With the US moving into the later stages of the business cycle, the US Federal Reserve raising interest rates, and monetary and credit conditions diverging widely across the other major global economies, the potential for renewed volatility in both equity and fixed income markets remains high.
Over the shorter term, global investors may need to buckle up, as political, monetary, and trade uncertainty could generate more of the sudden spikes in market volatility seen in 2018.
While volatility creates risks, it also yields select opportunities. Going into 2019, we predict that disruptions in various forms – technological, political economic, and monetary – is likely to determine the direction of global financial markets. Correctly identifying the winners and losers in this era of significant change will be key to investment outperformance.
The current disruptive environment will allow active investors to be well-positioned over the next decade. High-quality active managers can benefit from having a long-term horizon, which allows them to make the kind of investments that potentially will add value. As an active investment manager, we have drawn on our research and identified several disruptive forces that we believe will shape the investment landscape in 2019, including slowing global growth momentum, late US rate cycle, monetary policy divergence, geopolitical events, bifurcating global equity valuations, and a disruptive force to highlight among all – secular challenges.
Secular Challenges as a Disruptive Force
Disruption is pushing valuations for the winners and the losers in sharply opposite directions. Although many investors equate disruption with the major technology platform companies, the effects also are being felt in a host of other sectors and industries. Energy markets, for example, are being disrupted by the crosscurrents of shale fracking and the increased competitiveness of solar and wind.
Our research suggests that about 31 per cent of S&P 500 market capitalization – and up to 35 per cent of S&P revenue – is being impacted by some level of secular challenge. Traditional mean-reversion investing will likely be less successful than in the past, and value investors will face a difficult challenge as the universe becomes predominantly economically cyclical stocks and secularly challenged stocks.
Challenged companies are likely to experience slower revenue and earnings growth over the next 10 years than they did in the previous decade. When companies become secularly challenged, we normally see multiples compress even more than earnings growth. This can potentially create value traps.
Companies free of secular risk are likely to trade at higher valuations than they have in the past. Active investors who can identify these opportunities and underweight secularly challenged companies are therefore more likely to achieve investing success than index investors.
On the other hand, structural change may have made aggregate EM equity valuations more attractive. As of the end of third quarter 2018, technology accounted for 27 per cent of the MSCI Emerging Markets Index, up from virtually nothing 10 years ago. This reflects not only the growth of China’s own technology giants, but also the rise of other high‑value EM industries based on intellectual property. This brings strong growth potential and an opportunity set that is widening and deepening.
Disruption Could Yield Opportunities
Although the odds of a downturn appear above average given where we are in the economic cycle, we believe a global recession is a relatively low risk in 2019. But in the meantime, technological innovation and competitive challenges will continue to threaten established leaders in a host of global industries.
In this less supportive environment, markets have begun to punish bad behavior, taking aim at overleveraged companies and antiquated business models. As a result, security‑specific risks are becoming increasingly critical. But these same risks also can generate potential opportunities for active investors to buy attractive assets at temporarily depressed prices. In‑depth research and solid fundamental analysis are vital.
David Giroux, Chief Investment Officer, U.S. Equity and Multi-Asset, T. Rowe Price
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