BY GEORGE HAY

Are global equities cheap yet? After two sharp corrections in February and October 2018, investors will be running their rules over stock-market valuations. They should be wary of falling victim to a value trap.

On one measure, U.S. equities still look eye-wateringly overpriced. Economist Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE, which smooths the S&P 500 Index PE ratio over the prior 10 years, is running above 30 times based on data for November 2018. That’s in line with where it stood 90 years ago as the Wall Street Crash commenced, and second only to the 40-odd multiple seen in 1999 to 2000 during the dot-com era.

That’s not the whole story, though. After declines in 2018, U.S. equities in the Russell 1000 trade at 15.4 times next year’s estimated earnings, roughly in line with their 10-year average, according to FTSE Russell as of early December. And the CAPE picture looks more reasonable applying the upward-sloping trend line since World War Two. Assuming reversion to that trend, S&P 500 earnings per share would only need to increase 10 percent in 2019 for the market to grow into its current valuation, FTSE Russell reckons.

That’s less than half the 24 percent profit growth U.S. companies are on track for in 2018, albeit with a boost from tax cuts, according to Refinitiv data. As of early December, analysts are forecasting S&P 500 earnings expansion of 8.4 percent in 2019. The danger, though, is that at this stage of the cycle they are routinely too optimistic. Revenue, which turns into earnings, usually lags nominal GDP — where growth could slow in 2019. Leading indicators like the U.S. ISM Manufacturing Index may be peaking, too.

What about everywhere else? Forward earnings multiples in Europe and emerging markets are also in line with 10-year averages, and their discounts to U.S. stock prices remain in place. Emerging markets are relatively more heavily exposed to banks and big technology groups, and they tend to suffer an outsized response when the U.S. lurches down — a risk given the hoariness of the U.S. economic recovery, uncertainty over interest rates and trade tensions.

In fact, only in the UK and Japan do stocks look relatively cheap on an expected earnings multiple basis, but they come with extra layers of cloud covering the outlook. In 2019 there could be plenty of falling knives, and a dearth of safe bets.

First published Dec. 11, 2018.

BY PETE SWEENEY

American executives who prayed for a trade war truce are a disappointed lot. Following the arrest of Huawei’s chief financial officer in Canada, they’ve been sent to the front lines.

President Donald Trump is focused on the trade deficit. But administration hawks also want to thwart Beijing’s “Made in China 2025” plan to build state-subsidised global champions in sectors like aviation, artificial intelligence, and communications. The 90-day tariff freeze Trump negotiated with Xi Jinping has only halted hostilities in one corner of a vast battlefield.

Meng Wanzhou could be the first big casualty of American extraterritorial force. The United States alleges the Huawei executive violated its sanctions on Iran. Whether she did or not, arresting the daughter of the telecommunications equipment maker’s iconic founder Ren Zhengfei fires a loud shot across China Inc’s bow. Ditto for the October extradition of a Chinese intelligence agent from Belgium to face U.S. industrial espionage charges.

China could retaliate. It has already detained Canadian ex-diplomat Michael Kovrig, according to Reuters; his employer, International Crisis Group, says it is seeking his release. Huawei’s American rival Cisco Systems told employees not to travel to the Middle Kingdom after Meng’s arrest, although it later backtracked. Reuters reported the U.S. State Department is considering warning citizens not to visit the People’s Republic.

That might be prudent. Because it can be difficult to succeed in China without cutting corners, U.S. executives who have done so — or looked the other way while local employees did — are vulnerable, and can be held responsible for their company’s sins. Economic forces might also generate inadvertent flare-ups. Detention is a semi-legal negotiation tactic in the People’s Republic, usually the result of business disagreements over cancelled orders or price changes. In the past, upset Chinese managers have held foreign representatives involuntarily inside offices or hotels until they concede. Police rarely intervene. Foreigners can also be banned from leaving China until a dispute is settled. Reports of such incidents rose sharply during the global financial crisis.

As rising costs, tariff threats and general anxiety cause U.S. companies like GoPro to move parts of their supply chains out of China, more detainments could ensue. Even legitimate arrests will feed conspiracy theories. The popular emotions such incidents unleash could easily undermine efforts for lasting peace.

First published Dec. 12, 2018.

BY JOHN FOLEY

Disappointment is coming for the clients of private equity firms. Companies which use debt and management wiles to take businesses private typically target an annual yield — the so-called internal rate of return — of at least 15 percent. It’s hard to see recent deals matching that. Instead of 15, investors should steel themselves for more like five.

For one, purchase prices are looking expensive. Deals struck in 2018 were at a median valuation of 13 times EBITDA, according to Refinitiv, compared with an average of 10 between 2010 and 2016. They’re getting bigger too. Blackstone’s purchase of a majority stake in the financial data business of Thomson Reuters — the parent company of Breakingviews — was the largest leveraged buyout since the financial crisis, worth $20 billion.

With generous debt, reasonable growth and a buoyant market in which to exit investments, that should be just fine. In a sign of what might be confidence, many buyout firms even include future cost-cuts in their measure of current profit when borrowing money from the debt market. The trouble is, it’s not likely the benign conditions will all hold for much longer.

Imagine a company taken private at 13 times its EBITDA of $1 billion, juiced up with $6.5 billion of debt, and held for five years. If its EBITDA grows at 6 percent a year, it will amass a total of $6 billion. Say a fifth of that goes to capital expenditure, in line with industrial norms according to CSIMarket, and just over one-third is eaten up by interest payments, leaving $2 billion after tax to pay down debt. If the private equity firm can sell the company at the same 13 times EBITDA, the fund would make a return of 15 percent a year, according to a Breakingviews calculator. That just about cuts the mustard.

