The Missing Peace
Not only have the odds of a resolution to the trade war diminished over the past 48 hours, but the White House appears to have opened up new fronts against Brazil, Argentina and France. The equity market has (quite rightly) concluded that this raises the prospect for December’s tariffs to go ahead. Moreover, it has probably undermined hope that the previously imposed tariffs are rolled back. While the price action has been negative for risk assets, it has been modest so far in the context of the consensus belief that a phase one deal was imminent and that a re-acceleration in global growth was underway. The longer the dispute is permitted to fester, the greater the probability that corporate confidence, hiring, investment and profits are impacted. In that context, an above-average equity valuation multiple is probably vulnerable to de-rating and a deterioration in risk perceptions.
On the positive side, with most policymakers in easing mode and the threshold for policy tightening high, liquidity conditions ought to be positive for global equities in 2020. Of course, the recent rally in equities has also been prefaced on the belief that a re-acceleration in global growth is underway. While some of the indicators are mixed, most notably the US manufacturing ISM, a range of global data is probably consistent with the re-acceleration prevailing bias. For example, the year on year change in spot oil prices is consistent with a recovery in US ISM manufacturing new orders. On the assumption that the bias is correct and notwithstanding the risk of further tariffs noted above, cyclical sectors in emerging markets (and globally) are compelling in valuation terms. As we noted in our recent series of non-predictions for 2020, a basket of EM cyclical sectors (industrials, materials, energy and financials) trades at 1.2 times book value, 6 times cash flow and a 68% discount to US equities.
Similarly, the MSCI World Energy sector appears inexpensive on a range of valuation measures. MSCI World energy trades at a 6.2% free cash flow yield (a 42% yield premium to world equities). The free cash flow yield is near a record high and comfortably covers the dividend yield at a time when sovereign bond yields trade near a record low. European energy companies have a negative implied cash flow return on investment. That is probably too pessimistic even in the context of the secular risks to supply (substitution) and demand (decline in oil intensity). Another positive development for the major European energy companies is that capital spending to sales is at a ten year low and net debt to EBITDA has decreased to 2013 levels (when oil was trading above $100). The energy sector has the second-lowest leverage of all sectors in Europe. The valuation and leverage metrics for the US energy majors are at similar extremes compared to the US market.
One tactical risk to a long position in world energy equities is a failure of global growth (demand) to re-accelerate. While the physical markets are broadly balanced today, the risk of potential oversupply looms in 2020 in the absence of a strong recovery in demand. According to most industry analysts, Non-OPEC supply appears likely to expand significantly faster than global demand next year. That would likely put further pressure on the Cartel’s market share which has been in decline for several years. Looking forward, either OPEC plus Russia will implement deeper cuts to balance the market or prices fall to slow the growth in US shale production. The good news is that the relative performance of MSCI World Energy to Global Equities is probably already consistent with a lower spot price and mid-cycle (3 year forward) oil price.
In conclusion, cyclical sectors of the global and emerging markets are attractive in valuation terms, particularly energy. However, the conditional element of valuation – cash flows – might remain challenged if the anticipated re-acceleration in global demand disappoints in 2020. Put another way, that valuation anomaly has persisted for some time and there are some genuine secular or structural challenges to the sector over the medium term. Of course, it is important not to make secular arguments to justify cyclical positions.
