During the third quarter of 2018, returns generally were strong for equities, especially those in the U.S. The major exception was emerging markets equities, which continued to slide, returning -7.5% on a year-to-date basis. As expected, the Federal Reserve raised rates an additional 25 basis points during the quarter and telegraphed heightened expectations for further rate hikes. As a result, fixed income with any duration sold off at the end of the third quarter, and U.S. bonds are now in negative territory year to date.
As we have for the past few issues now, InvestorView sat down with BBH Chief Investment Officer Suzanne Brenner and Chief Investment Strategist Scott Clemons to hear their thoughts about the current state of the economy and financial markets and how developments are influencing portfolio positioning.
InvestorView: As we go to press, the table of quarterly returns included nearby has quickly become outdated. By late October, stocks were down 10% from a month ago. Why the renewed volatility?
Scott Clemons: There are plenty of things to blame for the market sell-off, and you can take your pick: concerns about escalating trade tensions, uncertainty surrounding the midterm elections, strength of the U.S. dollar, rising interest rates and so forth. But none of this is new – these trends were in place a month ago as stock prices were making new highs. I think we’re simply seeing a return to more normal levels of volatility.
IV: This is normal?
SC: In some ways, yes. The equity market typically has a 5% to 10% correction several times a year. But the market did not correct at all in 2016 or 2017, so this renewed volatility seems like a new or different thing, when in reality it is a return to more typical patterns.
Suzanne Brenner: Investors driven by the pursuit of value welcome this return of volatility. Remember that our managers are looking to acquire assets at a discount to intrinsic value, and this becomes more difficult as markets only move up. Although price volatility is certainly not pleasant while it is happening, it does create more disconnects between price and value that disciplined investors can exploit.
IV: Have our managers been putting capital to work in this downturn?
SB: Yes, and many of them are doing so with the excess cash that has built up in portfolios. Cash at the manager level is not a function of market timing, but instead a reflection of the challenges in applying a value strategy in a market that has risen so steadily over the past few years. We expect managers to deploy capital as and when stock prices offer a compelling discount to intrinsic value, and this sell-off has provided some of those opportunities at the margin.
SC: Fundamentally, we expect the third-quarter earnings season, which is well underway, to provide proof that corporate earnings remain healthy, and that should provide some support for the equity market. This is a normal and welcome reminder that stock prices go down as well as up, not the beginning of a bear market.
IV: Speaking of earnings reports, companies have repeatedly addressed the trade and tariffs issues in their commentary. Has our thinking on this topic shifted over the past quarter?
SC: Not from a macroeconomic standpoint. The fact remains that trade comprises a relatively small part of our economy: For the second quarter of this year, exports totaled 12.6% of GDP, and imports were 15.3%, for a net -2.7%. The net negative simply reflects the trade deficit. To put this into context, personal consumption is 68.0% of GDP, business spending 17.5% and government spending 17.2%. The threat of trade disputes is certainly important for some parts of the economy and markets, but it’s a minor part of the overall economy.
SB: Our equity managers make investment decisions one company at a time, so our portfolios aren’t positioned to anticipate a particular outcome of the trade negotiations with China, Europe or anyone else. External developments such as this do, however, emphasize the importance of good management and talented capital allocation. Furthermore, our portfolios have very little exposure to industries at the center of the more disruptive trade threats, such as basic materials, automotive, construction and other capital-intensive industries.
SC: Tariffs do pose a potential inflationary threat that warrants attention. The current 10% tariff on a wide range of Chinese imports means higher prices for companies that import from China. Companies respond to rising input prices in one of two ways: They either absorb the rising costs to the detriment of margins and earnings growth or pass on higher costs to their customers. So far, companies have generally chosen to absorb costs, in the belief that tariffs are a temporary negotiating tactic that will be lifted at some point. A fundamental backdrop of strong earnings growth makes this an easier option. Should companies start to pass on higher prices, this could become inflationary, thereby prompting the Fed to raise interest rates more rapidly than it otherwise would in 2019.
SB: In reality, companies do a bit of both: They exercise pricing power where they have it and absorb higher input costs where they don’t. We’ll get more information on this dynamic as companies report third-quarter earnings. In general, our managers invest in high-quality companies – those with strong cash flows and balance sheets that enjoy sustainable competitive advantages, or “moats.” It is these high-quality companies that over time have the most pricing power – and therefore, the greatest ability to protect client portfolios during inflationary periods.
SC: There is no question that developments in trade pose a threat to market sentiment from day to day, but the threat to economic fundamentals is limited. The labor and housing markets remain healthy, and the index of leading economic indicators continues to set new highs. We’ll watch this macroeconomic data as well as the microeconomic company reports to monitor economic health and the potential threat of inflation.
IV: Is this economic strength translating into corporate earnings?
SC: Yes, and we believe that earnings growth is the real reason for market performance so far this year. Operating earnings for the S&P 500 rose 27% in both the first and second quarters of 2018, and consensus expectations call for a similar year-over-year comparison for the third quarter. We calculate that a little over half of this growth is due to the tax reform enacted at the beginning of the year, but that still implies decent profit growth in this ninth year of an economic cycle.
