2020 Global Market Outlook
With monetary policy worldwide largely committed to ensuring market liquidity and supporting economic growth, the market outlook for 2020 appears...
Comfortable with the uncomfortable
2020 vision
Introduction
The market outlook for 2020 seems brighter than it did just a few months ago, as the three major global central banks expand their balance sheets. However, considerable political and economic risks remain.
With monetary policy worldwide largely committed to ensuring market liquidity and supporting economic growth, the market outlook for 2020 appears considerably brighter than it did at the midpoint of 2019.
To put it another way, we do not believe investors will want to stand in the way of the three major central banks – the US Federal Reserve, the European Central Bank and the Bank of Japan – when they are expanding their balance sheets.
However, considerable downside risks – both political and economic – remain. Although equity valuations overall do not appear extended relative to historical averages, forward‑looking multiples in the US market may reflect overly optimistic forecasts for 2020 earnings.
Global credit markets are unlikely to deliver the double‑digit returns seen in 2019, but attractive opportunities can still be found in emerging market (EM) debt and high yield – assuming the economic data confirm the reflation expected in 2020 is actually underway.
By contrast, low or negative yields on many sovereign bonds create the risk of subpar returns or even capital losses if a strengthening global economy causes interest rates to rise. However, sovereigns potentially can still be a useful hedge against extreme political or economic shocks.
Non‑US equities – EM equities in particular – appear attractive based on relative valuations, raising the possibility the long streak of underperformance relative to the US market could be broken in 2020. However, stronger global growth – and in Europe, improved banking margins – will be essential.
In an uncertain market environment, investors will need to be ‘comfortable with the uncomfortable’ to take advantage of potentially attractive opportunities. As always, with a wide dispersion of returns both in and among sectors and industries, in‑depth fundamental research will be particularly critical for identifying potential opportunities and risks.
In an uncertain market environment, investors will need to be ‘comfortable with the uncomfortable’ to take advantage of potentially attractive opportunities
The quickfire global state of play
Following renewed monetary easing from global central banks, economic growth could be poised to reaccelerate in 2020. However, investors will need to be vigilant, as a major political or financial shock may trigger a renewed downturn. We see a number of global issues investors must keep a close eye on in 2020.
global growth expectations
Renewed efforts by the US Federal Reserve and other key central banks to support the global economy with monetary easing appeared to be working as 2019 drew toward a close, potentially setting the stage for a reacceleration in economic growth in 2020.
As 2019 drew to a close, we saw three signs that growth and inflation expectations might be bottoming. Firstly, as of late November, manufacturing and export indicators appeared to be stabilising. In addition, copper prices – traditionally a key signal of global industrial activity – also had rebounded. Finally, the US Treasury yield curve, which briefly inverted across the 2 to 10‑year segment in August – a phenomenon that may occur ahead of a recession – returned to a positive slope.
However, these signals do not mean the global economy is entirely on solid footing. A major political or financial shock potentially could trigger another slowdown in growth or even tip the world economy into recession.
US equity earnings forecasts may be ‘overly optimistic’
As of late 2019, the US economy remained in an expansion, largely sustained by consumer spending. But a slowdown in capital spending had put the brakes on earnings momentum, with 2019 per‑share earnings growth for companies in the S&P 500 Index expected to be in the low single digits.
As of late November, forward‑looking multiples for the S&P 500 appeared somewhat high, in our view, although not exceptionally extended in historical terms. However, those valuations were predicated on consensus estimates of roughly 10% earnings growth in 2020. That might have been overly optimistic. If an economic re-acceleration does not materialise or is not strong enough to produce the expected earnings gains, we believe equity markets have a lot of room for the downside.
Past performance is not a reliable indicator of future performance.
Source: Citigroup, as at 30 September 2019
European equity outlook depends on bank earnings
European economic and earnings growth both were weak in 2019, as the slowdown in global trade hurt Germany’s export‑dependent manufacturing sector. Although European economies started to see ‘green shoots’ of recovery late in the year, we think longer‑term factors – such as declining populations and weak productivity – could limit growth to 1% in 2020.
The European equity outlook also will depend on earnings in Europe’s financials sector, which has a heavy weight in regional indexes. However, low interest rates and flat or inverted yield curves are major obstacles. We believe that for European equities to do well, banks need to be able to start making positive spreads on new lending.
