Geopolitical Risks Test Markets' Resiliency as Earnings Come into Focus
US equities began the New Year carrying over the momentum from 2019, with optimism from the United States and China signing a “phase one” trade agreement and a solid start to the fourth-quarter earnings season sending markets to a series of new highs.
Even a temporary spike in oil markets, following the US killing of a high-ranking Iranian military leader, was not able to disrupt the market’s positive sentiment through the first few weeks of the month.
However, late in the month, fears over the rapidly spreading coronavirus epidemic in China brought geopolitical risks and global growth concerns back into focus. The uptick in uncertainty triggered a similar market response to what we observed during periods of escalation in US/China trade tensions in 2019 — a spike in volatility, a flight out of equities, and rising stock correlations. The broader S&P 1500® closed down 0.3% for the month, the large cap S&P 500® was unchanged, the S&P 400® mid cap was down 2.6%, and the S&P 600® small cap closed the month down 4.0%.
We would caution that we are still early in the coronavirus outbreak, and the ultimate impacts on both global economic growth and market direction are still uncertain. However, even with the late month sell-off, domestic equities remained within about 3% of their mid-January all-time highs. Despite growing concerns over the coronavirus, equity investors appear to be focused more on solid underlying economic growth and better earnings reports from companies.
Entering the year, we viewed the US economy and equity market as much more fundamentally sound than at the start of 2019. Central to this view were expectations for a material rebound in US corporate earnings. While we are only about halfway through the fourth-quarter earnings season, results thus far have been better than expected, with the blended earnings growth rate (actual reported results combined with consensus estimates for those yet to report) of -0.3% versus consensus expectations at the beginning of the quarter of -1.7%. Furthermore, calendar year 2020 earnings revisions have remained in check, with consensus earnings growth estimates still forecasted to come in at a robust 9%.
The forward price-to-earnings (P/E) ratio of the S&P 500 hit a new business cycle high of 18.6 times in early January, leading some to question if market valuations would constrain future performance. In our view, the higher valuations are largely a function of an improving global macro outlook, lower interest rates, and index composition. For example, Apple Inc. (AAPL) and Microsoft Corp. (MSFT) now make up nearly 10% of the S&P 500 market cap, and forward P/Es for both companies ended January at or near business cycle highs. We continue to believe this context matters for valuations. Additionally, consensus expectations are for next-12-month earnings-per-share (EPS) for the S&P 500 to reach all-time highs; therefore, with earnings growth inflecting higher in 2020, we do not see current valuation levels as overly concerning.
From a technical perspective, US equity market sentiment had reached aggressively bullish conditions following the very strong performance in fourth-quarter 2019 (the S&P 500 was up 9.1%). Leading into the news of the coronavirus outbreak, equity markets were running at a historically low S&P 500 put/call ratio, experiencing significant fund flows into US equity exchange-traded funds and sitting with the highest percentage of stocks trading above their 200-day moving average since 2014. This type of overbought technical backdrop typically leads many investors to look for a reason to sell in anticipation of a potential pullback, and we believe the virus outbreak could have been the catalyst for a near-term sell-off in stocks.
In our view, market pullbacks following a period of strong performance are normal for a well-functioning market. Furthermore, market pullbacks that coincide with a strong fundamental backdrop typically represent good buying opportunities over the long term rather than a time to panic.
US real GDP grew at an above-consensus 2.1% annualized rate in the fourth quarter. A significant contribution to this growth came from an increase in net exports, which offset a lower rate of growth in consumption, along with a decline in capital expenditures (capex). For the full year, GDP grew at a 2.3% rate. In our view, the US consumer remains healthy, as evidenced by strong retail sales, high saving rates, low borrowing rates, and strong consumer sentiment readings. These factors should continue to help support steady consumption and be a key driver of economic growth.
However, we continue to see a divergence between corporate and consumer spending. For the third straight quarter, corporate investment contracted and catalysts for meaningful increases in near-term capex, which we see as critical for boosting productivity, have remained elusive. While the US/China trade deal may have removed a key overhang on business sentiment, the new unknown impact of the coronavirus, combined with potential uncertainty surrounding the November presidential election, may present additional challenges for capex growth.
After climbing 38 basis points in the final four months of 2019, the US 10-year Treasury yield fell to 1.54% in January as the Federal Reserve decided to keep monetary policy unchanged and concerns over the coronavirus dampened sentiment. The fall in yields helped push some parts of the yield curve back into inversion but was supportive of fixed income returns, with the Bloomberg Barclays Aggregate Index returning 1.9% for the month.
In corporate credit, high yield and investment-grade spreads moved wider, albeit to varying degrees, amid strong issuance as companies seek to take advantage of low rates and easier credit conditions. As a result, investment-grade corporate debt outperformed high yield by more than 2%, with high yield effectively flat for the month due primarily to spread widening. We believe improved financial conditions bode well for businesses and consumers alike, as evidenced by the recent surge in housing starts, which reached their highest level since 2006.
Tax-exempt municipal bonds were among the best performing sectors within fixed income for the month (+1.8%), continuing last year’s strong performance. The outperformance over similar maturity Treasuries helped push the 10-year Municipal-to-Treasury ratio back near cycle lows, with valuations underpinned by 56 consecutive weeks of fund inflows and taxable issuance accounting for an increasing share of municipal supply.
