A look at key risks and opportunities as we begin 2019
Simon [Sam] Davis, Co-Head of Equities
Portfolio Manager of Putnam International Equity Fund and Putnam Europe Equity Fund
Shep Perkins, CFA, Co-Head of Equities
Portfolio Manager of Putnam Global Equity Fund and Putnam Sustainable Leaders Fund
Risk: U.S–China trade conflictSHEP: The ongoing U.S.–China trade dispute remains among the top concerns for equity investors, despite the “non-escalation” agreement in December that paused hikes in tariffs for 90 days. Higher tariffs undermine confidence among corporate leaders and complicate and delay investments in their businesses. Tariff hikes can also lead to inflationary pressure, reduce demand for products, and shrink profit margins.
Risk: China slowdownSHEP: A slowing economy in China — which has been such a strong engine of global growth — is a key risk to equities. Growth in the world’s second-largest economy has been slowing for several years, and it weakened further in 2018. This has consequences not only for China’s trading partners in Asia, but also for the broader global economy. Demand from China has been a significant source of revenue for U.S. and European automobile, consumer, and technology companies, for example.
Opportunity: China stimulus and trade resolutionSHEP: There is a considerable amount of fear in the marketplace. Investor sentiment is about as low as we’ve seen it since 2011. If the China-related issues conclude in a reasonably positive manner, we could see a significant rebound for stocks across global markets. We believe that a favorable resolution of the tariff conflict is quite possible. Even if an agreement is only partial in scope, equity markets should respond positively.
SAM: In China, we’re seeing signs of more aggressive stimulus measures, which could improve the economic outlook for both China and global markets. If trade negotiations proceed smoothly and lead to some type of resolution, even for the short term, this could prompt an equity market rebound. It would be particularly beneficial for fundamentally strong companies that have been punished in the recent market turmoil.
SHEP: It is also worth noting that President Trump views financial markets as a gauge of his success. Now that markets have sold off, he may consider easing up on the aggressiveness in the tariff dispute and may feel more pressure to find a resolution that could help ease investor anxiety.
Risk: Political uncertainty in EuropeSAM: A range of political issues in Europe have pressured price/earnings multiples, and continued uncertainty in many regions could dampen equity performance. Worries over the budget situation in Italy eased somewhat when the Italian government and the European Commission reached a compromise. However, slow growth, combined with Italy’s high debt-to-GDP ratio, is still a potential headwind. In France, the populist uprising and violence from “yellow vests” protesters could continue to be disruptive to the economy and equity markets. And, of course, Brexit remains unresolved, which could be destabilizing for the United Kingdom, with ripple effects throughout Europe.
Risk: Monetary policy and inflation
SAM: We are monitoring risks related to U.S. Federal Reserve policy and the potential for inflation. Some data show that U.S wage growth has been very strong, but there is uncertainty about its sustainability. Many economists believe that it is limited only to certain areas of the economy, and that wage growth in aggregate has not been as strong. One possible scenario is that inflation becomes more prevalent and widespread than expected. This could cause an inflation shock to the upside and force the Fed to tighten more aggressively. A policy error from central banks, such as becoming too aggressive with rate hikes, remains a risk in the current market environment.
SHEP: While we believe it is unlikely at this point, a meaningful pickup in reported inflation would be negative for equity markets. Tighter labor markets could push up inflation in the United States, Japan, and Europe, where central banks may determine that interest-rate hikes are necessary. We are less concerned about this risk, particularly as oil prices have declined, easing some inflationary pressure. Also, In the United States, we have seen that the Fed is willing to take a more dovish stance when interest-rate hikes are taking a toll on markets.
"The Fed is willing to take a more dovish stance when interest-rate hikes are taking a toll on markets."
Opportunity: The bright side of down markets
SAM: For many reasons, we can categorize the 2018 market selloff as an opportunity. Valuations are more attractive today. It is quite possible we will benefit from a Goldilocks scenario, in which U.S. economic growth continues at a controlled, healthy pace while the Fed avoids policy mishaps and gradually raises rates in line with growth.
Many market observers believe that the benefits of the stimulus from the Tax Cuts and Jobs Act will last longer than just one year. More importantly, structural tax reform, which reduces corporate tax rates, could be a game changer in terms of competitiveness. It could attract more investment back into the United States, boosting the U.S. economy, and ultimately strengthening global markets as well.
SHEP: All of the key concerns weighing on the equity markets at the close of 2018 have the potential for a positive outcome. And experienced investors recognize the advantages of a market downturn. Through several corrections and the worst of the fourth-quarter declines, many companies have continued to demonstrate fundamental strength and still offer solid long-term growth prospects. In particular, stock prices of many high-quality companies in cyclical sectors collapsed when worries about global growth intensified. We are sifting through the damage to identify those that we believe have been unfairly punished and adding to those positions if appropriate.
Opportunity: Compressed multiples and sectors to watchSHEP: In the wake of the challenges we encountered last year, price/earnings multiples have compressed. A year ago, equities were more expensive, with valuations near the top of their typical range. Today, those valuations are lower, and many more are below average.
"We are sifting through the damage to identify those stocks that we believe have been unfairly punished."
In the recent market pullback, defensive stocks outperformed by a significant margin. This included utilities, telecommunications, and consumer staples. The worst performers were economically sensitive sectors, such as energy, financials, and technology. Going forward, we believe a balanced portfolio of cyclical and defensive names is appropriate. Recently, we have favored energy pipeline companies and technology stocks, while trimming some positions in global industrials.