Reflation needed to continue Japanese stock boost
Japanese equities – like Japan’s economy – remains vulnerable to the global economic cycle. As a result, Japanese equities lagged other major developed markets in early 2019.
However, by the same token, we believe Japanese equities stand to benefit disproportionately from an improved global outlook. Whether this relative trend persists in 2020 will depend on a continued global reflation.
China growth impacted by trade and structural factors
China’s growth slowed sharply in 2019, and we think it is likely to continue decelerating in 2020. This slowdown is only partially due to the trade war, with high debt levels and declining demographics also imposing structural constraints.
Chinese policymakers appear less inclined than in past slowdowns to stimulate credit and spending, as curbing debt growth among highly leveraged financial institutions appears to be a higher priority. On the positive side, China’s consumer market continues to expand, driven by real (after‑inflation) gains in wages and household disposable income.
EM equities inexpensively priced relative to the US
Like Japan, the emerging market (EM) economies as a group are highly leveraged to the global economy. This led to volatile equity returns in 2019. With currency values adjusted on a purchasing power parity basis, EM equities appeared inexpensively priced as of late November– particularly compared with the US market. Currency effects could boost this appeal if the US dollar weakens in 2020.
We believe attractive valuations and potential currency gains also could benefit developed non‑US equities in 2020. As of late November, on a cyclically adjusted basis, relative price/earnings ratios favoured non‑US equities by the widest margin since at least 1995.
What investors should watch in 2020
By Yoram Lustig
Globally synchronized monetary stimulus could have a profound impact on currencies, high quality fixed income and risk assets. For currencies, an easing Fed could lead to a weaker US dollar – which could boost emerging market currencies and the Japanese yen.
High quality government bonds and investment grade credit may get a boost from falling rates in a low inflation and slow growth environment. This would boost US Treasuries and UK Gilts, as well as global investment grade credit.
As for risk assets, as rates decline, the discount factor falls, and the prices of assets may rise further. As long as the economy does not derail, risk assets – such as equities, high yield bonds and EM debt – could benefit.
What are your 2020 global growth expectations?
- Re-acceleration of economic growth
- Slowdown of economic growth
Why the bond sweet spot may be in global HY
The shift to monetary accommodation in 2019 produced an unanticipated windfall for fixed income assets. If global reflation strengthens in 2020, opportunities in a number of out-of-favour industries – such as energy groups and auto manufacturers – could prove appealing.
Alarmed by spreading signs of global economic weakness, key central banks changed monetary policy direction in 2019, cutting interest rates and reviving or expanding quantitative easing (QE) programs.
The policy shift has been both widespread and dramatic. While 2018 saw approximately two interest rate increases globally for every cut, this trend flipped in 2019, with 91 rate cuts worldwide but only 16 rate hikes through the first three quarters of the year. Clearly, central banks have been making a synchronised effort to expand liquidity to support the global economy.
While we do not believe the US Federal Reserve is likely to cut rates in 2020, we expect global monetary policy to remain supportive as the European Central Bank and the Bank of Japan continue QE.
Clearly, central banks have been making a synchronized effort to expand liquidity to support the global economy
Mark Vaselkiv - Chief Investment Officer, Fixed Income
Navigating a negative yield world
For bond investors, the shift to monetary accommodation in 2019 produced an unanticipated windfall, with virtually all global fixed income sectors delivering solidly positive returns.
Yields dipped into negative territory across a wide spectrum of sovereign issues, producing capital gains at the long end of the yield curve. As for corporate bonds, the investment grade and high yield sectors both delivered double‑digit returns in 2019, as investors reached to lock in yields. Emerging market (EM) debt, including EM corporate credit, also performed well despite a stronger US dollar, as easing inflationary pressures gave some EM central banks room to cut interest rates.
While the pool of negative‑yielding debt shrank somewhat in 2019’s second half as bond markets recovered from a late‑summer flight to quality, it still accounted for more than US$13trn in bonds outstanding – 24% of total global market value – as of the end of October 2019.
Potential credit opportunities in reflation
Lingering concerns about the global economy have led many high yield investors to remain cautious about troubled companies and industries.
