Setting the Stage for a Favorable Global Equity Environment
Stocks have made impressive gains in the years following the financial crisis, with the U.S. leading the way. But the tide may soon turn. International valuations look increasingly attractive by comparison, and many of the factors that have held these markets back appear to be abating.
For more on the outlook for equities in 2017, we sat down with several members of the Capital Group Private Client Services equity team. Taking part in the discussion were portfolio managers Gerald Du Manoir, Cheryl Frank, Greg Fuss, Will Robbins and Steve Watson; research portfolio coordinator Jan Inscho; and Capital Group European retail analyst Najah Abouelafia.
Will, U.S. stocks had a good year in 2016, particularly following the election. How does the market look to you now?
Will Robbins: Prior to the election, stocks in the U.S. followed the expected pattern of moving along with reported earnings. But once Trump was elected, valuations moved up largely based on expectations of corporate tax reform and the positive impact that could have on future profits. If corporate taxes go from the current 35% rate down to 20%, that could provide an immediate positive and significant boost to net margins. It’s very clear this won’t be symmetrical, and some companies will benefit more than others. But even without tax reform, I expect earnings growth in the high-single-digit range for 2017. That gives me reason to be somewhat optimistic about the U.S. market.
International equities have struggled by comparison. Steve, why is that, and what are your expectations going into 2017?
Steve Watson: This tension between U.S. and international returns is a recurring feature of global stock markets. We see the leadership baton get passed back and forth. The U.S. market has led the rest of the world for about seven years now, to the tune of 90 percentage points of cumulative excess return. That’s a big number. Today we have the U.S. market selling at 2.9 times book value versus its long-term average of 2.2. By contrast, the rest of the world sells at a significant discount to long-term price-to-book.
Why the huge disparity?
Watson: The U.S. recovered relatively well from the Great Recession of 2009, and the headlines in many other markets have been terrible. Europe faces financial difficulties, China has its issues, the emerging world has struggled with growth and governance, and Abenomics has had only fitful success in Japan. The question for global investors is whether the tide will turn and, if so, when. I do believe that valuation will win out and the baton will eventually be passed from the U.S. to the rest of
When might that be? Valuations have been more attractive outside the U.S. for some time now.
Gerald Du Manoir: There is a misconception that global investing is about regional allocation. That’s not how we invest. We invest one company at a time, regardless of where it might be based. Many of these companies do business all over the world, so you have to factor that in. I agree with Steve that the main reason the U.S. has done better is because it has been a country of great innovation since the financial crisis, helping to fuel the recovery. But if you consider the lag time before monetary stimuli begin to feed into the system, you could argue that Europe and Japan look pretty well positioned relative to the U.S. today.
Jan Inscho: Another big factor has been currency. Until we began to see weakness in commodities and strength in the dollar, emerging markets were actually the best-performing asset class last year, despite the currency headwind. I think emerging markets as a whole will continue to exhibit stronger growth than the developed world.
One of the most prominent emerging markets is China. Steve, you’re based in Hong Kong. Are you finding any compelling investments there?
Watson: There is a lot of uncertainty in China today. The country relies too heavily on infrastructure development and credit expansion. It’s true that the economy is growing better now, but the quality of growth isn’t great. Having said that, I feel that China has a number of levers it can pull and expect that it will continue to get on steadier footing. The consumer and service economies are both growing nicely at around 10%, and there’s more that can be done. A reform of state-owned enterprises is coming, and the government seems to be backing off on its anticorruption campaign, which has held the economy back for the past three years.
Gerald, you mentioned Europe, where you spend a lot of your time. Europe came back into the headlines after the surprise Brexit vote last year. How is the economy faring?
Du Manoir: Clearly, the risk premium on equities suggests that people are still worried about Europe. I think investor concerns fall into three buckets. First, Europe needs to come up with a common policy to address its structural problems across the fiscal spectrum, from labor laws to the treatment of pension liabilities. Second is Brexit and the uncertainty of future electoral outcomes. You have three big elections this year, in France, Holland and Germany. Third is the issue of the banking system, which the U.S. dealt with in a clear-cut, aggressive way. Europe has taken a more gradual approach. If Europe gets these hurdles behind it, you could see a favorable reaction in the stock market.
Steve, how are you feeling about the equity market overall right now?