SB: However, the performance of the index hides a wide variety of performance at the individual stock level. Through the end of September, the S&P 500 is up 9.0% (10.6% including dividends), but much of this performance is localized in a handful of names mostly in the technology sector.
SC: It is indeed a narrow market. For the first nine months of the year, only seven names accounted for half of market gains. Without Amazon, Apple, Microsoft, Netflix, Mastercard, Alphabet and Visa, the S&P 500 would be up just 5%. Only 40 companies in the S&P 500 are trading closer to their 52-week highs than the index itself, and 109 companies are down more than 20% vs. their 52-week highs.
SB: This is reminiscent of the narrow market leadership at the tail end of the dot-com bubble in the late 1990s, during which so-called “old economy” companies trailed the market as investors fell in love with profitless – and in some cases, revenue-less – dot-coms. I remember clearly that at the tail end of this cycle, many value investors capitulated and invested in dot-com stocks at exactly the wrong time – and we know how that ended.
SC: This same dynamic is reflected in the performance of growth stocks vs. value stocks. Over the past 12 months (through the end of September), the S&P 500 Growth Index is up 25.2% vs. a rise of 10.1% for the S&P 500 Value Index. The Growth and Value Indices trade leadership throughout the cycle, but usually within a range of plus or minus 10%. A 15% deviation – while not unprecedented – is a rare occurrence.
SB: Yes, but it’s important to note that our managers would reject the value vs. growth comparison as a false dichotomy. After all, the intrinsic value of a company is simply the net present value of all the future economic value that a company is expected to create, whether through cash flows, dividends or earnings. So, the value calculation necessarily includes an expectation of growth. No manager would buy growth at absolutely any price, just as there are assets so encumbered with liabilities that the intrinsic value is zero or less. Investing has always has been a trade-off between the two concepts of value and growth.1
IV: Narrow leadership notwithstanding, domestic markets have done well this year despite trade tensions, whereas the rest of the world – and particularly emerging markets – has lagged. Does this simply reflect the relative health of the U.S. economy and corporate earnings?
SC: To some extent, yes, but the performance gap is wider than the fundamentals would imply. Over the past decade, the S&P 500 has compounded at 11.9% (including dividends), whereas the MSCI Emerging Markets Index has compounded at only 5.4% – and the difference isn’t all due to the strength of the U.S. dollar. In local terms emerging markets have compounded at 5.8% over this same period, so currency accounts for just 0.4%. This isn’t proof positive that emerging markets offer better value, but it does indicate that there are value opportunities on offer outside the United States.2
IV: If the U.S. is growing faster and offers better earnings growth, why invest internationally at all?
SB: Interestingly, if you look back two decades, the picture is very different. Over the past 20 years ending September 30, 2018, the MSCI Emerging Markets Index generated an annualized return of 10.18% vs. 7.42% for the S&P 500. For long-term investors who are willing to tolerate the price volatility, emerging markets play an important role in a portfolio. The fact is that some emerging economies offer access to rising personal consumption, domestic demand and economic activity that developed markets just don’t have. The key is to find those markets and companies that are exposed to this growth in domestic demand. An important lesson of the 2008-2009 economic crisis is that emerging companies with too much exposure to export markets act as leveraged plays on developed economies.
SC: This is why active investing is so important in emerging markets.
SB: Yes. Emerging market indices are often skewed by what businesses went public and when, and can therefore be dominated by a handful of companies, which in many cases are still partially or formerly state-owned. Our managers are more interested in truly domestic companies that serve local populations. That’s the growth that we are trying to access
IV: As we wrap up, what should our readers look out for between now and the first quarter 2019 issue of InvestorView?
SC: We’ll watch third-quarter earnings reports closely for evidence that the earnings growth story remains intact. As we’ve already discussed, we believe that earnings provide the fundamental underpinning of this market, and we need to see that continue. At the same time, we’ll look for how companies are handling tariffs and whether these higher input costs are being absorbed into margins or passed on to consumers in the form of price hikes.
SB: We’ll also watch how fixed income markets continue to respond to the prospect of tighter monetary policy and rising inflation. Although investors usually think of higher interest rates as bad, higher rates offer a more attractive risk-return trade-off. As interest rates more fully reflect the prospect of inflation, we will look for ways to reintroduce longer-duration fixed income into our clients’ portfolios.
SC: And we must acknowledge that there are elections coming up! We don’t think that the midterm elections pose a fundamental risk or opportunity for investors, but the heated U.S. political environment could certainly be a source of price volatility in markets.
IV: Thank you both for your thoughts.
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© Brown Brothers Harriman & Co. 2018. All rights reserved. 2018.
1 For more on the pitfalls of the value vs. growth investing framework and why we prefer a quality and discount to intrinsic value model, read our fourth quarter 2017 InvestorView article, “Value vs. Growth: A False Dichotomy.”
2 For more on the current state of emerging markets equities and their role in an investment portfolio, read this issue’s third-party manager interview, “Manager Spotlight: Interview with Rajiv Jain from GQG Partners.”