However, if global reflation strengthens in 2020, we think investors may want to consider selected opportunities in some disfavoured sectors – such as energy companies and auto manufacturers – where credit spreads remain relatively high.
Overall, credit quality in the high yield universe has improved since the 2008-09 global financial crisis, which we think could provide a cushion if the global economy falters again in 2020. If we were to go into recession, we believe the overall default rate in high yield could be lower than it was 10 years ago.
The double-edged duration sword
The sharp declines in bond yields seen in 2019 have generated downside risks for 2020. Duration is a double‑edged sword, and even a modest rise in bond yields from current low levels could negatively impact total returns.
If 2020 economic data catch up with expectations, we think the yield on 10‑year Treasuries could move north of 2%, maybe as high as 2.25% to 2.5%. This is not enough to cause massive pain, but further out on the yield curve – for example, the 30‑year US Treasury bond – a move to a 3% yield could cause losses on a mark‑to‑market basis.
In such an environment, we think short‑duration high yield credit instruments are likely to offer the more attractive risk/reward combination in 2020.
The Importance of going global
A global high yield strategy can take advantage of pricing dislocations caused by unsynchronised credit cycles, relative value disparities, and geopolitical events. There are also potential diversification benefits from investing globally.
Both the European and EM high yield markets are less mature and are not followed as closely by investors as the US market. For example, dedicated EM corporate investors make up only 5% of this market. Such low levels of dedicated ownership result in a more inefficient market and, in our view, present more opportunities for skilled active managers to take advantage of pricing dislocations and attractive relative value.Overall, we believe the enhanced diversification of a global high yield strategy can help overcome periodic bouts of changing market sentiment toward particular issuers, countries or regions.
US disruptive revolution to continue
With today’s disruption dynamic unlikely to slow in 2020, companies at the epicenter of technological obsolescence will continue to be negatively impacted. As the number of attractive industries to invest in shrinks, navigating secular risk is critical to success in 2020. Relying on traditional mean reversion for companies is certainly more difficult than in the past.
Innovation, technological change, and automation – particularly the use of artificial intelligence (AI) applications, continues to disrupt a growing number of global industries. We expect this dynamic to continue in 2020.
Companies at the epicentre of technological obsolescence continue to be negatively impacted, including cable television networks, newspapers, retail, legacy tech, and legacy oil. However, the next stage in this economic revolution – which we call ‘Disruption 4.0’ – is not limited to specific sectors but is structurally transforming business models across the entire global economy.
In 2018, our T. Rowe Price analysts estimated that 31% of the S&P 500 market cap was threatened by disruption. As of October 2019, the number of at‑risk companies had increased but, due to underperformance, their share of S&P 500 market cap had declined to 29%.
Disruption has created a strong fundamental backdrop for its beneficiaries – such as the major technology platform companies – while curbing earnings growth for many incumbent groups trading at lower multiples.
Amazon is probably one of the the biggest factor driving secular changes for other companies – particularly traditional retail, malls and grocery stores. With the emergence of AWS, its cloud‑based platform, tech hardware has come under pressure as well.
Source: FactSet Research Systems; data analysis by T. Rowe Price. 1 June 1 2007 through 31 October 2019
Past performance is not a reliable indicator of future performance.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by T. Rowe Price, and no assumptions should be made that the securities identified and discussed were or will be profitable.
Managements fail to fix fundamental issues
Although a number of challenged, or ‘incumbent,’ companies are seeking to meet challengers head on, the track record for these efforts so far has been relatively poor. In our view, too many boards and management teams are – using an American football analogy – throwing ‘Hail Mary’ passes by pushing ambitious acquisition deals to try to fix fundamental problems.
Many, if not most, of these deals have resulted in poor financial returns and have failed to achieve the intended strategic objectives. Because of these bad capital allocation decisions, we believe many challenged companies are likely to be sub-par long‑term investments, almost regardless of valuations.
However, disruption also is improving the growth characteristics of some traditional sectors, Utilities, for example, typically have been viewed as defensive yield plays, but the sector has evolved in recent years. In recent years it has demonstrated newfound growth potential, which may not have been fully rewarded by the market.
