Good investors do not evaluate companies in a vacuum.
As well as examining financial statements, they also take into account macroeconomic factors and variables when making the decision of whether or not to take a position in a stock. A key source of information here are economic reports issued by major financial institutions. In this two-part series, we will be looking at banking giant HSBC Holdings’ (HSBC, Financial) top 10 risks to markets in 2019.
Eurozone crisis 2.0
“If stimulus is needed, the Eurozone may have a problem in a year of (possibly disruptive) leadership changes. The political landscape is much changed since 2012, with populist views gaining more traction across Europe. Shaky economic foundations and political uncertainty would not be a healthy backdrop and could lead to renewed risks for the Eurozone.”
The context of Brexit and the major leadership changes HSBC is alluding to (the EU Commission, Council, Parliament and the European Central Bank are all changing hands in 2019) could cause major market uncertainty, especially if populist, tariff-happy parties perform well in the coming European elections. A more reactionary political environment could hamstring the ECB’s ability to respond effectively to an economic slowdown and the currency weakness that would accompany such market uncertainty. European equities would undoubtedly be affected, which could have a chilling effect on U.S. markets.
Trade tensions
“The post-G20 truce in China-U.S. trade tensions gave some relief to the market, as negotiations get underway. But the outcome of the trade conflict remains uncertain, and trade prospects are further clouded by WTO disputes and Brexit. An end of trade tensions could boost investor sentiment and would have a positive impact on growth expectations and on China in particular.”
We have covered the issue of the U.S.-China trade war in a previous article. Recent market volatility has reflected investor apprehension over the state of negotiations. If these were to break down, we would continue to see U.S. stocks decline. Any positive developments, however, would obviously be bullish for the market overall, and in particular for commodities. Expect mining stocks to do well as Chinese demand recovers.
Climate impact
“Extreme climate events are becoming more costly and more visible. Damage costs are impacting developed markets, not just emerging markets.”
Stocks will be affected in two ways by this. First, there are the direct impacts to equities from events such as the recent California wildfires and the 2017 hurricane season. But just the expectation of extreme weather events will drive insurance premiums up and will make credit comparatively harder to access, a point emphasised in HSBC’s report: “credit downgrades and spreads widening could happen if the market is more focused on extreme weather events.”
Falling U.S. corporate margins
“Profit margins have been the key drivers of U.S. earnings. Corporate profit margins are at an all-time high and consensus expects them to move up further. But rising costs, including wage growth, trade tariffs and financing cost could bring them down next year."
President Trump’s tax reforms supercharged U.S. equity earnings last year. However, the Street’s inflated earnings expectations are set up to disappoint if costs grow faster than anticipated. With the Federal Reserve hiking rates, borrowing costs are set to rise. This will make refinancing short-term debt harder. A worsening trade war would also bite. Most importantly, with unemployment at 3.7%, the lowest it has been in roughly half a century, accelerated wage growth could impact margins significantly. As the report notes, were net profit margins to fall back to their 10-year average of 9% (currently margins average around 11.7%), U.S. earnings per share would fall by 20%, which would have obvious negative implications for investors.
Emerging market reforms
“We remain broadly cautious on emerging markets going into 2019 given the tightening in financial conditions and enduring trade conflicts. But what if emerging markets start focusing on structural reforms to address their imbalances , boost productivity and improve efficiency?”
Weakness in the emerging markets will have a negative impact primarily on commodity-focused U.S. companies, as noted in the point on the trade war.Economic reforms in countries such as Argentina, Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey, however, could provide an unexpected boost to markets if properly implemented. Although this is a relatively minor point for U.S.-focused investors, individual companies that have strong link to these countries will be significantly affected by the success or failure of these reforms.
While some of the issues highlighted by the report may seem abstract and inapplicable to the average U.S. company, they do in fact have serious implications for financial performance. Savvy investors look outward as well as inward.
(This article was co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC and a former research analyst for Almington Capital Merchant Bankers.)
Disclosure: No positions.
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