International Developed Markets
Improving Financial Conditions, Valuations Help Support the Case for Developed International Assets
Hopeful signs for improving economic growth and attractive valuations remain tailwinds for developed international assets. In January, the IHS Markit Eurozone Manufacturing PMI® improved, with the three largest economies in the region (Germany, France, and the United Kingdom) all increasing in unison, which we find encouraging.
With the region particularly pressured by trade tensions over the last couple of years, gains in the manufacturing sectors of these countries are important to a broader economic recovery for the region. The signing of the US/China trade agreement should offer a reprieve from this overhang, in our view.
The United States and France also reached a truce regarding the imposition of tariffs on the digital revenues for companies, removing yet another layer of trade uncertainty.
At its January meeting, the European Central Bank kept its interest rate policy unchanged at -0.5%, maintaining its accommodative stance as select “green shoots” appear to be forming in the region. For example, Eurozone unemployment remained near a cycle low, retail sales volume was strong, and a variety of business confidence surveys (for example, the European Sentix Investor Confidence Index, German ZEW Indicator of Economic Sentiment) have moved considerably higher in recent months.
Similar to their domestic counterparts, many equity markets across Europe and in Japan hit 52-week highs in mid-January before moving lower due to risk-off sentiment caused by coronavirus concerns. Before the outbreak started, however, market breadth, as measured by the percent of constituents reaching 52-week highs, increased significantly across these markets. This is encouraging to us, as it indicates most investors were discounting a more favorable outlook for the underlying fundamentals of companies across the Eurozone and Japan. We believe these dynamics will ultimately come back into focus once uncertainty around the coronavirus impact fades, but investors should anticipate continued volatility in the near term.
With roughly 20% of companies in the MSCI World ex USA Index reporting fourth-quarter earnings so far, the blended earnings growth rate for the quarter is about -3.0%, below the -0.3% expectation at the beginning of the quarter. Earnings revisions for the index have been steady over the last three months, with EPS growth expected to be up more than 6.0% in 2020. Despite the forward P/E ratio expanding by roughly one multiple turn for the benchmark over the last three months, the index’s valuation discount relative to the S&P 500 has actually widened.
While a number of unsolved headwinds remain, we believe stabilizing geopolitical conditions, accommodative monetary policy, and favorable relative valuations could be setting the stage for a longer-term period of outperformance.
The Bank of Japan (BOJ) kept monetary policy and forward guidance unchanged at its January meeting, revising GDP forecasts higher but reducing estimates for inflation through 2021. The decision came following a record budget for fiscal 2020. Should inflation continue to wane, we believe the BOJ may consider additional policy action, in line with the actions taken by other developed countries over the past 12 months.
Developed market bond yields followed US Treasury yields lower during the month, resulting in a $4 trillion increase in the market value of negative-yielding debt. However, we expect this number to remain volatile in the coming months, with bond yields of many countries employing negative interest rate policies slightly below the zero bound.
Coronavirus Fears Drive Emerging Markets Lower
After being up approximately 3% mid-month, the MSCI Emerging Markets (EM) Index ended down more than 4.5% for the month, negatively affected by coronavirus fears across most of EM Asia. Chinese authorities put several major cities under quarantine ahead of the Lunar New Year, effectively cutting off a key source of global market liquidity. While the coronavirus took center stage for most of the latter half of the month, the Chinese economy delivered solid data throughout the month. Headline figures point to the slowest economic growth in nearly 30 years, but GDP came in as expected and reportedly grew more than 6% for 2019. Both industrial production and retail sales data either beat or met consensus estimates, and industrial production accelerated for the second consecutive month, reaching the highest year-over-year growth rate (6.9%) since March 2019.
Fourth-quarter earnings season for EMs is just starting, with fewer than 5% of companies having reported. Unlike the S&P 500, which is expecting low-single-digit growth, EMs are expecting EPS growth of more than 10%.
Consensus estimates for 2020, which are already expecting EPS growth of approximately 15%, have been revised higher in recent weeks. In our view, these positive developments reflect optimism around potential green shoots in the global economy.
Despite coronavirus concerns, Chinese and other Asian markets, which were closed for various time periods for the Lunar New Year holiday, did not even have the lowest returns for the month. Country-specific issues in South Africa continue to plague the sixth largest country weighting in the index, with the total return for the country index down nearly 9% for the month. Despite a positive return over the last 12 months, the South African Index has trailed the EM Index in 9 of the last 12 months. In our view, given the highly idiosyncratic nature of the EM universe, we believe investment allocations to active managers that can underweight or remove stocks in certain regions or countries are preferable to a passive approach to EM equities where this flexibility does not exist.
In spite of volatility in equity markets, the Bloomberg Barclays EM Bond Index is on pace for its fourteenth consecutive month of positive performance; not even the Bloomberg Barclays US Aggregate Index can match that feat.
A further gauge of positive developments in EM continues to be the resilience of the EM debt market: Rather than showing signs of stress, spreads are only at their 12-month average. In our view, this is another indication that EM equities and debt remain attractive.
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