The three factors powering utilities
We see three trends powering earnings growth for some utilities. Firstly, we are seeing a more favourable regulatory climate. Many states are allowing utilities to start earning a return upon breaking ground on new power plants, rather than when the facility comes online.
Secondly, advances in fracking technology have caused natural gas prices to drop dramatically in many US service areas. While much of those savings are being passed along to consumers, utilities also have been able to retain part, boosting return on equity.
Finally, utilities are benefiting from the falling costs of renewable energy, with solar and wind generation now cheaper than coal‑fired power in some regions and at certain times of the day. Operating costs for renewable installations also tend to be significantly lower than for conventional power stations.
The dramatic impact on utility earnings
The impact on earnings has been dramatic. While the utility industry saw virtually zero earnings growth from 1986 through 1998— even as S&P 500 earnings rose 150% over that same period—that gap has narrowed substantially over the past two decades.
We believe continued declines in renewable costs and improvements in storage capacity could fuel a sustained, multi‑decade period of above‑trend earnings growth for utilities. Yet, recent valuations have reflected only a small premium over the broad US market.
Careful stock selection is needed to avoid troubled utilities, as well as companies with significant markets in poorly regulated states. However, in our view a utility able to grow earnings at 6% per year, with a dividend 1.5x the yield on the 10‑year US Treasury note, should trade at a higher multiple than on offer today.
Companies that are at the epicenter of technological obsolescence continue to be negatively impacted.
David Giroux , Chief Investment Officer, Equity and Multi‑Asset
Navigating a disruptive future
The number of attractive industries is shrinking, so navigating secular risk is critical to investment success. Relying on traditional mean reversion for companies is more difficult than in the past. It is hard to paint a picture of how companies like Viacom, Discovery or General Mills can innovate out of the secular challenges.
Even a successful company not exposed to secular risk or disruption can suffer severe multiple compression if the market perceives its problems as a secular risk.
We think the emergence of secular risk could create a powerful tailwind for active investing and poses a significant challenge for passive investing over the next five to 10 years. In our view, it also highlights the importance of long‑term investing on a three to five‑year time horizon. At T. Rowe Price, we try to manage this risk by being structurally underweight secularly challenged companies.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by T. Rowe Price, and no assumptions should be made that the securities identified and discussed were or will be profitable.
Three geopolitical risks investors must watch
The US presidential election is likely to be the most significant political event of 2020, but a variety of other geopolitical risks, including the trade war and the protests in Hong Kong, also are likely to impact global markets.
Find out what these major risk events could mean for investors.
The trade war is unlikely to be resolved
The US‑China trade dispute was a key driver of market volatility in 2019, as seen in the fluctuating fortunes of the companies most directly exposed to the Chinese market. After stumbling sharply in August, following a US announcement it would raise tariffs on an additional US$300bn in imports, China‑related stocks subsequently rallied along with the broader market as hopes rose for an interim trade agreement.
While there are signs the US and China could finalise a short‑term deal that boosts sales of US agricultural goods and rolls back some tariffs, the underlying conflict is unlikely to be resolved in 2020. On some core issues, such as technology subsidies, we think compromise may not be possible at all.
For example, we do not think China will back down on its long-term strategic goals in areas such as AI, robotics, electric vehicles, and domestic semiconductor production. In our view, China will never agree to a deal that ends its state support for these key industries.
Unclear how Hong Kong troubles will end
The mass protests in China’s special administrative region began in reaction to a proposed extradition law allowing residents to be tried on the mainland but have evolved into a movement demanding democratic political reforms.
While the disturbances clearly have had a negative effect on Hong Kong’s economy, the impact on China as a whole has been difficult to distinguish from the trade‑related and structural issues slowing growth.
It also remains unclear what steps, if any, Beijing might take to restore order. As things stand now, we are uncertain what a reasonable outcome in Hong Kong would look like.
What will the biggest risk to markets in 2020?
- US-China trade dispute
- Hong-Kong protests
- US election
US election could be extremely disruptive
We think equity markets may be underestimating the potential impact of the 2020 presidential race on tax rates, regulation, and companies in the healthcare, energy, and financial services sectors. We’ve been surprised by the market’s lack of concern so far, as we believe the election has the potential to be very disruptive for many sectors.
