Written by: Paul Quinsee
Themes and implications from the Global Equities Investors Quarterly
- Our investors are cautious of rising U.S. interest rates and economic and profits cycles that are long by historical standards, but we still expect profits growth to support markets next year.
- Many of us see opportunities in out-of-favor areas including emerging markets and Europe, and in terms of sectors many portfolio managers continue to like financials.
- The case for value stocks is building relative to growth after significant underperformance, but this may well prove to be a relative rather than absolute opportunity; we don’t yet see a compelling case for moving into value.
- Near term, trade tensions continue to pose the greatest risk to our outlook; we are also more cautious on U.S. growth stocks after recent outperformance and some signs of frothiness. Longer term, rising interest rates and high levels of U.S. corporate debt will constrain the stock buybacks that have been a critical driver of the bull market, but that’s not an issue just yet.
In our last Global Equity Views, three months ago, we suggested that the gap in returns between a strong U.S. stock market and weakening markets across the rest of the world was likely to narrow as international markets caught up. The opposite has happened so far. U.S. stocks enjoyed a terrific third quarter—the S&P 500 hit new record highs—while equities elsewhere struggled and emerging markets were especially soft. The long dominance of the growth style over value also continued to play out in global stock markets, with technology and internet commerce stocks especially favored by U.S. investors.
Why? Several forces are in play. First, sustained strength in the U.S. economy and corporate profits; the second-quarter earnings season was one of the strongest we can recall, and all the more impressive when we remember that we are a long way into this cycle and profits have already been growing nicely for several years. Second, the pressure exerted by a robust U.S. economy on the rest of the world via higher U.S. interest rates and a stronger dollar, which is always a sign of trouble in emerging markets. And finally, a growing list of political issues for investors to fret over (fights over trade and tariffs, the Italian budget, and, of course, Brexit) that weigh more on international markets and value stocks; these concerns encourage money to keep flowing into tested market leaders, where profits growth appears unassailable.
Looking ahead, overall our equity investors have become a little more cautious as U.S. rates march higher and the economic and profits cycles are already very long by past standards. We still think that investors should be adding to out-of-favor areas of the world’s equity markets rather than chasing the winners ever higher; the weakness in markets in early October may well be a sign that the momentum trade is ending. We continue to see sufficient growth in profits to keep markets going in the face of higher interest rates, and after the latest setback, valuations in many places look quite attractive.
Despite worries over interest rates and trade, our work suggests that profitability remains pretty healthy across the equity world, and we see further gains in profits next year. Earnings in the U.S. are very impressive, and although growth should cool next year as the impact of tax cuts fades, the business cycle seems in good health and standing up well to the gentle rise in interest rates so far.
From a regional perspective, U.S. stocks have led strongly this year, with Japan not far behind; Europe has been dull and emerging markets quite weak. On a style basis, growth has led value, and by industry, health care stocks have joined technology (EXHIBIT 1) at the top of the leaders list, with more cyclical industrial sectors falling far behind.
EXHIBIT 2 presents a snapshot of our outlook.
We continue to believe that emerging market (EM) equities offer a level of opportunity that justifies the risk, despite the poor performance so far this year. These markets have reacted rather severely to a harsher environment, and risk aversion has been the dominant theme; apart from low risk, the returns to all the other nine style factors that we analyze in emerging markets have been negative this year. This degree of pessimism is unlikely to persist. Meanwhile, our fundamental analysis (the RIGOUR system) suggests that stocks are now priced to provide above-average returns, if not quite at the levels we have seen in the depths of past crises. We identify beaten-down opportunities in Chinese growth stocks (how differently they have performed from their U.S. peers!), and Brazilian equities and many financial stocks are also worth consideration.
Related: Factor Views 4Q18
European equities have once again disappointed. Our European portfolio team recognizes that, aside from the obvious endless political uncertainties, a lack of dynamism in the European corporate sector leaves many problems unaddressed. This has contributed to the long-term underperformance of profits and stock prices in the region when compared with the U.S. or much of Asia. However, there is a price for everything, and European stocks do look very out of favor again, while in the near term earnings are growing at a decent rate. Some of the most cyclically exposed companies look very cheap—for example, automobile manufacturers—while the higher quality banks, harshly treated by the market, also look interesting.
Indeed, financial stocks continue to appear attractive to many of our investors. Our U.S.-based value team has long found good opportunities in this sector, and the industry now seems well positioned, with profits rising and capital return to shareholders in full swing. Outside the U.S., the outlook is less convincing, but we find plenty of good long-term growth prospects in the better developing market financial companies. As mentioned, there is also real value in European banks for those who can do the research to avoid the value traps.
As the spread between value and growth stocks continues to widen, it is very tempting to make the call that clients should be buying value. There are a couple of caveats, however. First, as our value managers themselves point out, the returns from the style have been weak only in a relative sense. After all, the Russell 1000 Value index has compounded a 9% annual return over the past five years. And there are some rather significant structural issues facing many industries that represent important weightings in value indices—for example, the long struggle of energy companies to realize economic returns on their enormous capital spending. The message of historically very wide discounts on value stocks vs. the broader market is one too strong to ignore, but investors should probably not expect any dramatic returns in the near term.
U.S. growth stocks were on a tear until the recent bout of weakness in October. As prices have risen and some of the classic warning signs of excess have begun to bubble up (a strong pipeline of IPOs with no current earnings, the dominance of price momentum as a factor in the marketplace and, of course, some rather spicy valuations), our portfolio managers have become more conservative. We would argue that comparisons of the current situation with the 1999 bubble in growth stocks are overdone; the businesses these days are far stronger and also much less overpriced. But the outperformance of U.S. growth may well have gone on long enough, and at this stage we recommend some caution toward the most popular growth stocks.
We also suggest that investors take note of high levels of debt building up in many parts of the U.S. corporate sector. Financial services companies (under the force of the regulators) and cash-rich technology companies are the notable exceptions, but elsewhere debt has accumulated steadily as firms have borrowed at very low interest rates to repurchase shares. We think there is nothing to worry about for now, but when a harsher economic environment appears and interest rates have moved higher, some companies will find themselves in an uncomfortable position.
Finally, we keep trade and tariffs on our list of risks for equity investors. The issue is tough to analyze and even tougher to forecast, but there is no doubt in our minds that the boom in world trade over the past 30 years has had a disproportionately positive impact on the corporate sector and is a key support for historically high levels of profitability. Since a partial reversal will have a much more acute impact on company profits than on overall economic growth, we have to watch this one closely.
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