Economy and markets

The start of the year saw most major indices recover with double digit growth after a disappointing fourth quarter of 2018. Global equities rose 12.6% during the first quarter of 2019, as measured by the benchmark MSCI World index in US dollar terms. Markets were buoyed by progress in US-China trade talks and the increasingly dovish tone taken by the US Federal Reserve and the European Central Bank, both of which delayed further interest rate hikes. Sentiment waned towards the end of the period, however, as investors contemplated several factors including Brexit, the unsuccessful US-North Korea summit and a flare-up of military hostilities between India and Pakistan. From an economic standpoint, a weakening outlook brought concerns over global growth which saw the US Treasury yield curve invert – historically a harbinger of recession – for the first time since the last financial crisis.

All sectors posted gains for the period. Investors rotated into cyclical stocks, which outperformed more defensive areas of the market, and the technology sector led the market higher – IT services stocks fuelling much of the growth. Energy stocks also outperformed the broader market, boosted by a recovery in oil prices after sharp declines in the previous quarter. Health care and financials lagged.

Exhibit 1: Sector returns, MSCI World Index

Source: Rosenberg Equities, MSCI. Exhibit shows cumulative return of each global sector in USD over period shown to 31 March 2019. Sector returns are based on GICS classifications, calculated with gross dividends re-invested in USD terms.

Factors: mid-quarter reversal in factor performance

Our Factor Monitor, below, plots the performance of key style-based factors in Q4 2018 and Q1 2019.

Exhibit 2: Rosenberg Equities Factor Monitor

Source: AXA IM, Rosenberg Equities, MSCI. Data as of 29 March 2019. Investment universe is MSCI World Index; performance spread calculated using gross of fees returns, in USD. See Important Information section for more details*. Performance spread buckets are not actual Rosenberg Equities portfolios.

Global factor trends Q1 2019

Quality: Quality provided a small outperformance versus the broad market in Q1. The factor’s defensive properties were out of favour early in the period as investors were looking to take on risk, but proved more attractive later in the quarter as a weakening economic outlook brought concerns over global growth and investors shifted toward defensive equity.

Value: There was a Value rally in January, but this faded as the quarter progressed and all measures of Value underperformed the broad market over Q1.

Momentum: Momentum finished the quarter slightly ahead of the broad market. Having underperformed at the beginning of the period amid significant market trend reversals, the factor stabilised later in the quarter.

Low Volatility: Low Volatility underperformed over the full quarter, but this masked a recovery of Low Volatility equities in the second half of the period as investors became more risk averse in the face of a weakening global economic outlook and the increasingly dovish tone taken by Central Banks.

Valuation: Higher than normal mispricing creates a valuation opportunity

In last quarter’s update, we introduced Rosenberg Equities’ unique perspective on mispricing and highlighted how it had evolved in the S&P 500 Index over time. To do this, we showed the index’s exposure to different categories of mispricing, analysing the weight in over- and undervalued companies and in different buckets of mispricing. This quarter, we shift our focus away from index exposures and towards the extent of mispricing at an individual stock level. Exhibit 3 tracks the median mispricing in the S&P 500 since 1985; to enable us to compare this among companies our model finds to be both over- and undervalued, we use an absolute measure of mispricing, such that the greater the value on the vertical axis, the greater the degree of over- or undervaluation.

The picture we see is closely aligned with the exposure-based view of mispricing observed last quarter, but arguably contains more information. In both charts, the influence of the so-called “dotcom” bubble in the late 1990s is immediately evident, with the degree of mispricing for the median stock in the S&P 500 Index beginning to spike sharply above its full-period average in 1998. Separating our analysis into over- and undervalued companies shows that this leap was initially driven by overvalued companies becoming even more expensive. This is consistent with a momentum-driven market, in which recent outperformers continued to outperform. As the bubble inflated, the gap between these and lower valued stocks widened, leading to a similar spike among undervalued companies (which became increasingly undervalued, according to our model) in 1999, but median mispricing in both categories dropped precipitously as the bubble burst in the subsequent years.

While the degree of mispricing in the current market environment is considerably lower than in the late 1990s, it is notable that mispricing among both over- and undervalued companies is above its long-term average for the first time in a decade. That seems to suggest a fertile ground for active investment management in the years to come.