Part of the political backdrop to the 2020 election is the debate over the rise in income inequality that has accompanied the free-market reforms of the past four decades. Although these structural changes have boosted growth and lowered inflation, the benefits have not always translated into rising wages and living standards. While economic anxiety has helped fuel populism, the political appeal of candidates promoting tighter regulation and income and wealth redistribution poses the more immediate risk to markets, in our view.
We think the odds are about even that such a candidate will win the Democratic nomination. While a Democratic president would probably find it difficult to push a left‑leaning legislative agenda through the US Senate, we don’t see potential regulatory changes by such an administration – such as stricter limits on oil and gas fracking – being priced into the market. This gives us reason to be a little more cautious.
Further insights
Our investment experts share their outlooks for Japan and China equities.
As Japan looks to the future, productivity is the key
When you strip economic growth back to its basic parts, it is essentially powered by population growth, particularly a growing labor force, and improving productivity. In applying this equation to Japan, the country’s challenging demographic trends are well documented—an aging and shrinking population represents perhaps the biggest risk to Japan’s long‑term growth outlook. Crucially, however, Japan is taking action to counteract this challenge. And the magic word is “productivity.”
Japan is not the only country facing the modern reality of challenging demographics. However, among the world’s advanced economies, it is the country where the problem is most pronounced and, thus, where the imperative to act is most urgent. Accordingly, Japan is leading the way in pioneering new and innovative solutions aimed at boosting productivity.
Efforts to boost productivity are being driven by both the public and private sectors in Japan. On the public side, a focus on broad structural reform is creating a more flexible and dynamic working environment, with increased workplace participation a key objective. Meanwhile, the private sector also understands the need to boost productivity in order to stay globally competitive. Companies are investing in new technology and systems with the aim of encouraging smarter, more efficient work practices.
Structural workplace reform has laid the groundwork
One of the principal “arrows” of Abenomics has been the overhaul of Japan’s corporate environment, in order to improve efficiency and encourage greater investment inflows. Significant progress has already been made here, most notably in the form of improved standards of governance and a new framework of tighter regulatory control. At the same time, a range of government initiatives, from new laws and policies to investment in infrastructure to financial incentives for companies, have all been specifically aimed at encouraging a more inclusive, and dynamic, Japanese workforce.
The historically inflexible nature of Japan’s labor market goes some way toward explaining why Japanese productivity has slipped behind global peers over recent decades. Tradition and culture meant that jobs were generally considered to be for life, creating limited competition and few opportunities for advancement, and so little incentive to move. This kind of inflexibility has a negative impact on productivity, in three key ways.
- It tends to lead to overstaffed, inefficient workforces where necessary downsizing in leaner times is difficult.
- With limited movement of employees between companies, the important function of regular sharing of best practices is lost.
- With little incentive to move jobs, employees are less likely to continue developing new skills throughout their career.
However, the legal confines that once enabled, even encouraged, companies to provide lifetime employment have today been largely removed. While it will take time for the ingrained one‑company “salaryman” mentality to unwind, the benefits of free and open movement are already apparent, with evidence of shared best practices between companies as well as increased employee upskilling, as competition for jobs intensifies. Businesses are also employing more staff on temporary or contract bases, which makes for a more flexible and efficient pool of labor than was possible in the past.
“Womenomics” is central to Japan’s economic growth agenda
Meanwhile, Prime Minister Shinzo Abe has emphasized Womenomics—dedicated to making it easier for women to rejoin the workforce—as a central component of his economic growth agenda. A large percentage of Japanese women leave the workforce after their first child, and many never return to full‑time employment. In response to this problem, the government has announced several initiatives, including:
- Extending paid parental leave
- Expanding child care services, including building more dedicated facilities
- Increasing the number of women in company management roles to 15% by 2020.
These policies are having success in encouraging more women back into the Japanese workforce. The percentage of working‑age women in employment reached a record‑high 72% in September 2019. This compares with a 67% female employment rate in the US, with the gap widening noticeably over the past five years.
