2019 investment outlook – US equities

Key takeaways

• A balance of cheaper cyclical companies – especially within the energy sector – and more defensive companies – notably in health care and telecom – is an appropriate approach to 2019.
• Key to restoring both business and consumer confidence is a resolution to the Chinese tariff situation.
• Investors will keep a close eye on the Fed, led by a new chairman, as it continues to define its priorities. Expect three rate raises in 2019.

The US equity market entered 2018 buzzing with optimism. After strong 2017 gains, expectations for 2018 were high, fuelled by the president’s tax cut bill, improving global growth and strong corporate earnings growth. The S&P 500 Index was up over 7% by the end of January.

The subsequent fall back to earth was swift and painful and a sign of things to come in 2018. Despite the acceleration in gross domestic product (GDP) and the substantial step up in earnings growth driven by tax cuts, the S&P 500 has struggled to hold onto gains. The escalating trade war and its implication for global growth have weighed heavily on sentiment. Volatility returned in 2018 and is unlikely to hibernate in 2019.

When we think about equity markets, there are three components to return: corporate earnings growth; the valuation multiple we will pay for those earnings; and return of those earnings via dividend. 

It is the valuation multiple that will be the most intriguing aspect of market returns for 2019. Essentially it represents confidence in the economic and business cycles. In 2018 that confidence has eroded meaningfully, and multiple developments would be needed to restore it in 2019.

Most importantly, China’s tariff situation needs to be resolved. Although the blunt economic effect of tariffs on the US is small, the ripple effect is significant, particularly on business confidence and consumer confidence. This has repercussions for capital spending, hiring and consumer spending. The effect on China is a lot more significant, and with global growth again looking somewhat precarious, a growing (or at least stable) Chinese economy would be positive for global economies overall and US equity markets (let’s not forget that 44% of S&P 500 revenues are generated outside the US). To reiterate: A resolution is key.

But an agreement looks some way off. US President Donald Trump’s Chinese tariffs policy is one that resonates with both Republicans and Democrats as well as with voters. Hence there is little pressure to act quickly. It is equally unclear what a satisfactory resolution for both sides would even look like. But if Trump’s presidential form is anything to go by, it may not be as severe as investors are thinking. Trump needs something that can be presented as a trade victory. Our sense is that as we see US GDP start to decelerate (probably Q1 2019), the timing will look better to declare a victory. 

The Federal Reserve (Fed) also represents a source of uncertainty for investors in 2019. With the change in chairman, the market is still trying to get a feel for this new Fed. For now the Fed seems a lot more focused on its goal than the path to get there. Under previous Feds there were more intra-meeting speeches from governors that were clearly meant to influence the stance on interest rates. For now, this Fed has taken a line and appears reluctant to sway from that. Consensus seems to be to expect three rate rises in 2019. The market is crying out for the “Fed put” – the confirmation that rate rises are data-dependent and not set in stone. We expect the Fed’s stance to soften through 2019. Fed chairman Jerome Powell’s decision to start giving press conferences after each rate decision, starting in January 2019, is a step toward a more market-savvy Fed.

So all this suggests confidence could improve as we move through 2019, but perhaps not in the first several months. That should help equity market multiples eventually. But expect volatility.

While the risk of US recession in 2019 is low in our mind, the market’s potential to worry about a recession in 2019 is high. We suspect corporate earnings growth in 2019 will be solid low double digits – but still well below that of tax-boosted 2018. The market is likely to become comfortable with this growth outlook only later in the year, though, leading us to a barbell approach in portfolio construction. We want to own cheap cyclical sectors, balanced by a healthy weighting in more defensive sectors.

We still believe there is substantial risk in the technology sector, where earnings are more cyclical than the market believes and valuation multiples are still very high. This year’s late pullback in technology has lured many to “buy the dip” (after so many years of technology outperformance, the fear of missing out is enormous), but our sense is that there is more damage to come. Although we recognise that if the market worries about a recession, our cyclical positions also will be out of favour, we take comfort in the fact that the low valuations we are paying for these companies compensate us for much of any earnings risk. Technology companies do not have this luxury. Our favourite cyclical sector remains energy. 

Having avoided defensive sectors for much of the last five years, we saw good value emerge in some companies through 2018 and think 2019 could be a good year for many of them. In particular, we think healthcare looks very opportune, particularly in the area of large cap biotech. We believe the result of the mid-term elections removes the overhang of punitive actions on drug price controls. We still expect some pricing pressure – but far less than the market appears to be discounting – and demand should hold up given strong demographic forces. Innovation is still very important, and there are several therapeutic areas that have unmet needs that are being targeted. In many cases there is limited value being attributed to the drug pipeline, which we think is too harsh.

Telecom is another sector we have recently re-appraised. It is a sector we had long avoided due to heavy capital investment requirement, poor balance sheets and too much competition, resulting in destructive price wars. With AT&T broadening its focus to non-telecom areas and T-Mobile attempting to acquire Sprint, the wireless environment has improved measurably. The upgrade to 5G technology looks much less capital-intensive than previous upgrade cycles. We also see it as expansionary to their addressable market, again in contrast to previous upgrade cycles. Over time 5G will open the markets of home broadband and Internet of Things (IoT) to wireless providers. IoT examples include autonomous vehicles, home appliances, even clothing – all of which will want to connect to the internet via wireless.

We see a tricky year in 2019 where markets will debate the potential for sustained US growth with the potential for a globally driven US slowdown. We believe a balance of cheaper cyclical companies and more defensive companies is appropriate.

 

 

Investment risks

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Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

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