The three themes from our midyear investment outlook still ring true as the fourth quarter of 2018 kicks off: a widening range of growth outcomes, tighter financial conditions and a rising need for portfolio resilience.
We see the steady global expansion rolling on, underpinned by above-trend U.S. growth. Yet the range of potential economic outcomes is widening. Stimulus-fueled surprises and productivity gains could boost growth and risk assets, whereas escalating trade disputes and rising price pressures could create downside risks. Gradual increases in U.S. rates are tightening financial conditions globally, and have contributed to bouts of volatility and sharply depreciating emerging market (EM) currencies. This argues for a greater focus on making portfolios more resilient to downside shocks.
Against this backdrop, we update our market views in our Global Investment Outlook Q4 2018, and take a deep-dive into the prospects for EM assets.
Here’s a quick look at our equity and fixed income views below:
We favor equities over bonds and believe it still pays to take risk in equities, but we see an uneasy equilibrium between rising macro uncertainty and strong corporate earnings growth. This calls for portfolio resilience, expressed through our preference for quality exposures and U.S. equities over other regions. Robust 2018 earnings estimates make the U.S. our favored region. We stick with our preference for momentum alongside quality exposures for added resilience. A duller earnings outlook and looming political risks have us less enthusiastic about Europe, while Japanese equities lack a clear catalyst to propel performance.
We haven’t lost confidence in EMs, where economic strength is starting to translate into sustained strong earnings growth for the first time in a decade. Consensus estimates as of September 2018 point to earnings-per-share (EPS) growth of 12% for 2019, with China at nearly 16%, Thomson Reuters data show. This compares with 10% EPS growth globally and has EMs just ahead of the U.S. The recent selloff also has restored a lot of value, and EMs are now trading at a large discount to developed market (DM) equities. The On sale chart paints the picture. Value stocks may be particularly underappreciated in EM, our Risk and Quantitative Analysis team finds.
What is feeding EM earnings?
Changing sector composition is a big part of the story. We’ve seen a flood of new offerings in higher-profit new economy sectors that appears unlikely to abate. The technology sector, for example, has ballooned from 4% to 28% of the MSCI EM Index over the past 20 years. Tech has led EM equities down this year amid tighter regulation in China and potential for trade risks to disrupt global supply chains. Yet valuations relative to DM tech are among the lowest seen in the past decade. This makes EM tech a large field that could be ripe for picking. We see potential opportunities in both consumer platforms and enterprise services.
In fixed income, we favor short-term bonds in the U.S. and an up-in-quality stance in credit. We also prefer selected hard-currency EM debt over the local variety on relative valuations and the insulation they provide against currency depreciations. Hard-currency yields have risen to the top of their range this decade, erasing the usual gap with local currency yields. See the Hard currency preferred chart below.
Too soon to jump back in?
No two downturns are identical, but historically this has been a good entry point. We analyzed EM hard-currency debt returns since 1994, using the benchmark JP Morgan EMBI Global Diversified Index. Each time trailing 12-month returns were of the current magnitude (a 4% loss), total returns were positive in the next 12 months.
Local-currency markets have been the main recipients of EM debt inflows in recent years, putting them at risk of more outflows. And they are more exposed to any further weakness in EM currencies. Currency depreciation is a double-edged sword for EM. On the one hand, it acts as a stabilizing force in a crisis—helping rebalance current accounts. Yet it also comes as a market shocker.
Looking for more details on our asset class views? Read our full Global Investment Outlook Q4 2018, which also covers why we see room for renewed flows into EM assets.