However, there is still more to do. Japan’s gender pay gap, for example, remains one of the widest in the world, and closing this will be crucial for encouraging more women to stay in, or return to, the workforce. Also, the sharp increase in female employment over the past 10 years has been driven by a rise in the number of women working in part‑time or non‑regular jobs. This is encouraged by a tax framework that penalizes higher‑income‑earning households. Policy reform in this area, therefore, could see more women return to full‑time employment.
Encouraging older workers to remain in the workforce for longer is another government priority to help boost productivity. In 2013, a rise in the mandatory retirement age started to be phased in, from 60, rising to 65 by 2025. The government has also introduced subsidies for companies that employ or retain staff beyond retirement age. Meanwhile, companies are also realizing that valuable skills and experience can be retained for longer.
Private sector investment is also driving productivity gains
Crucially, after decades of underinvestment, the private sector is also beginning to act, with more Japanese companies investing in human and physical capital and pioneering new and innovative productivity‑enhancing solutions. Born of necessity, these companies are pushing the boundaries of what is possible today and, in the process, setting new standards.Japanese companies, for example, are investing heavily in automation and artificial intelligence technologies with the aim of improving or optimizing processes. In turn, this could potentially alleviate many of Japan’s social challenges, such as resolving labor shortages, releasing people from overwork, and improving productivity across a range of industries. While we are still in the relatively early stages of these disruptive trends, Japanese companies, both large and small, are increasingly utilizing intelligent machines and automation technologies. As this trend continues and broadens across industries, the impact on Japanese productivity could be significant. The most significant impact could potentially be felt in Japan’s service sector, where productivity lags that of the U.S. by some margin.
Leading the way in robotic process automation
One of the hottest developing areas in technology currently is in service‑industry software, like robotic process automation (RPA). This is technology that can speak, hear, read, conduct transactions, and automate process‑oriented work. While it is increasingly being
used in all industries, more process‑driven businesses, such as banks, insurers, utilities, and telecom companies, are the biggest adopters so far. The software is helping these companies to automate procedural and repetitive tasks that would otherwise be done by human workers. If you consider that these industries currently employ thousands of people to do this kind of process‑driven work, it is not hard to see the efficiency‑creation potential offered by RPA software, enabling vast amounts of work to be automated. This is potentially transformational for Japan in terms of the productivity‑enhancing outcomes.
RPA Technology Is Potentially Game‑Changing for Productivity
Pioneering investment in potentially disruptive technologies
One company that believes in the disruptive, productivity‑boosting potential of RPA technology is SoftBank. In late 2018, the Japanese multinational conglomerate invested USD 300 million in US startup business Automation Anywhere, which specializes in the field of automated technology. Investing via its Vision Fund, SoftBank is at the forefront of identifying and investing in disruptive technology businesses that it believes have the potential to lead the next age of innovation.
Abenomics has laid the crucial groundwork, delivering necessary structural reform, creating jobs, and encouraging investment. However, if Japan is to counteract its long‑term demographic challenges, then improving productivity is the key. To this end, efforts to boost workforce participation are bearing fruit, and this is an ongoing positive trend. Meanwhile, closing the productivity gap between the manufacturing and service sectors in Japan is also a priority. We can already see a positive dynamic starting to develop here, with the private sector investing in new technologies and systems, which is driving a “smart” upturn in service‑sector productivity. Importantly, the combination of public and private sector efforts could deliver a meaningful boost to Japanese productivity, counteracting demographic challenges and paving the way for potentially sustainable long‑term growth.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by T. Rowe Price, and no assumptions should be made that the securities identified and discussed were or will be profitable.
Are you likely to allocate to Japan next year?
China outlook: Stabilization first, improving later
There was a broad-based slowdown in the Chinese economy in 2019 arising from weaker exports, fixed investment, and property. Real gross domestic product (GDP) growth fell from 6.4% year‑on‑year in the first quarter to 6.2% in the second quarter and 6.0% in the third quarter, the lowest since 1992.1 Economic forecasters expect growth will fall below 6.0% next year, the minimum if Beijing’s long‑held target of doubling China’s GDP over 2010 to 2020 is to be met.
Beijing has not been panicked by a slowing economy into introducing another massive stimulus package as in 2008 or 2015. We think this signals a more mature policy approach, where official targets can be missed if circumstances dictate that is prudent. The Chinese economy’s deceleration since 2011 is partly structural in nature and is expected to continue.
