Equity investors will need a selective approach in 2020

Global and US stocks hit a record high last week amid mounting optimism about a US-China trade deal. China's Ministry of Commerce said the two nations had "reached consensus on properly resolving relevant issues," and US President Donald Trump later said talks were in their "final throes." But with the MSCI All Country World Index now up over 22% year-to-date and rallying ahead of a potential deal, we favor an overall neutral stance on stocks, and see greater opportunity in relative value equity trades.

1. The final outcome of trade talks is hard to predict.

• It remains to be seen whether any agreement would merely delay the imposition of tariff increases on 15 December, or, in fact, roll back previous tariffs. It is also unclear whether it would resolve longer-term diplomatic and technological disputes. Last week, President Trump signed the "Hong Kong Human Rights and Democracy Act of 2019," resisting China's calls to veto it. China’s foreign ministry warned it may enact “resolute countermeasures.” Although we believe this development will not derail trade negotiations, it is a reminder that relations between the US and China remain fragile.

2. We see the potential for disappointment in corporate earnings.

• Global earnings estimates have been lowered throughout the year, yet equity markets have rallied and, as a result, valuations have increased. The 12-month forward price-to-earnings ratio for global equities has climbed back to its average since 1987, and, on our below consensus earnings forecasts, looks stretched. This means that further upside will have to come primarily from earnings growth. Yet we forecast just 4.3% for next year, suggesting limited upside for stocks. Our earnings view assumes no further tariff escalation between the US and China, but does not assume a rollback of existing tariffs.

3. Scope for significant global fiscal or monetary support looks limited.

• Major central banks are currently on hold and look likely to remain so unless growth deteriorates further. This stance was underlined by Federal Reserve Chairman Jerome Powell’s upbeat tone last week when he said, “I see the glass as much more than half full.” The European Central Bank and Bank of Japan also appear on hold for now. In addition, we think the likelihood of the governments of major nations stoking extra demand through fiscal policy is limited.

So instead of focusing on overall price gains for stocks, we prefer relative value trades within equities.

For example, we like US equities relative to Eurozone stocks. The recent third quarter earnings season supported our position, with around 80% of US firms beating expectations, against just 35% in the Euro area. We also favor Japanese equities versus the Eurozone based on attractive relative valuations. Japanese stocks are now trading at a more than 20% discount to Euro area stocks on a price-to-book ratio basis, compared to a 10-year average of around 14%.

Aside from these geographic preferences, we advise investors to prioritize both quality and dividends within their equity holdings. Such stocks should benefit from the hunt for yield in 2020 as global central banks keep monetary policy easy in an effort to prolong the expansion. Meanwhile, with global trade tensions likely to persist even if the US and China strike a deal in the near term, consumer-facing sectors should prove more resilient than firms reliant on business investment. In the US we prefer the consumer discretionary sector, and our least preferred global sectors include materials and information technology.

For more details, please see our "Year Ahead 2020" publication.

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