Comeback Time for International Equities?
In our view, the biggest risk to investment markets in 2020 is stagflation—a combination of low economic growth and rising inflation. This business cycle has been characterized by low growth, but also—fortunately—low inflation and, therefore, low interest rates. This has been very supportive for growth stocks, as companies that have been able to grow their earnings during this period of scarce economic growth have benefited, not only from their higher earnings but also from higher valuations.
Potentially adding inflation into this mix changes the overall investment dynamic. Higher inflation would likely mean higher global interest rates, presenting a challenge to some parts of the equity market. In this scenario, companies that are not credit dependent, that have growth in their end markets, and that have pricing power, will likely fare relatively well. In other words, it is important to find those companies that have strong balance sheets, the ability to fund growth from internally generated cash, and customers whose purchase decisions do not require borrowing large sums of money.
What type of companies may do well in this environment? If we see greater wage inflation, it would likely support companies selling consumer staples or luxury goods—leisure providers and restaurants would also likely do well. If we see commodity price inflation, we would expect resource companies, as well as the industrial companies that provide capital equipment to them, to hold up very well.
We believe international equities—especially in emerging markets, the U.K. and Japan—present a particularly compelling opportunity. U.S. equities have had a fantastic run over the past 10 years, supported by healthy economic growth, strong earnings growth, a rising corporate profit share of GDP and falling corporate taxes. However, a number of the tailwinds seem likely to dissipate. For instance, it will be difficult to further reduce U.S. corporate taxes beyond the tax cuts implemented by President Trump in 2017, and the corporate profit share of GDP is unlikely to rise further without becoming an even bigger political issue than it is already. Because the U.S. equity market is broad and deep, there will almost always be opportunities—but in aggregate, we think international equity markets may be more compelling over the next year.
One prediction is that 2020 brings with it the re-emergence of wage inflation in the U.S. The current economic cycle is the longest in history, and U.S. unemployment stands at 3.6% today. Based on past cycles, U.S. hourly earnings should be rising around 4.5% per annum—but they are currently only rising by about 3.5%. The acceleration that we’ve seen in recent quarters, however, suggests more wage inflation is on the horizon.
There are two potential catalysts for this. The first is the global trade decline that we’ve seen in recent years. The prior period of global trade growth allowed cheaper labor markets to access the lucrative U.S. market via exports. The U.S. benefited from importing cheap goods, but in return saw an erosion of pricing power for its workers. We think declining global trade could cause some of that pricing power to return. The second catalyst is politics. Wages, income distribution and other forms of inequality look likely to become key issues for the 2020 election—and regardless of the election outcome, we believe there will be a continued political undertaking to help U.S. workers, which should lead to a wage inflation rise.
While rising wages would certainly present challenges in the equity market, companies with pricing power, strong labor relations and high employee satisfaction will likely be better positioned to withstand any resulting pressure.
WILL 2020 BRING THE RE-EMERGENCE OF WAGE INFLATION IN THE U.S.?
U.S. UNEMPLOYMENT AND HOURLY EARNINGS
Source: CPI Data. As of September 30, 2019.
This commentary is provided for informational purposes only and should not be construed as investment advice. The opinions or forecasts contained herein reflect the subjective judgments and assumptions of the investment professional and do not necessarily reflect the views of Barings, LLC, or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.