Structural factors affecting growth include property peaking as a growth driver, a falling labor supply and aging population, the switch from manufacturing to lower‑productivity services, and a share of world trade that is no longer increasing. We believe that despite this less favorable background, China can continue to transition its economy successfully, balancing growth stabilization with deleveraging efforts while managing the impact of trade tensions, which seem likely to persist beyond the US presidential election next November.
As investors in Chinese equities, we look for leaders in industries that are undergoing consolidation, as well as gaining market share. For the longer term, we view China as a potentially rich source of high‑quality companies, with leaders that are successfully moving up the value chain, pushing out the boundaries of innovation.
Western financial media comment often focuses on the problems of China’s state-owned enterprises (SOEs). We think this is misleading since China’s SOEs and heavy industry are unrepresentative of the modern economy. It is the private sector today that drives the business cycle in China, accounting for 85% of urban employment2, 70% of total investment spending, and 60% of GDP.2
Tariffs not the main factor in china’s slowdown
While President Donald Trump’s import tariffs have hurt China, we do not believe they were the major factor behind the slowing economy in 2019. First, the loss of momentum in China’s total exports in 2018/2019 mirrors closely that of other emerging markets (and also developed economies). This points to the weak global economy, not U.S. import tariffs, as a bigger factor in explaining China’s economic slowdown. The global trade slowdown will also have contributed to the weak performance of export‑oriented manufacturing investment.
Second, China’s financial deleveraging policies have remained in place for longer than was expected at the start of the year. “Shadow banking” flows, for example, as proxied by the sum of trust loans, entrusted loans, and bankers acceptances, fell 8% year‑on‑year in October.3 This partial credit crunch gave rise to strong financial pressures that fell mostly on China’s private enterprise sector, such as property developers and manufacturing exporters.
Another significant drag on the Chinese economy in 2019 was the cyclical downturn in the automobile sector, a shock big enough to reduce annual GDP growth by 0.5% on some estimates. Demand for autos in China was down 5.9% year‑on‑year in October,4 with sales at their lowest level since 2015. We expect demand for autos to begin to stabilize soon, in which case the headwind to growth from autos should fade and later reverse in 2020.
Macro economic policy in 2020
While China’s government has accepted lower trend growth, we expect a pause in deleveraging in 2020 and a switch to infrastructure spending from tax cuts in a more determined effort to support growth. In 2019, Beijing probably wished to keep some powder in reserve until there was greater clarity on trade. We assume a “phase one” trade deal is agreed with the U.S. and that China will introduce further policy stimulus that may succeed in stabilizing the economy close to 6.0%.
We have not seen significant monetary easing from the People’s Bank of China, China’s central bank, in 2019. China’s credit cycle troughed early in 2018, and there has been no strong acceleration since. There is good reason for this. Looser monetary policy could undo Beijing’s efforts to stabilize the residential property market over the past two years, igniting an asset bubble.
We expect further modest cuts in short‑term interest rates and in the required reserve ratio in the coming months. Monetary policy overall, however, is expected to play a subordinate role to fiscal policy in 2020. More fiscal stimulus measures are expected to be announced after the government’s annual economic work program meetings in December. The decision to allow local and regional governments to bring forward some of next year’s “special bond” quota (mainly used to finance infrastructure) is another sign that policy has switched from deleveraging to supporting economic growth.
Forget GDP, follow household wealth
The correlation of the A‑share market to real GDP growth is weak. Far more important for equities are nominal income aggregates, such as household incomes and wealth. These represent a more important growth metric for many domestic Chinese companies. The middle class in China continues to expand, with household income growing around 10% annually. Already, around 47 million wealthy middle class Chinese are in households with an annual income that is above USD 50,000 (RMB 351,500),5 a number that is projected to increase over four times in the next 20 years or so.
Many of the China stocks that we favor are supported by domestic demand rather than by exports. Hence, the actual direct economic impact of the US-China trade uncertainty on them may be quite limited, although sentiment can be more volatile. Investors should note that about 90% of listed enterprise profits in China are domestic. Only 10% are earned overseas, and the US share is a mere 3% to 4%.6 The uptrend in household income makes the story of the Chinese consumer one of the world’s most exciting for equity investors, and it still potentially has decades to run.
