Tuesday 22 January 2019

Ross McEvoy: 'US heads for slowdown - but can avoid a recession'

Relations between the US and China remain a concern. Photo: Reuters
Relations between the US and China remain a concern. Photo: Reuters

Ross McEvoy

Last year saw a significant uptick in volatility as the synchronised global upswing stalled. Fears of a US slowdown, the escalation of trade tensions between the US and China, below-trend growth in China, political tension in Italy and Brexit tail risks combined to derail investor confidence. This has driven global equities more than 10pc lower during the final quarter of the year.

While there are pockets of weakness in the US, particularly in the housing sector, in general the concerns on Wall Street have yet to be reflected on Main Street, with both the US consumer and labour markets in good health.

One topic that has created a frenzy among market commentators over recent weeks is the potential inversion of the US yield curve, where long-term rates move below short-term rates. An inversion of the yield curve has historically been one of the best indicators of an impending recession, hence the intense interest in this development.

However, while market cycles are similar, they are rarely exactly the same, which is one of the reasons the Economic Cycle Research Institute falsely predicted a recession in 2011.

And even if the yield curve does invert over the next few months, this does not necessarily mean a recession is inevitable.

Importantly, the unemployment rate tends to bottom a year ahead of recession.

But labour market expectations indicate further tightening in 2019 and according to the latest manpower survey, employers are reporting the strongest hiring intentions in 12 years. In addition, the latest collapse in oil prices should underpin consumer spending into 2019.

The length of the current US expansion is also unnerving investors. At almost 10 years long it is close to the longest expansion in 75 years. But cycles don't tend to die of old age, rather they are often ended by central banks raising rates too quickly. This risk has somewhat receded as Federal Reserve chairman Jerome Powell reversed course by saying interest rates are just below neutral.

So, we expect a slowdown in 2019, not a recession, and believe US GDP growth of 2pc-plus is achievable.

One key risk for our 2019 thesis revolves around the ability of Chinese policy-makers to stabilise growth. Since mid-2018, the Chinese authorities have used targeted measures to kick-start investment in the private sector. These have yet to take hold and we expect something more significant if the economic data remains subdued or if Donald Trump imposes duties on all Chinese imports.

From a European perspective, we expect negotiations between the Italian government and the European Commission to reach a deal averting further contagion. On the interest rate front, it now seems unlikely Mario Draghi will raise rates before his tenure as ECB president ends in October. A potential pick-up in Chinese growth should also support export-driven countries like Germany.

Looking at political risks in 2019, some predict Trump's agenda will be crippled by a Democrat-controlled House of Representatives, with eventual impeachment a possibility. However, a split Congress has historically been supportive for equity markets.

In fact, the S&P 500 has always been positive in the 12 months following the mid-term elections going back to 1946. Globally, 2019 should see fewer political hazards with a number of elections in major emerging economies including Argentina, India and South Africa, but nothing major in developed economies.

But there is an increasing risk of snap elections in Spain and the UK.

A key focus will also be on the European Parliament elections in May and the appointment of a new EU Commission. The composition of the European Parliament will be crucial in preventing fragmentation during its five-year term.

Domestically, Brexit will dominate proceedings. 2018 has been a frustrating year for the Irish equity market with some areas pricing in a higher probability of a hard Brexit. The indiscriminate selling has pushed a large number of Irish companies to the cheapest valuations since 2011. The ISEQ has fallen 22pc year to date versus a 12pc decline for the broader European market. This weakness looks overdone, particularly for some names with minimal direct UK exposure.

Here we outline some companies where we view the investment case as compelling for investors as part of a diversified portfolio with a medium-term outlook. Distribution and business support services group DCC boasts a long track record of delivering shareholder value through mergers and acquisitions.

Following a recent share placing, we estimate DCC has the balance sheet capacity to deploy up to £1bn (€1.11bn) on M&A over the near term. Recent entry into the US and Hong Kong has opened numerous opportunities in large fragmented markets, providing the potential for DCC to replicate its expansion in Europe. This potential firepower, coupled with an increased emphasis on incremental organic opportunities, should offer defensive growth in an uncertain environment.

Smurfit Kappa is a global corrugated board and containerboard producer. Fears of global slowdown and over-capacity have led its share price more than 40pc lower since rejecting International Paper's bid during the summer.

During this period the stock de-rated from a valuation multiple of 8.3x EV/ebitda to 5.3x, a discount to the long-term average multiple of 6.3x. The stock should be underpinned by its dividend yield of 4.5pc (covered c3 times), low gearing and continued growth in the Americas.

The listed Irish house-builders of Cairn Homes and Glenveagh have fallen sharply in recent months in line with the UK house-builders. While we see supply peaking in the UK, the market conditions are different in Ireland with lack of supply a big issue. There is significant demand for housing, particularly starter homes.

The lack of supply has resulted in only 16pc of all houses in Ireland being owned by people aged below 39 and the level of indebtedness of the 25-34 age category in Ireland is among the lowest in Europe.

Competition for Cairn and Glenveagh remains fragmented and sub-scale with limited access to attractive credit terms.

Cairn highlighted in a recent investor presentation it can complete a scheme four times faster than the average builder and construction costs were 10.9pc less expensive.

Following the recent correction, global building materials group CRH is now trading on a PER of less than 13x, which is its lowest multiple in nine years. CRH is heavily leveraged to any potential recovery in European end-markets. The stock offers optionality on further M&A, a potential ramp-up in US infrastructure spend and a pricing recovery in Europe.

Majority State-owned AIB is dealing with the departures of its chief executive and chief financial officer, a slowdown in the Irish mortgage market and a de-rating in European banks.

However, we estimate the bank has excess capital of €2.5bn (25pc of the market capitalisation). AIB's capital ratios are among the strongest in Europe, hence we expect a dividend (4pc-plus) stream from a rising earnings distribution ratio, combined with potential special dividends and share buy-backs.

  • Ross McEvoy manages portfolios on behalf of high net worth individuals and corporates with Goodbody.

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