Franklin Templeton 2019 Outlook for global equity markets – The East gains appear over, but unloved stocks may draw new interest


“US stimulus is fading and US earnings growth should have a hard time matching 2018 levels. But with interest rates rising and political issues a concern, the quality of earnings along with valuations will be an increasingly important investment consideration.”

The year ahead looks to be one of restrained global equity market performance. As the benefits of substantial fiscal stimulus from US tax cuts and greater public spending wane, US earnings and the broader global economy may have a hard time keeping pace with 2018 levels. However, we see opportunities outside the United States as earnings and economic disparities with the United States narrow. We also believe equity valuations in non-US markets remain attractive relative to the United States. Additionally, we expect companies with low debt and high, strong cash generation to do well as economic and earnings growth moderates.

Falling Back in Line

US companies had a strong run in earnings and revenue growth in 2018, with numbers largely surprising on the upside in the aggregate. A run like that looks unlikely in 2019, and companies are already signaling that they will not be able to keep up the pace in the next year.

The hurdles come both from a slowing economy and steeper input costs. The US economy’s growth rate is set to slow as the benefits of the tax cuts and greater public spending have less impact on the broader economy. Nonetheless, growth is likely to remain relatively robust, and the business environment should remain favorable, helped by continued efforts to pare back onerous regulations and the broad benefits of the US shale oil boom.

Meanwhile, input costs, both in terms of labor and materials, have been rising. Getting profit margins to increase from already lofty levels would require a surge in productivity. And while technology may help on that front, a significant increase likely won’t be forthcoming in the near term.

All in all, US corporate earnings and economic growth rates should fall back in line with other regional markets in 2019. The International Monetary Fund (IMF) sees US growth in 2019 slowing to 2.5% from a projected 2.9% in 2018, while it forecasts European growth to come in at about 2% over 2018 and 2019. Overall global economic growth is expected to hold steady at 3.7% in both 2018 and 2019, according to IMF forecasts.

Less distinction between US and non-US corporate earnings growth could help get investors more interested in non-US stocks in 2019. Many non-US markets have been undervalued relative to the United States for the past few years, in our assessment, due to the strong US corporate earnings performance. Europe, for instance, has not seen as robust growth, giving European corporations an easier hurdle to clear in 2019. Meanwhile, the Japanese market, which has seen decent earnings growth, could benefit from any signs of a more durable pickup in inflation.

Politics’ Rising Importance

The main challenge for European markets may be the increased political uncertainty that looms in 2019. Populism and economic nationalism remain on the rise. Brexit negotiations between the United Kingdom and European Union may have reached a breakthrough on a deal in November, but substantial uncertainty remains. And Germany faces some significant political changes in the coming years as the era of Chancellor Angela Merkel draws to a close.

We think the continued rise in populism, not just in Europe but globally, is slowly chipping away at some of the economic and political institutions that have been the bedrock of many market-based economies. We also believe the rise in economic nationalism bears close watching. If countries look increasingly inward, the environment may become more favorable for domestically focused firms instead of larger multinationals.

The US-China trade war also is less about the economics of trade, in our view, and more about China’s growing geopolitical influence. We expect those issues to be much more difficult to resolve in the near term, creating greater uncertainty.

A Potential Change in Leadership

Within the equity markets themselves, stocks should continue to adjust to a change in the interest-rate environment. The ultra-low interest rates of the post-global financial crisis era have assigned more value to stocks with significant long-term potential, as their predicted future earnings are assigned a higher present value. Rising rates mean that these future earnings have less value than they would if rates were near zero. Consequently, we would not be surprised to see a change in leadership and an eventual reemergence of stocks with more stable growth profiles.

That is not to say that technology stocks or companies using technology to transform their industries will not continue to grow. Many of them should. Markets will now have to grapple with what valuations to assign to those businesses as interest rates continue to push higher and monetary stimulus is withdrawn.

Over the longer term, we continue to see tremendous opportunities in disruptive companies. Major US and Chinese technology companies are innovating and have become a more important part of the global economic and political landscape. We believe the question for investors now is how much value to assign to this growth.

Emerging Opportunities

Other opportunities are also beginning to emerge in many unloved areas of the global equity markets. While headline rhetoric about the trade war’s impact on the Chinese economy has made many investors wary of Chinese equities, we believe growth in China is driven more by domestic consumption than trade these days. And although the residential real estate market is a concern and economic growth has been decelerating, we do not see a “hard landing” ahead. We believe there could be long-term opportunities in China’s more domestically oriented sectors over the longer term.

Latin America also offers new promise. The election of Jair Bolsonaro as Brazil’s new president suggests to us a return to more orthodox economic policies, despite some of his more extreme political rhetoric. Similarly, we have seen a return to better economic policy in Argentina in recent years. While it is still early, with ongoing political and economic challenges facing both countries, we believe the days of the kind of significantly bad economic policy that hobbled both countries may be ending. In general, the underlying fundamentals in emerging markets look positive to us and valuations have been falling back to levels that historically have proven attractive to us.

So while the easy gains for global equities look to be over as growth rates in the United States moderate and geopolitical and trade issues persist, a rising-rate environment can lead to a shift in leadership as unloved stocks and regions begin to draw renewed interest.

By Stephen H. Dover, CFA, Executive Vice President, Head of Equities

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