Many of the China stocks that we favor are supported by domestic demand rather than by exports.
More and more Chinese households are buying products that are prominent in the western world, such as cars, electronics, cosmetics, and health insurance. They are also spending increasing amounts on food, vacations, and entertainment. “Premiumization,” or switching to higher‑quality brands, is also a big theme, as Chinese consumers are discerning and are increasingly demanding higher‑quality products.
China’s aging population will eventually act as a drag on demand. But in the interim, demographics may actually boost consumer demand, postponing the day of reckoning for the one‑child policy. Here’s how: About 44% of adult consumers in urban China fall into the 40 to 64 years age bracket.6 Many are “empty nesters” (i.e., couples, often with two incomes, whose only child has recently left home). China’s empty nesters tend to have more discretionary income available, while many will have paid down their mortgages. Consumer surveys point to them shifting their spending to “experiential consumption” rather than more of the goods that they have already acquired.
This has important implications for the growth in demand for specific products and services, particularly services such as tourism and entertainment. These empty nesters want to stay fit and healthy, spend more on higher‑quality food and beverage, travel more, and spend on home improvements. This is a rich vein for foreign investors to potentially exploit.
China’s domestic A-share market...provides a growing and exciting long‑term investment opportunity for foreign investors.ere…
China A‑Shares: A growing opportunity
Foreign participation in China’s onshore A‑share market is still only at a low‑single‑digit level (around 3%),7 even after inclusion in the key MSCI indices. Over the longer term, we are confident that international investors and fund managers will not wish to fall so far behind China’s new and rising benchmark weightings and will reposition their China mandates accordingly.
China’s domestic A‑share market currently accounts for nearly 70% of the investible China equity universe.8 It provides a growing and exciting long‑term investment opportunity for foreign investors. There are many new opportunities to be explored and potentially exploited, such as the small‑ and mid‑cap space, which, in China, tends to be very liquid, if at times volatile. Foreign ownership of 3% looks anomalous and out of line with other Asian markets such as Taiwan and South Korea, which are around 40% foreign owned.9 We believe that increasing foreign investor participation over time will not only help to underpin A‑share returns, it will also support greater transparency, working with the grain of the efforts of China’s financial regulators to improve the quality of domestic markets.
We also believe that an active, bottom‑up investment style is the best way to approach the expanding investment opportunity set in China. China’s domestic equity markets today remain inefficient, dominated by retail investors given the narrow local institutional investor base and marginal presence of foreign investors. This offers good opportunities for bottom‑up stock pickers to add alpha by choosing the right stocks. An edge in fundamental research should help foreign investors to identify good opportunities among China’s higher‑quality domestic equities.
Valuations remain attractive
Valuations in China have fallen significantly since 2015/2016. Even after this year’s rebound (Shanghai Composite Index +18.5% in USD, as of November 22, 2019). China A‑shares are still at very attractive levels. The market is trading below its post‑2005 historical mean in terms of trailing and forward P/E ratio, something that applies to few other major stock markets today. The 12‑month forward P/E ratio is 11.1X for MSCI China and 11.3X for the CSI 300 Index of top A‑share stocks. Consensus forecasts are for earnings per share growth of 12% and 9% for MSCI China in 2019 and 2020, respectively, and 17% and 14% for the CSI 300 Index.10
1 Source: Societe Generale: Country Briefing—China, November 26, 2019.
2 Source: HSBC Global Research, July 2019.
3 Source: CLSA Infofax, November 12, 2019.
4 Goldman Sachs: China Weekly Kickstart, November 22, 2019.
5 Source: HSBC Global Research, July 2019.
6 Source: HSBC Global Research, September 2018.
7 Source: Goldman Sachs Research, May 2019.
8 Source: Goldman Sachs China Research, May 2019.
9 Source: Goldman Sachs China Research, June 2019.
10 Source: Goldman Sachs Research, November 22, 2019.
Past performance is not a reliable indicator of future performance.
What we are watching next
We will be watching for signs of stabilization in China’s domestic economy in the first half of 2020, especially with regard to private consumption and infrastructure investment. We will also monitor producer price index momentum closely for an end to deflation and a rebound in enterprise profits.
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