What equities might have left to give in 2018
August 21, 2018
So far in 2018, equities have seen more turbulence than in recent years, including a sharp volatility spike in February. But in general, bulls have continued to hold sway in global stock markets. Trade wars, rising interest rates, and resulting uncertainty about global growth trends have left investors wondering about economic effects, and whether a historically long bull market is poised to finally wind down, or ramp back up. Below, several of our portfolio managers provide short takes on what might portend for equity markets in late 2018.
Expecting continued strength, but trade presents potential headwinds
Christopher S. Beck; Kent P. Madden – Small/Mid-Cap Value Equity / Philadelphia
We expect economic strength to continue into the latter half of 2018 as the positive impact of tax reform in the United States continues to filter through the economy. Signals such as strong job growth, which on average has been higher in 2018 than in 2016 or 2017, and low unemployment* have been a boon to economic strength.
We believe that this demand strength may continue in the near term. However, certain pockets of uncertainty could lead to growth trends that are more subdued than what we are currently experiencing.
Tariffs and/or a trade war represent potential headwinds to the economy. We have already seen increases in input costs, such as steel, affect earnings of manufacturing companies. While these companies are doing their best to pass along these costs by raising prices, there is often a lag that can affect profit in the near term. Additional tariffs imposed by the US, or by other countries on US exports, all have the potential to disrupt earnings growth. While a trade war would not be ideal, small-cap companies have less exposure in aggregate to international markets and should be less exposed than their larger-cap peers if tariffs should increase.
Another area we are watching is wage growth. While average hourly pay has been rising very slowly (it increased at an annual 2.7% rate in July, the same pace as in May and June, according to the US Bureau of Labor Statistics), wages nonetheless have been going up. Rising wages have affected profitability in certain labor-intensive industries, such as restaurants and trucking. While we believe that most companies will eventually be successful in passing pricing through to customers, this is representative of the modest uptick in core inflation that we have seen recently. We believe that the US Federal Reserve will react prudently to this inflation change by raising rates. Overall, we are cautiously optimistic that the aforementioned headwinds will not derail economic growth in the near term.
*US unemployment rate reported at 3.9%. Source: US Bureau of Labor Statistics, Aug. 3, 2018.
US job growth, monthly average rate
Source: US Bureau of Labor Statistics; 2018 figure is through June.
This year has seen the fastest rate of job growth since 2015.
Fundamentals matter, and they are driving the market
Alex Ely – Small/Mid-Cap Growth Equity / New York
Both within the US and worldwide, the cycle continues to take hold. It appears that the pendulum swing from fear to confidence has begun in earnest. After a lost decade of growth during which macroeconomic issues dominated the equity markets, we are now seeing fundamental strength matter more and more. We’ve tried to balance our optimism, but if anything, we feel we haven’t been optimistic enough. The trends we are invested in are large in scope and are gaining momentum. Enormous markets such as food, content, transportation, and banking are being completely transformed. We expect the fundamental and economic strength to continue in 2018. We believe that tax reform will likely help strengthen the overall momentum in the equity markets and the economy.
The markets, in general, have rebounded from the correction that occurred earlier in the year and are nearing old highs. Year to date, small- and mid-cap companies have outperformed the larger-cap indices due to concerns over global trade’s impact on multinational companies. We expect returns will be more in line for the remainder of the year, as trade worries should be baked in at this point.
Russell 2000 versus S&P 500 year-to-date, weekly observations
Source: S&P Dow Jones Indices and FTSE Russell, both via the Federal Reserve Bank of St. Louis. Data shown through Aug. 10, 2018.
The Russell 2000 Index, representing small-cap stocks, has outperformed the S&P 500 Index as 2018 has progressed.
We believe the consumer is in a good position to take advantage of the opportunity presented by greater growth. Unemployment is low, wage growth continues to strengthen, and credit scores are high. These statistics are key. When people have confidence in keeping their jobs or their abilities to get new ones, purchase activity remains solid. Also, because of the retrenchment of consumer debt over the past decade, debt-service levels are historically low. As banks become more willing to lend again, we should see consumers take advantage.
We monitor for basic risks such as global trade wars or an overly aggressive Fed, but what we believe will likely end this run is inflation. All the stimulus from both monetary and fiscal resources should eventually cause prices and yields to rise and bring about change in the constructive economic conditions we have today. We don’t think this threat will happen soon. Rates are still historically low in the US, and many foreign countries have bond yields near zero. Therefore, we feel an end to this expansion is far off. While corrections can happen at any time, we do not think we are nearing a recession or a bear market. In this environment, growth-oriented companies should do well.
Valuations have retreated from ‘nosebleed territory’
Sharon Hill – Equity Quantitative Research / Philadelphia
At the start of 2018, among the biggest concerns about equity markets were outsized valuations. This was especially true in the US, where forward price-to-earnings (P/E) ratios had exceeded levels not seen since the technology, media, and telecommunications (TMT) bubble. Investors were concerned that the market appreciation enjoyed since the global financial crisis was fueled primarily by valuation expansion, a source of return that is generally ephemeral. However, continued strong earnings growth, and a brief market correction in February, has taken the market to a valuation level more in line with history. Equity markets are still not cheap, but they are no longer in the “nosebleed territory” of late 2017.
