February 2019 was another positive month for global equities. So far this year, the main indices are up by around 11-12%, with rises across the board almost wiping out the correction that took hold at the end of 2018. And although investors were actively underexposed to equities in the end-2018 downturn, this is still the case.
We can also say that the fever pitch reached in December 2018 in terms of the political risks threatening economic activity and global trade is now behind us. The possibility of gaining some time (Brexit and US-China trade negotiations) and the more accommodative central banks are bolstering the markets. The issue now is whether there is a risk of underexposed investors being encouraged to return to the market because of its positive performance.
In our view, this risk is low: the easing of geopolitical tensions has already been factored in by the market; the 2018 results season has confirmed the deterioration in growth expectations and has yet to be incorporated into the consensus; and lastly, the macroeconomic conditions are unlikely to improve before the start of the third quarter.
After a record high reached in early 2018, followed by a 25% drop, it is worth looking at the case of the automotive sector as a general illustration of how the markets are performing. An alignment of the planets drove the sector until the start of 2018. From a low point at the start of 2009, the automotive sector has enjoyed growth of close to 12% per year, supported by improving profitability thanks to favourable lending conditions, falling costs, underinvestment and positive currency effects favouring European manufacturers. The improvement in lending conditions on the back of the accommodative monetary policies of the central banks boosted the automotive industry’s pricing power by 2-3%. This effect, coupled with low inflation, enabled the automotive sector to expand its profitability to record levels.
The turning point came in 2018, with one of the sharpest falls since the financial crisis: -20%.
The performance of European vehicle manufacturers was hit both by the threat of a trade war (risk of a tariff hike of between 2.5% and 25% on European exports to the USA, with the potential impact on German manufacturers’ earnings estimated at €1.7-2.5 billion), and by the introduction of the new WLTP emissions tests. The new regulations impose a CO2 emissions target of 95 g/km in 2021, and then 75 g/km in 2025/30, and carry a fine for non-compliance of €95 per additional gram of CO2. Meanwhile, a combination of factors is weighing on the automotive industry: the slowdown in China, shrinking margins and cash flow (which in some cases will no longer cover dividends), and the biggest challenge of all, the structural transition to electric vehicles.
Since the bottom reached in early 2019, the European automotive sector has fully participated in the market rebound, outperforming the global index by almost 3%. Attractive valuations and, in general, above-consensus 2018 results have supported the recovery, although the announcements were accompanied by some rather nuanced comments. Sector firms are anticipating an uncertain and volatile environment in 2019. As such, the strong pricing power of the top-end manufacturers makes them better placed than mass market players, whose financing margins have already begun to decline, suggesting that they will be less able to move on prices. A highly selective approach will therefore be essential given the structural challenges, the partnerships announced for electric vehicles and possible sector consolidation.
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