Equity markets completed a near-perfect V-shape in Q1, recouping their Q4 losses to sit at or close to six-month highs at the start of the second quarter. In local currency terms, the S&P 500 returned over 15% in Q1, the Eurostoxx 50 12% and the FTSE 100 14%.
In 2018, global equities de-rated pre-emptively throughout much of the year ahead of a decline in earnings forecasts that only really began to materialise in the fourth quarter. In 2019, stocks have re-rated sharply and the deterioration in the perceived outlook for earnings, which took hold around the turn of the year, has somewhat moderated.
What should investors focus on in global equities?
Large swathes of the global equities market will likely experience two successive quarters of declining earnings in Q4 2018/Q1 2019 (thus achieving the technical definition of an “earnings recession”), but investors are disposed to look through the tepid earnings environment and focus instead on the rebound in global economic activity and corporate earnings expected later in the year.
With valuations in most sectors no longer particularly compelling after the Q1 bounce, and gains from further multiple expansions consequently bounded, the onus will be on earnings to resume rising in order to validate the recent rally and drive stocks higher through the remainder of the year.
Gilts have seen good performance
On the fixed income side, conventional gilts produced their best quarterly performance since Q2 2016, returning 3.4%. Inflation-linked gilts also produced their best quarterly performance since 2Q16, returning 6.0%. The return differential between the two was simply due to the much greater duration of the ILB index.
What drove the stellar performance of risk markets over the period? It was not the economic data, which remained lacklustre, particularly in the goods sector, where industrial production figures were weak and manufacturing PMI surveys not being indicative of a recovery in the short-term.
Service sector data were more encouraging and, given this sector accounts for the bulk of economic activity and employment, explain why job creation in developed economies remains healthy. Together with reasonable wage growth and tame consumer price inflation, this is supporting real household incomes and preventing the manufacturing recession from metastasising into a broader economic downturn.
However, two major tailwinds emerged during Q1 to propel markets higher
Firstly, the trade wars between the US and China have materially de-escalated. At the start of the year, the market was discounting a broadening of US tariffs to encompass the entire roster of Chinese imports, likely accompanied by further targeted attacks on Chinese corporations deemed to threaten US national security.
However, there has since been a significant softening of the US stance, likely because Trump was becoming increasingly aware that his stance was proving damaging for US business sentiment as well as the US equity market, the performance of which he regards as a personal report card.
The 2020 Presidential campaign has kicked off in earnest over the past couple of months. Therefore, the President needs a ‘win’ on trade and this is likely to come in the form of a summit meeting with Chinese President Xi and accompanying deal in the next month or two.
Secondly, a wave of central banks have pivoted to a more accommodative policy stance since the start of the year. The European Central Bank has guided that it will not raise rates this year and has also announced a new targeted longer-term refinancing operation (TLTRO) funding programme for eurozone banks.
Most importantly, the Fed is now signalling that it will not hike interest rates at all in 2019 and that it will conclude balance sheet reduction (so-called “quantitative tightening”) in the third quarter.
This marks a total reversal of its position on rates (as recently as last December the balance sheet shrinkage process was described by Fed Chair Powell as being ‘on auto-pilot’). This change of stance greatly reassured investors fearful of a relentless tightening of global dollar funding conditions, with corresponding repercussions for asset markets.
Indeed, the lower rate environment is conducive to some increase in the “neutral” price-earnings ratio for equities; however, further gains really depend primarily on economic activity, and hence corporate earnings, responding positively and promptly to the more stimulative policy environment.