Despite trade concerns, value in international equities still on the horizon
Sept. 18, 2018
In an August 2018 survey of global fund managers, 57% ranked a possible trade war as the biggest tail risk facing equity markets1. Yet with the bull market continuing its run, it’s difficult to argue that trade concerns have been negatively affecting stocks, even with higher tariffs one of the areas that we are closely watching.
As value equity managers who select stocks based on individual valuations and appreciation potential, we don’t engage in explicit economic forecasts. But macroeconomic analysis is factored into our decisions, and to that end, we are mindful that risks such as tariffs and potential trade wars, rising interest rates, or simply the duration of the bull market could result in an economic slowdown. Nonetheless, we believe that adversity creates opportunity and that there will be stocks that could potentially outperform in any market.
Tariffs and their possible wide-ranging effects
If we define “trade war” as an increase in tariffs — which have been either imposed or threatened by the United States and a number of countries and regions — then the results could be anything from mild to catastrophic, depending on the duration and severity of the tariff implementation.
Tariffs represent an additional cost to consumers, and basic economics tell us that when prices go up, consumers reduce their consumption. Rising commodity costs will affect any production using those commodities. For instance, tariffs on steel will drive up the price on any goods that are made with steel. Likewise, tariffs on individual products will lead to a slowdown in that sector. Currently, the automobile sector is facing rising costs in commodities and imported parts. In the case of autos, the finished goods also can have a tariff attached to them, raising the price even more.
While the purpose of tariffs may ostensibly be to protect jobs domestically, they often can have the opposite effect. For instance, the biggest exporter of autos in the US is BMW, exporting from its Spartanburg, South Carolina, plant. If tariffs make production prohibitively expensive, however, a company may shift jobs abroad to a more tariff-friendly geography. This is the phenomenon that we are already seeing with motorcycle manufacturer Harley-Davidson.
There is a risk that these types of changes could become permanent. For example, China imposed a 25% tariff on US-grown soybeans in April, which has hurt American farmers with plunging prices. But if it serves to drive up the cost of the beans for the Chinese, they could react by simply shifting soybean purchases to areas such as South America.
Higher rates and what they could mean for sectors
We are also monitoring the rise in interest rates, not only at a macro level but also for what they could mean for international value equities. We see rising rates offering the potential for both benefits and challenges for our portfolio, depending on the sector. For example, banks could appreciate if interest rates rise, as their net interest margin (NIM) widens. Higher rates allow the banks to charge more for loans, and while the cost of deposits will also rise, it is unlikely that they will go up as much as lending rates.
On the other hand, certain sectors could suffer. Highly levered areas, such as utility companies or real estate investment trusts (REITs), could face challenges, as their cost of variable debt goes up. Likewise, companies that pay a large dividend could sell off, as their dividends aren’t as valuable in a high-interest rate environment as in a low one.
A bull market nearly a decade old
In US equities, we are almost 10 years into the bull market, and valuations are well above traditional levels. Thus, it becomes increasingly difficult for companies to outperform expectations, which are built into the price of the stock (if we assume that the market acts as a discounting mechanism). Likewise, the cause of earnings strength contributes to the stock’s performance. A stock that “beats numbers” on the back of currency effects or tax rates isn’t viewed as favorably, we believe, as one that beats on organic measures, such as revenue growth from increased demand. As an international value strategy manager, however, we look for those stocks that still have fundamental upside but may have been left behind in the market’s run.
We believe that there is value to be found in international stocks, particularly since the gap between US and developed market valuations has widened greatly, in our observation. A strong US dollar would be considered a positive for international companies, since their goods become less expensive to US consumers.
While it’s possible that forces such as trade concerns and rising rates may indeed rein in the bull market at some point, we continue to focus on areas of opportunity, especially those that may be offered in international equities.
1Source: Bank of America Merrill Lynch monthly Fund Manager Survey, August 2018.
The views expressed represent the Manager's assessment of the market environment as of September 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Diversification may not protect against market risk.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.