In the chart below, we show the distribution of P/E across the past 60 quarters, with breakpoints drawn at the 25th, 50th, and 75th percentiles for the Russell 1000® Index (US), MSCI EAFE Index (developed markets), MSCI Emerging Markets Index (emerging markets), and MSCI ACWI Index (global). Note that developed and emerging markets are valued at about median levels relative to their trailing history. The US is at about the 75th percentile, but this level is far lower than the reading as of the end of 2017, which was above the 95th percentile.
Valuation distribution among equity markets
Sources: Russell 1000 Index (US), MSCI EAFE Index (developed markets), MSCI Emerging Markets Index (emerging markets), and MSCI ACWI Index (global).
The bars show a distribution of valuation ranging from the 5th through the 95th percentiles of P/E for the next 12 months, with breakpoints at the median, 25th, and 75th percentiles. Quarterly observations over the last 15 years.
A decomposition of stock market return, using the S&P 500® Index as a proxy, can provide additional insight into recent market dynamics. In the table below, we break down the annualized return of the S&P 500 Index into three primary components: income (which represents the effect of dividends), earnings growth, and the remainder, valuation expansion.
From early 2009 through the end of 2017, the market’s total return was about 18.2% per annum, with 2.5% of this due to income. The remainder of the return was split between 8.3% of earnings growth and 7.4% valuation expansion. Almost 40% of total return was due to valuation expansion, significantly more of a share than we have seen over the long term, and more than we would expect based on fundamental principles. (Source: Bloomberg.) Looking at this same metric over the first half of 2018, the decomposition is quite different. Earnings growth has been exceptionally strong, almost 18% on an annualized basis. Valuations have compressed more than 14%, leaving a net (annualized) total return of 5.4%. This valuation compression is a welcome occurrence, alleviating fears about stocks being priced to perfection.
Annualized return decomposition of S&P 500 Index
||31 Jan 1990 to 29 Jan 2018
||27 Feb 2009 to 29 Dec 2017
||29 Dec 2017 to 29 Jun 2018
|| 2.0 %
|| 6.3 %
|| 8.3 %
|| 1.5 %
|| 7.4 %
|| 5.4 %
While investors still have plenty to fret over, such as a possible trade war, midterm elections in the US, or mounting uncertainty about how Britain will exit the European Union, valuation concerns can now move lower on the list of worries.
With global growth disappointing, looking to fiscal stimulus
Stefan Löwenthal – Multi-Asset Solutions / Vienna
As global growth outside the US was disappointing in the first half of 2018, we expect fiscal policy to take over as the main policy stimulant in the medium term. The US has already engaged in significant fiscal stimulus as a result of tax reform, so it is not surprising to us that US growth and assets have continued an upward trajectory despite ongoing monetary tightening.
Although, historically, monetary tightening and associated yield curve inversion have often been used as an indicator for predicting economic slowdowns, we note that even after the 2018 rate hikes, US financial conditions remain loose. Despite ongoing Federal Reserve tightening, the US policy rate remains far below a rate currently implied by the Taylor rule (the guideline for central banks to adjust rates in response to changing economic conditions). In fact, using this common measure, the US is below its implied rate by exactly as much as the European Central Bank (ECB) is behind a Taylor rule-based rate for the euro zone.
As such, we do not think that monetary policy with the current pace will lead to meaningful economic slowdown. Recent events in Italy highlighted that the underlying pressure from voters for easier fiscal policy is particularly acute within the euro area. We believe that the potential for more fiscal stimulus (that follows the US path) will represent an ongoing inflation risk, particularly against a backdrop of closed output gaps.
Because we expect rates to rise as a reaction to rising inflation expectations, this might ultimately lead to higher input prices for companies (including higher wage costs), thus decreasing profit margins compared to recent years. We see signs that the multidecade disinflationary trend is coming to an end, which in turn will make it very challenging for static multi-asset portfolios to generate positive real returns, which has been the case in previous periods of higher inflation. However, we still expect equities to outperform fixed income assets, albeit by a much narrower margin.
International and emerging markets stocks lagged their US peers again in the first half of 2018. While growth was solid in these economies, the US growth momentum was much stronger recently. In addition, uncertainties around a trade war, Fed policy, ECB tapering, European politics, and the like have fueled concerns that some idiosyncratic factors (for example, heightened country risk in emerging markets such as Turkey and Argentina) may have a negative impact on the entire asset class. We note, however, that since the 2013 “taper tantrum,” several major emerging market countries significantly improved their external imbalances and are able to withstand higher global rates easier now than in the past. This has also been reflected in the recent International Monetary Fund report, 2018 External Sector Report: Tackling Global Imbalances amid Rising Trade Tensions, which highlighted deteriorating external imbalances in developed markets (plus Argentina and Turkey) and generally improving trends in most other large emerging market countries.
Overall, a somewhat-but-not-overly tighter global monetary policy and looser fiscal policy should remain supportive of equities, in our view. As such, we are sticking with our relatively constructive stance on global equities.
The views expressed represent the Manager's assessment of the market environment as of August 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.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization weighted index designed to measure equity market performance of developed markets, excluding the United States and Canada.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance across emerging market countries worldwide.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance across developed and emerging markets worldwide.
The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe.
The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe.
Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company.
All third-party marks cited are the property of their respective owners.
All charts are for illustrative purposes only. Charts have been prepared by Macquarie unless otherwise noted.
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Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.