Exhibit 3: S&P 500 Index – median mispricing among overvalued and undervalued stocks, 1985–2019

Source: AXA IM, Rosenberg Equities, Standard & Poor’s. Data as of 31 March 2019. Mispricing is based on Rosenberg Equities’ valuation model, excluding unvalued companies. No representation is made that the degree of mispricing estimated by Rosenberg Equities will be recognized by the market.

Earnings: a more challenging backdrop for corporate earnings in 2019

As exhibit 4 below shows, the forecast for global earnings growth in 2019 (light green line) has fallen steadily since October last year and consensus expectations now are for earnings to grow at just 4.2%; well down on the 16% delivered in 2018 (as can be seen in exhibit 5).

Exhibit 4: MSCI World Index earnings per share growth forecast, 2018 vs. 2019

Exhibit 5: Earnings growth by region, 2018 (delivered) vs. 2019 (forecast)

Source: Rosenberg Equities, MSCI, S&P, IBES. Data as of 29 March 2019.

The double-digit global earnings growth for 2018 was driven predominantly by the US which received a significant boost in the form of President Trump’s tax stimulus. It is therefore no surprise that 2019 earnings growth is sharply lower as the impact of the US tax stimulus tailwind fades.

Indeed, as exhibit 4 shows, a step down in the rate of earnings per share growth between 2018 and 2019 was expected all of last year. However, US earnings are facing other headwinds; growth expectations for 2019 have been falling since last October as the impact of rising labour costs and modestly slower top line revenue growth put further pressure on corporate margins.

Exhibit 5 provides a breakdown of global earnings into the major regions for both 2018 and 2019. This clearly illustrates how the dramatic change in the growth picture for the US dominates the global outlook for the year ahead. The chart also shows earnings growth expectations falling in the UK. However outside of the US and UK the picture looks a little better, with growth rates generally stable in EMU, Asia ex-Japan and emerging markets, and improving in Japan.

Summary and outlook

  • Global equity markets have started the year strongly, helped by accommodative central banks. We believe that global macroeconomic growth will modestly decelerate in 2019; against that backdrop, central banks are likely to tread much more cautiously along the path of monetary policy normalisation.
  • Quality outperformed as concerns over global growth led investors to more defensive equity. With a more demanding backdrop for earnings, we expect this to continue as investors favour companies with a proven track record of sustaining profitability and delivering stable earnings growth. Some areas of Quality are expensive, which argues for an active approach to obtaining Quality exposure.
  • We observe a higher-than-normal level of mispricing in equities, which we believe is supportive of active management.
  • We expect corporate earnings to expand more slowly due to a combination of slowing revenues, fading tax stimulus and margin pressures as labour costs rise.

*The Factor Monitor (Exhibit 2) calculates the performance of companies that rank highly (top 30%) relative to those that rank poorly (bottom 30%) on each measure. This best-versus-worst performance spread allows us to characterise a given period according to factor dominance and provides insight into the drivers of return in the market. For each factor we measure the performance of the best (top 30%) of the market by square root of market cap on a regionally neutral basis, rebalanced every month during the timeframe shown. Returns of the factor “portfolios” are calculated on a dividends reinvested basis and shown gross of management fees and in USD terms. Past performance is no guarantee of future performance. Please note that the factor “portfolios” are (i) hypothetical in nature and used to illustrate market dynamics in the past, (ii) not actual Rosenberg Equities portfolios, (iii) not available for investment, and (iv) should not be understood as being representative of Rosenberg Equities Sustainable Equities strategies.

Below we provide details of the company-level measures used in the Factor Monitor: (i) Low volatility: We measure both market volatility (beta) and stock specific risk over both the long term (5-year horizon) and short term (1-year horizon); (ii) Quality: We measure both simple Return on Equity (RoE) and Earnings Sustainability. Earnings Sustainability is Rosenberg Equities’ proprietary measure of earnings quality that predicts the likelihood that a company will deliver positive recurring earnings and sales growth next year. Companies with stable historical earnings growth that has not been distorted by accounting anomalies (e.g. by inappropriate accruals or extraordinary items) will likely have high earnings sustainability; (iii) Value: We use three key measures within the value spectrum: price-to-book, price-to-recurring earnings and dividend yield. In this way, we hope to capture the varying flavors of value investing, acknowledging that they do not always perform in unison; (iv) Momentum: We measure trailing price momentum of a security relative to its local market over the last year, ignoring the most recent month to reduce the effect of short-term price reversal.

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