The Year of the Pig - Will it Fly?

The US correction in the fourth quarter we think was mainly about valuations, as there was no big change in fundamentals. There was nowhere for investors to hide, as real returns were negative across all major asset classes, a rare situation that reflected the pressures imposed on global bond markets by the end of quantitative easing (QE).

Investor sentiment globally remained poor in November and December. With few positive catalysts, equities remained in “risk off” mode with tight correlations across markets. The long awaited G20 Xi-Trump meeting at the end of November provided markets with only a brief respite, as the surprise arrest of Huawei CFO Sabrina Meng soured sentiment, denting market hopes of a US-China trade deal.

Chances of a US-China trade deal in 2019 have increased

The G20 agreement between President Trump and President Xi was more than just a truce − it paves the way for more substantive talks in the first quarter of 2019 that may lead to an interim deal and a significant reduction in trade friction between the world’s two largest economies.

We see the burden of meeting expectations being mainly on China, which has been remarkably conciliatory in the face of President Trump’s aggressive import tariffs. A long-term solution will still depend on some fundamental reforms from China in areas that, aside from trade and tariffs, include industrial policy, security threats, and external influence.

The Trump administration, Congress and US business are all united on the key issues that China needs to address and the US negotiating team will insist on meaningful targets, dates, and verification for what is agreed in the next three months. China is prepared to put quite a lot on the table immediately – and with mounting pressures from a slowing economy – is anxious to bring the trade war to a close.

A trade deal would be an obvious catalyst for a rally in global equities in the first quarter of 2019. The potential support is greatest for China equities, whose valuations could recover significantly if domestic investor sentiment improves. Chinese stocks have fallen around 20% in 2018, to a large extent due to valuation compression from the twin headwinds of financial deleveraging and the trade friction.

Low expectations create scope for a surprise in 2019

Every bear market starts off with a dip, but not every dip goes on to trigger a bear market. So how can investors distinguish between the two cases? Should the fourth quarter 2018 correction be sold on further dips, or bought aggressively?

Of these two choices, our strong preference is for the latter. While 2018 was the year when politics dominated stock markets, 2019 could be the year that brings renewed focus on the economy. Some geopolitical concerns have been mulled over for so long that they have lost the power to shock. And the global economy faces a moderation in growth at the margin, not a meltdown that the media talks so much about.

We are struck by how many of the sell-side 2019 outlooks that have landed on our desk are at best cautious or negative in tone. Is it time to take the other side of the trade?

Looking to Main Street rather than Wall Street, guidance from management on earnings remains positive while forward multiples are back close to their historic averages. For example, the MSCI AC World forward price-to-earnings ratio (P/E) has de-rated to a below average 13.6 times.

Stocks appear inexpensive relative to growth, cash flow, and bonds. Meanwhile, positioning is light and sentiment depressed. Moreover, in those few cases historically where a strong global economy was accompanied by flat or negative stock-market returns, the following year has always seen a strong rebound.

Where to invest in 2019?

For a sustainable recovery in emerging markets (EM) equities, we are probably going to need to see:

(a) evidence of slower US growth and lower earnings

(b) stabilisation in China and signs of recovery in those EM countries that stumbled earlier this year.

There are a number of other positives that could see investors warm to EM equities in 2019.

First, the sharp depreciation in the currencies of a number of “problem” EMs this year has the potential to improve current-account deficits significantly in 2019, cutting those of Turkey and Argentina by percent or possibly more.

Second, EM sentiment and valuations have fallen to low levels that in the past have been followed by significant market rebounds.

Third, with the Fed close to pausing, oil prices down, and global growth moderating, the balance of risks is shifting towards cuts rather than increases in EM interest rates.

Manulife Asset Management’s views on Asian Equities and Asian Fixed Income

Asian Equities: Overall, Asia should be better positioned globally in 2019 despite ongoing trade tensions. As the key drivers of the US markets begin to fade in 2019, Asia’s strong economic fundamentals, supportive domestic policies, and accommodative monetary policy should be attractive to investors.

We believe that these factors, coupled with historically low equity valuations in Asia, should drive capital flows back into the region. In particular, we are constructive on markets and sectors that leverage on the region’s positive domestic-driven story.

Asian Fixed Income: A raft of macroeconomic headwinds, including rising Fed rates, a stronger US dollar, and deteriorating US-China trade relations have challenged bond markets in 2018. Heading into 2019, market re- pricing is expected to reach an end and Asian bond markets should have priced in slower growth prospects. This divergence in economic expectations between markets should provide ample opportunities in the areas of rates, credits, and currencies.

After a volatile 2018, 2019 will likely see continued uncertainty, but more focused on economics and the fate of the US economy. Indeed, the Fed’s interest rate trajectory will take centre stage next year in the late cycle environment, with the global and US economy likely to continue moderate expansion with a low chance of recession in 2019.

Against this macro backdrop, we are optimistic on Asian equities due to historically low valuations and domestically-driven economic growth prospects.