After a strong pro-growth start to the year, investors are ending the month moving to safe havens. Bonds are rising, equities are under pressure and the US dollar is back in vogue. The outbreak of the Coronavirus and its potential to halt the acceleration in the global economy is foremost on people’s minds. But, in the background, there have been some positive developments in earnings and the global economy that should not be ignored.
"The recent falls in equity markets are taking out some of the exuberance that did exist, making current index levels more interesting for buying opportunities."
We recently started to increase our exposure to equities but were conscious of the elevated level of indices and that sentiment towards equities was high. Consequently, we were going to move on a gradual basis. We still believe that the global economy will accelerate in 2020 and thus we will use the current weakness to add further exposure.
The impact of the Coronavirus is garnering a lot of attention at the moment. To gauge the potential impact many are looking at the effect of SARS virus in 2003. The outbreak started in January/February and did not peak out in terms of cases reported until
May. Back in 2003 the Chinese economy slowed from a year-on-year growth rate of 11% in the first quarter to 9% in the second quarter as retail sales growth slowed from 9.3% year-on-year in March to 4.3% in May. However, there was a sharp rebound once
the disease was under control. By July retail sales growth was back to 9.8% and the economy grew by 10% in Q3 and Q4.
This time the impact is likely to be greater but the length of time to the peak of the outbreak could be shorter. Already the number of cases with the Coronavirus has exceeded the maximum number of declared cases of patients suffering from SARS, which is likely to cause more fear and thus disruption. The authorities have reacted much more quickly this time and with more restrictions. Again, this implies greater disruption. So, in the short term we are likely to see quite weak economic figures from China and the rest of the Pacific Basin. But the important question is how long it lasts.
In the meantime, in the US most of the data released in January - covering December activity - was positive. The labour market and consumption were strong. There were rebounds in consumer sentiment and service sector sentiment. Only one indicator – the ISM manufacturing survey - disappointed. The picture was a little bit stronger in China with all indicators coming in better than expected. Even the euro area was delivering better than forecast data. Globally we got a picture of a stabilising/recovering manufacturing sector with the consumer and service sectors maintaining their momentum. This was a good outcome.
Coming into 2020 the one thing we felt could catch us was that the stronger performance of the global economy would not translate into profit. We could have an economic expansion but a profit recession. Lack of pricing power combined with technological disruption and rising labour costs due to tight labour supply could deliver such an outcome. That is why this earnings season was more important than normal.
Last year was a bad one for profits - globally the growth rate was close to zero. Some of this was due to macro considerations, such as slowing international trade due to trade tensions. But we felt that there were some industry-specific issues depressing the overall figure and that underlying profit growth was better than what the headline figures suggested. We thought that most of these issues would pass as we travelled through the first quarter. A better than expected trade deal added greater confidence to this.
The early indications from the fourth quarter results season have been good. The US is 40% through it and profits are up 6% year-on-year - 4% better than expected. Some of the specific news has also been better. Last year we identified four industries that had their own specific problems which pulled down the aggregate figure. IT was one of the biggest drags and it is showing a sharp rebound. Overall earnings are up 14% year-on-year and 96% of companies have beaten expectations. Profits in the energy sector are also encouraging. Earnings are down 3% year-on-year, a significant improvement from last year’s -29%. In the materials sector 60% of companies are beating expectations but earnings are down over 40%. From the last of 2019’s weak spots - the motor industry - we have no material updates yet. So, the earnings story is not conclusive but looking good at this point.
The outbreak of the Coronavirus is causing a lot of human distress and is likely to cause some economic turbulence. However, official reactions have been swift and significant. There is no reason to believe that the outbreak will last longer than the recent influenza epidemic and some reasons it could be shorter. If this is the case, then a troubled first quarter should be followed by a sharp rebound in the second quarter. Outside of it we have seen some healing in some of the weaker parts of the global economy and an improving profit picture. The recent falls in equity markets are taking out some of the exuberance that did exist, making current index levels more interesting for buying opportunities.