On 31 December billions of people across the globe said farewell to 2019 by watching the traditional new year’s fireworks. Just like these flares, equity markets reached sky high levels in 2019 too. Especially in the US, where equities touched all-time highs and the economy ran into the longest expansionary period on record. On a broader scale, many equity markets across the globe delivered very strong returns in 2019. What is the story behind these returns and can they persist in 2020?
2019 returns boosted by 2018 sell-off
We have to go back to the last months of 2018 to find the origins of the 2019 ride. During the last quarter of 2018, investors' risk appetite declined sharply due to a combination of weakening global growth and increasing trade war tensions. On top of that, investors perceived central banks' policies as too tight, given the deteriorating economic environment at that time. A big sell-off followed, pushing global equity markets down by no less than 15 per cent. In hindsight, this sharp correction set the base for equity markets to prosper in 2019.
As 2019 elapsed, each of the fears that triggered the 2018 sell-off faded. First central banks changed their tightening stance towards more supportive monetary policy. This induced equity markets to bounce back and offset the losses of the final quarter of 2018. Improving global growth numbers, although modest, continued to push equity markets upwards. Towards the end of 2019, equity markets rallied further on the back of a deal on Brexit and the agreement on the phase 1 trade deal between China and the US. By the time 2019 ended, global equity markets had achieved the strongest annual return since the start of the global financial crisis.
Equity markets: a breakdown
Equity returns have been quite impressive in 2019. Global equities delivered almost 28%, the best result since 2009. Although global performance was strong, regional returns differed markedly. The UK gained a decent 17%, but underperformed other developed markets. The high returns are however partly a function of the low starting point of the year after the 2018 sell-off move. Annualized returns in all regions are roughly 20% lower when including the 2018 risk-off period, with Japan even delivering a negative return.
Source: Aegon Asset Management, Bloomberg
Rising equity prices and falling interest rates
The question that follows is what caused equity markets to rally in 2019. Equity price increases can typically be explained by two factors. Either underlying corporate profits rise or are expected to rise, increasing shareholders' claim on company profits. Or interest rates fall, thereby increasing the discounted value of future profit claims. 2019 was certainly a story of the latter. With stale corporate profits in 2019 and a slowdown in global growth, expectations on earnings growth were low. Rather, both the Fed and the ECB cut rates and started to (further) increase their balance sheets, pushing global rates down and asset prices up. The course of the forward price to earnings (P/E) multiple shows how global equity prices inflated as 2019 progressed. As can be seen in the graph below, the forward P/E started the year below the 14x range. By the end of the year, it was close to the 18x range. This is the second largest multiple expansion of global equities since 1988 (2009 being the largest). As such, markets stabilized after the 2018 turmoil in response to central banks' rates cutting and the fading of uncertainty.
Note: BEst P/E is 50 day smoothened
Source: Aegon Asset Management, Bloomberg
Equity markets offer relative value
Moving into 2020, a significant pick-up in global economic growth seems unlikely. Consensus of global earnings growth lays around 20% for 2020, which is a high hurdle to outperform. At the same time, central banks of developed markets are expected to either further loosen monetary policy (US) or at least maintain loose policy (Eurozone, Japan). In contrast to developed markets, central banks in emerging markets currently employ a more restrictive monetary policy. The developing world is therefore expected to have more ammunition at its disposal to support asset prices should the slowdown in global growth accelerate.
Looking at the historically low yields in global bond markets, equities are still relatively attractive in terms of earnings yields. The earnings yield on global equities is around 5%, which compares favorably to the low yields on government and corporate bonds across the world. Apart from that, companies are typically able to increase earnings above inflation levels. It is therefore fair to add expected inflation to the earnings yield of equities. This would show that the relative attractiveness of equities is still above historical averages.
From a regional perspective, there is a clear distinction between developed markets and developing markets. The US, Europe and Japan all are trading around a P/E level of 20. P/E levels in emerging countries by contrast are trading significantly lower; more around the 16 P/E level. The question then remains to what extent developed markets and emerging markets will converge in terms of P/E valuation during 2020.