What if things aren’t so buoyant? If valuations fall back to their historical average of 10 times EBITDA during that five years, and the growth in the company’s profit falls just slightly to 5 percent a year — which is hardly conservative — the annualized yield drops sharply, to 5 percent. Moreover, investors would still have to pay fees, cutting their returns further. An extra sting in an already unhappy tale.

First published Dec. 19, 2018.

BY RICHARD BEALES AND VINCENT FLASSEUR

Want to know whether there’s going to be a U.S. recession, a flare-up in the trade war, or a spate of corporate implosions? You could stay glued to the news and social media. Or, if you have better things to do, just stay focused on these three proxy indicators.

First, take soybeans. American farmers have been early victims of the escalating response to President Donald Trump’s import levies. When crops from other countries like Brazil are relatively more valuable, it suggests traders are more worried tariff barriers will persist.

Then there’s the U.S. yield curve. Different experts pick different comparisons, but in the past when the yield on 10-year Treasury bonds has dipped below the return on two-year government paper, a recession has followed. As 2018 draws to a close, the gap is once again very thin.

Third, corporate health. One hint at sentiment comes from indexes that track how many stocks in given markets are in bear territory, meaning they have fallen 20 percent or more in value from their peak prices in the last 12 months. About half are in that zone in developed markets and more in emerging economies. That might mean shares are cheap. Or it might signify negative sentiment and an accelerating slide in 2019.

BY LIAM PROUD

U.S. President Donald Trump has a knack for claiming credit for others’ achievements. In 2019, his use of trade tariffs to boost domestic manufacturing will look like it’s working. But technologies such as factory automation are going to be the real reason global companies will manufacture more products locally.

Trump’s tariffs on China and other trade partners like Europe are a headache for companies that ship goods between the world’s three major economic blocs. Manufacturers like carmakers and pharmaceutical groups built low-cost, cross-border supply chains in the 1990s and 2000s, during which time worldwide trade doubled as a share of global economic output. BMW and Daimler import more than half the vehicles they sell in America, but also export more than half the vehicles produced at their U.S. plants, according to Moody’s.

That’s changing. BMW, for example, is mulling making more SUVs in China rather than incurring levies by shipping them halfway across the world from its South Carolina plant. And medical supplier Philips said in October it was “rearranging” its supply chain to make more American and Chinese products locally to avoid higher U.S. and Chinese tariffs.

But trade wars are only the latest force braking global trade growth. Having peaked at almost one-third of world GDP in 2008, trade flows shrank to just over one-quarter of output in 2016, according to McKinsey. And while the volume of global trade in goods grew at more than twice the pace of real GDP between 1990 and 2010, both grew at roughly the same average rate between 2012 and 2017, World Trade Organization data shows.

The aftermath of the global financial crisis bears a chunk of the responsibility. But a more structural change is that the benefit of making goods in distant countries with low wages is falling as machines replace people. High-tech plants run by software are easier to re-tool to make different products according to demand or geopolitics. Meanwhile consumer goods companies like Inditex , the owner of “fast-fashion” brand Zara, can quickly boost supplies of popular designs by producing them close to customers. That trend should spread beyond retail as 3-D printing techniques allow manufacturers to build complex, customised products more quickly.

Companies will produce goods closer to customers in 2019. Given the trend has as much to do with the switch from humans to machines as trade wars, the workers that Trump claims to be helping may not reap as many benefits as he touts.

BY SWAHA PATTANAIK

What’s the biggest threat to global markets in the coming year? It’s not a rise in U.S. interest rates, or the end of the European Central Bank’s bond buying. Rather, it’s the Bank of Japan. Even small adjustments by Governor Haruhiko Kuroda to ultra-loose monetary policy could agitate global asset prices more than other, widely expected changes.

The BOJ already owns assets collectively worth more than the country’s entire GDP. Even so, it will keep growing its balance sheet after other major central banks have stopped. Any hints of a shift could alarm investors, whose assessments of risk and reward have been distorted by years of global central bank liquidity injections.

Reports in 2018 that the BOJ was debating scaling back stimulus triggered bond and currency volatility.

Kuroda is, in one sense, damned either way. Japan’s central bank is some distance from hitting its 2 percent inflation target. BOJ monetary policy is, however, aggravating the problems of regional banks. Roughly half of them have reported losses in the past two years or more on their lending business as the gap between what they pay for funding and what they get from making loans to customers has been squeezed.

If monetary policy risks doing more harm than good, the BOJ may be tempted to signal it’s willing to allow 10-year government bond yields to move in a wider range around zero or even raise short-term interest rates from minus 0.1 percent. Yields on Japanese government bonds would immediately jump. Nearly half are owned by the central bank and trading can be illiquid. Other markets will also feel the chill. Japanese investors have gone abroad to earn better returns, and will return if domestic yields rise enough. For example, Japanese investors bought about 4.7 trillion yen ($42 billion) of foreign currency bonds in September alone.

French and Spanish government debt, as well as U.S. credit, have proved popular relative to the size of the markets and could therefore face outsize hits. Currency hedging costs have risen so Japanese investors may bail out of overseas assets instead of paying for expensive protection. Those who have left their exposure unhedged to avoid paying for such insurance will be even quicker to do so.

Doubtless, U.S. Federal Reserve chief Jerome Powell, who is likely to keep raising rates throughout 2019, carries a big stick. But his actions are widely trailed already. That’s why Kuroda has the greater potential to jangle the market’s nerves.

First published Dec. 24, 2018.