The resilient growth businesses that deserve higher valuations.

Many of the world’s major sharemarkets ended 2019 around record highs. Whether stocks can reach new peaks in 2020 is likely to hinge on two macroeconomic considerations:

1. the trade conflict between the US and China,
2. the likely direction of long-term interest rates.

In the China-US trade tussle it is important to separate the long term from the short term. The tensions between the world’s superpower and the usurper have weighed on the global economy from a sentiment perspective but also from a practical one, and is harming both sides. 

US manufacturing indicators have been negative since August and China’s were weak throughout 2019. Given this, there is a distinct probability of a short-term truce because neither country wants tariffs to derail its economy. 

Of the provisos on an imminent truce, the first is that such an outcome is subject to the currents of the US presidential election. It might, for example, be politically expedient for President Donald Trump to act aggressively towards Beijing to highlight the perceived softness of the Democrats on China. The other proviso is that China is better positioned to take a longer-term view – to “wait Trump out” – in the hope his successor will be less hardline. 

The fundamental issues, however, are strategic in nature and unlikely to be resolved soon because China’s economic rise and the associated military and soft power that brings are unlikely to be curtailed. The perceived risk this brings for the US and its allies has brought about the increased protectionism and nationalism seen in recent years.

The tensions between China and the US symbiotically needing each other in the short term, and the need to realign the nature of the relationship over the long term, are likely to weigh on sentiment in coming months until, most likely, a truce is reached that lasts until the US elections in November. 

As for interest rates, their importance for stocks was shown again in 2019 when the US Federal Reserve’s signal in January of an about-turn in monetary policy drove share prices to record highs over the year. This shift in market expectations from rate increases and quantitative tightening to lower rates played out when the Fed repeatedly cut the cash rate over 2019 to largely protect the US economy from the uncertainties created by the trade war with China. 

The Fed’s rate cuts helped extend the multi-decade decline in long-term bond rates that is tied to structural factors such as ageing populations and the deflationary impacts of technology advances.

Likely outcomes

In the context of the elevated prices on sharemarkets today, there are three scenarios centred on interest rates in play as we enter 2020. 

The first is a status-quo scenario, where the Fed cuts rates modestly as seen over 2019. Asset prices in this scenario might not change materially but the implications for stocks differ according to their growth and quality characteristics, as well as sensitivity to interest rates. Banks that rely on the shape of the yield curve, for example, would be challenged in such a scenario, whereas defensive assets would be resilient and growth assets advantaged. 

A second scenario is a shock to growth that would require the Fed to ease aggressively. The market impact of this is uncertain, however, as it skews to the downside the more a collective view takes hold that a severe economic slump is likely. 

The final scenario is the small risk that inflation re-emerges. The still-expanding US economy, a jobless rate at a 50-year low and the Fed’s proposed “make-up” strategy where inflation would be allowed to remain above its 2 per cent target, could push inflation to levels that warrant an aggressive response from the Fed. 

This is the largest risk to markets, in our view, going into 2020. In this scenario, a significant slump in stock prices is not inconceivable. 

The most likely scenario is that interest rates will be lower for longer, which has important implications for global equities valuations. 

All else being equal, lower interest rates imply higher stock valuations, as happened over 2019. Yet at the same time, lower rates reflect a broad slowdown in economic growth, proportionately lower forecast cash flows and, in fact, no net elevation in valuations. 

But while it is a mistake to inflate all valuations with lower rates, it is equally important to determine which businesses deserve higher valuations coincident with lower rates. These are the companies that enjoy resilient and growing cash flows thanks to structural competitive advantages. These are the businesses that will drive the performance of global markets in 2020. 

Structural growth can be driven by:

• Significant technology shifts such as cloud computing, an addressable market of up to US$1 trillion dominated by the hyperscale players Google, Microsoft and Amazon. 
• E-commerce growing from its current five per cent of retail sales.
• The shift in advertising towards digital channels and, in particular, on-demand video.
• Digital payments growth. 
• Demographics such as the doubling of the Chinese middle-class from 300 million to 600 million in the next five to 10 years. 

Companies such as Amazon, Facebook, Visa, Starbucks and LVMH stand to benefit from these tailwinds. The key feature of this growth is that it is agnostic to economic circumstances or inflation rates. Another well-positioned company is Alibaba because it taps into the consumption growth opportunities in China as well as those in cloud computing, payments and digitalisation. 

A structural advantage matters given the uncertainties surrounding stocks. It provides confidence a company will not succumb to disruption threats; it helps determine which businesses will be positioned to benefit from these tailwinds identified; and in the context of lower rates, provides conviction in the predictability of the cash flows a business will generate and therefore what it is worth. 

The Magellan portfolios are designed to hold such quality companies so they are positioned to navigate the uncertainties, known or otherwise, hovering over 2020.

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