What a difference six months makes. In the most consequential change for financial markets since the start of the year, the U.S. Federal Reserve put the brakes on its three-year-old interest rate tightening effort. The major policy shift in January provided an immediate boost to sentiment, as investors concluded that the central bank will keep rates steady for the rest of the year. The Bank of Canada followed suit with its own pause.
Reacting to the Fed’s dovish tone, stock prices took flight with a powerful first-quarter rebound that effectively reversed a late-2018 market selloff. A setback in U.S.-China trade talks has tempered equity gains somewhat since, but the Fed pivot and lower-for-longer interest rates are adding extra innings to this economic cycle. The stage has been set for potentially strong stock market returns ahead. At the very least, central banks aren’t expected to get in the way.
Thanks in part to shifting expectations around Fed policy for the rest of the year, long-term interest rates have come down after drifting higher in the fourth quarter of 2018. This removes a potential headwind to continued growth.
"We have an economy that is already experiencing healthy growth ― not booming, but healthy — and it is now finding itself with fewer impediments to that growth,” says Capital Group U.S. economist Darrell Spence. “With rates coming down at the long end, that’s going to reignite the cycle to a certain degree, so I expect decent growth into 2020."
Longer term rates could remain lower for longer even if the Fed resumes its hikes later this year. That’s because slowing external growth, political uncertainty in Europe, low government bond yields abroad, steady demand for U.S. Treasuries and the simmering U.S.-China trade dispute should continue to weigh on long-term rates.
Indeed, markets were rattled throughout May as the U.S. increased tariffs on US$200 billion of Chinese goods (including computers, clothing and shoes), China retaliated with its own tariffs shortly thereafter and the U.S. president proposed extending tariffs to Mexico. While the dispute has impacted U.S. exports and the industrial sector, at current levels the tariffs will not likely bring an end to the U.S. expansion, says Spence. However, the potential for further escalation is rising, and that is a clear risk to growth.
"I do expect market volatility to become more pronounced,” Spence adds. “And that might be incentive for the two parties to tone down the rhetoric and resume very difficult negotiations."
An extended cycle also suggests a longer runway for corporate earnings growth. Spence says this could provide support to equity prices despite somewhat elevated valuations. "Equities still have the potential to offer some modest appreciation in 2019," he says.
But make no mistake, after a decade of growth, economic headwinds are strengthening. "Whether it's rising wages or a tight labour market, the economy continues to exhibit late-cycle characteristics,” he adds. "These are likely to become more pronounced, placing increasing stress on companies and the economy."
The U.S. unemployment rate stood at 3.6% in April, a number not seen since December 1969. Such low unemployment typically translates into rising wages. Although higher wages tend to encourage stronger consumer spending, rising labour costs inevitably pressure profit margins and trigger market volatility.
Given rising volatility and ongoing trade disputes, it’s not too early for investors to position portfolios for a tougher environment.
"On the whole, there is reason to be optimistic about equities," says Hilda Applbaum, a portfolio manager for Capital Group Global Balanced FundTM (Canada). "But I don’t think this is a time to be swinging for the fences. Balance is key."
Investors may want to consider focusing on quality growth companies and companies in more defensive areas of the market that pay meaningful dividends.
Diversification hasn’t helped much in recent years, as dividend-paying stocks have generally lagged in a U.S. market dominated by a small group of tech and consumer companies. But when market volatility surfaced last year, some dividend payers held up reasonably well, serving as a reminder of the importance of diversification.
The utilities sector, for example, outpaced the overall market in each of the four periods of pronounced volatility since the start of 2018. And though they significantly trailed the market when it was rising, utilities ended with a gain in 2018 while experiencing relatively low volatility.
This late in the cycle, excesses inevitably build and risk rises. Where are the excesses today, and what are the risks? You might find them on the bloated balance sheets of companies that have been on a debt binge. At the close of 2018, non-financial corporate sector borrowing stood at 46.7% of GDP, a record high.
Much of this cheap debt has been used to fund dividends, share buybacks, and mergers and acquisitions. Since 2013, the first two have generally exceeded free cash flow levels. In many cases, debt issuance has covered the shortfall, artificially inflating earnings per share growth and driving up stock prices.
Such financial engineering cannot continue indefinitely. Many companies will need to go on a debt diet either because of rising rates or tighter credit conditions and dividends, buybacks and M&A will need to be reduced. This will pressure stock valuations and potentially trigger a wave of debt write-offs.
But without a catalyst such as higher interest rates or slower economic growth, these excesses will continue to build, potentially further boosting equity valuations in the short run, but leading to elevated market volatility down the road. As of May 31, 2019, the price-to-earnings ratio for Standard & Poor's 500 Composite Index was 16.5, above the 10-year average of 15.0.
After 40 years investing in dividend-paying companies, portfolio manager Joyce Gordon knows a thing or two about identifying those most likely to sustain their payments in a downturn.
"One lesson I learned is to avoid companies with too much debt," says Gordon, a portfolio manager for Capital Group Capital Income BuilderTM (Canada) and Capital Group U.S. Equity FundTM (Canada). "Those with significant debt face numerous challenges. For example, they may feel pressure to cut their dividend to maintain an investment-grade credit rating."
When you look at pairs of companies across different industries, you can see that those with a lower credit rating and lower interest coverage ratio might be more likely to cut their dividends when times get tough.
For example, Nestlé, with a manageable debt burden, hasn't done so in decades. Conversely, more highly leveraged Kraft Heinz recently cut its dividend.
"That's why it’s so important to look beyond simple dividend yield and do the research on whether companies can sustain them,” Gordon adds. "The longer this expansion goes on, the more attention I pay to company debt."
Growth-oriented investors may want to pursue companies that are proven innovators with long runways of potential growth.
"Innovation improves people's lives and drives growth and opportunity for companies,” says portfolio manager Anne-Marie Peterson.
Consider, for example, rapid innovation in health care. Advances in genomics have decreased the cost of sequencing a set of human genes from US$100 million in 2006 to about US$1,000 today.
Therapies derived from genetic testing have the potential to extend lives and generate billions of dollars in revenue. U.S. drugmakers AbbVie and Merck, the maker of blockbuster immunotherapy treatment Keytruda, have invested millions of dollars to develop gene-based treatments for various cancers.
It's not just the drugmakers making advances. "I am interested in companies that are arms dealers to the pharmaceutical industry, providing manufacturing and research," explains Peterson.
Genetic testing equipment maker Illumina is a leader in sequencing technology, while Thermo Fisher Scientific provides research and manufacturing resources to a host of drug developers. Of course there are risks, such as the steep cost of research and development and public debate over drug pricing, so selective investing is essential.
Joyce is an equity portfolio manager with 38 years of investment experience and has been with Capital Group for 43 years. Earlier in her career, she covered thrifts, banking and paper & forest products companies as an equity investment analyst. She holds an MBA and a bachelor’s degree in business finance from the University of Southern California. Joyce is based in Los Angeles.
Darrell R. Spence is an economist at Capital Group. He has 26 years of investment industry experience, all with Capital Group. He holds a bachelor’s degree with honors in economics from Occidental College graduating cum laude, and is a member of Phi Beta Kappa and Omicron Delta Epsilon. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics. Darrell is based in Los Angeles.
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