIX)  has historically trailed the flattening of the yield curve by 18 months, meaning we should expect more volatility ahead. 

Volatility Picks Up Following a Flattening Yield Curve
Source: Bloomberg, as of 9/28/18. 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.

Impact of The Political Cycle

The year following midterm elections has historically been positive for equities, with the S&P 500 up an average of 15.3% in the 12 months following midterms going back to 1950. Post-midterm election environments are also positively skewed due to the presidential cycle.

This phenomenon, which closely mirrors the economic cycle, shows that the economy has not seen the start of a recession during the third year of a presidential term in the modern era due to the nature of fiscal stimulus. Specifically, fiscal spending tends to be strongest during the middle of a presidential cycle. For example, consumers will see a $60 billion boost in spending potential in 2019 from tax refunds that reflect the reduced tax rates from the late 2017 tax reform. We could also see additional stimulus as a result of a divided Congress that may not agree on much but could come to a compromise that leads to higher infrastructure spending.

Post-Midterm Election Performance
Source: Factset.  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.

Sector Opportunity: Biotech

The outcome of the midterm elections should create opportunities within specific sectors or sub sectors. The health care sector has arguably the most to gain or lose. A congressional split takes drug price controls largely out of the near-term discussion. This should be viewed as positive for pharmaceutical and biotech stocks. Biotech is an interesting long-term opportunity. These stocks have not acted defensively despite what we believe are very reasonable valuations that have gotten cheaper along the way. Yet we find the sector to be among the most attractive across the market. Many biotech companies don’t have many financing needs and have good balance sheets. They could also be attractive acquisition candidates for larger pharmaceutical companies flush with repatriated overseas cash. 

 

2019 Investment Outlooks
Brandywine Global
The Limits of U.S. Growth
Clarion Partners
An Extended Business Cycle
ClearBridge
Liquidity is the Question
EnTrustPermal
A Plethora of Risks
Martin Currie
Current Volatility, Long-Term Opportunity
QS Investors
Choppy Markets Ahead
RARE Infrastructure
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Western Asset
Focus on Growth

Download Full Report 

Download The Full Report

Definitions

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.

A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.

A coverage ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period.

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.

Leverage refers to the amount of debt held by a company or sector of the market. Gross Leverage refers to total debt divided by the last 12 months (LTM) earnings before interest, taxes, depreciation and amortization. Net leverage is net debt (total debt minus the value of cash and other similar liquid assets) divided by the last 12 months (LTM) earnings before interest, taxes, depreciation and amortization.

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.

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


Disclosures

Active management does not ensure gains or protect against market declines.

Outperformance does not imply positive results.

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.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

  • 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.

    Important Information:

    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 only for distribution in those countries and to those recipients listed.

    Investment in real estate entails significant risks and is suitable only for certain investors as part of an overall diversified investment strategy and only for investors able to withstand a total loss of investment.

    All investors in the UK, professional clients and eligible counterparties in EU and EEA countries ex UK and Qualified Investors in Switzerland.

    Issued and approved 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:

    This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.