Watson: No doubt, there’s a lot of uncertainty around the world, but that’s not necessarily a bad thing from an investment standpoint. Markets famously climb a wall of worry. More importantly, Capital Group analysts scour the globe looking for companies with good businesses, the values of which are not fully reflected in their share prices. We’re definitely finding plenty of them right now.
Robbins: I doubt any of us would be willing to bet a cup of coffee on where the market will be 12 months from now, but there are plenty of companies we’re all really enthusiastic about.
Du Manoir: I’m pretty excited about the level of discovery around the world, both in terms of new business models and evolving technologies. You’ve seen fantastic Internet businesses created in the span of 12 years in both the U.S. and China, and amazing things are happening in biotechnology. The difficulty is determining the correct value to place on these new discoveries, which is where we add value.
What is your view of overall market valuations? After all, the bull run is about to celebrate its eighth anniversary.
Cheryl Frank: I think valuations in the U.S. are pretty high. The S&P 500 trades at a price-earnings ratio of 17.6 times earnings for the next 12 months. That’s higher than it has been for the past 10 years. The last time it went beyond this was during the tech bubble. We’ve also been in a period of low rates, which has supported higher valuations. But now rates are moving higher.
Greg Fuss: I’d agree that the market is a bit on the expensive side. But beneath the surface there’s a lot going on. Capital Group analysts have their eye on many innovative companies that have gone out of favor and are selling for much less than the market overall.
To that end, most flows into stock funds over the past year went directly into index funds. And we’ve seen numerous media reports suggesting that investors could save a lot of trouble by just indexing their portfolios.
Fuss: Keep in mind that the financial press often targets those individuals who invest on their own, and recommending index funds is the popular thing to do now. However, it’s our belief and experience that, over time, deep fundamental research helps to identify companies that can create superior long-term returns. Our track record demonstrates it can be done. The other part that really fascinates me is that index funds effectively buy the most expensive stocks in the largest quantity. Since most indexes are weighted by market capitalization, the more a stock goes up, the bigger a position it gets. In other words, you keep paying higher prices, while more attractively valued companies get a smaller percentage. The very construction of index funds seems to work against you over time.
It’s early on, but the Trump administration has put forward a number of initial proposals to help drive economic growth. Does that factor into your investment thinking?
Fuss: There is a high likelihood we’ll see some kind of tax reform. On the individual side, it’s relatively easy to imagine that rates will come down. What’s less clear is what deductions might go away. When individuals have more money in their pockets, they tend to spend it. From an investment standpoint, that could be interesting for certain retailers, particularly those that cater to discretionary purchases.
What about the massive infrastructure spending that has been proposed?
Fuss: During the campaign, they discussed a potential $100 billion annual spend. Our research shows that’s highly unlikely to materialize, largely because to spend that much, you’d need massive armies of construction workers to build everything from roads to hospitals. It would be nearly impossible to find all those people
Du Manoir: The largest beneficiaries of an infrastructure bill would likely be companies based outside the U.S. The biggest builder of roads, for instance, is a French company. It still employs a massive number of Americans, but it is headquartered outside the U.S. That’s part of what makes global investing so compelling.
Robbins: The primary thing we’re all doing right now is looking at the individual companies in client portfolios to determine whether political policy changes would help or hurt. There’s so much uncertainty that you really can’t do this with much accuracy at this point. But one by-product is bound to be inflation, so that’s something we’re keeping in mind. Incidentally, a whole host of companies will benefit from inflation, most notably those in the financial and commodity sectors.
Fuss: On the downside, inflation has already led to higher interest rates. It’s important to note that S&P 500 corporations have more than $4 trillion worth of collective bond debt. Over the past 10 years, interest rate expense on this debt has come down an average of 2.5 percentage points, which is very supportive for corporate earnings. While there is a lot of optimism among the people seated at this table, that could be a little headwind on earnings.
Will, let’s dig in and get a sense of what specific holdings you are emphasizing in the portion of client portfolios you manage.
Robbins: In general, I like companies with attractive and rising returns on invested capital. Ideally, I want to purchase them at compelling valuations on depressed earnings. That’s a hard combination to find in today’s market. Having said that, I subscribe to the belief that longer-term rates will move higher. This should lead to expanded margins, higher revenues and better earnings for the financial sector, which is already starting to play out. Specifically, I am interested in companies with rate exposures that don’t require compromising on credit. That has led me to some wholesale and trust banks, along with certain insurance brokers. Separately, I’m also interested in certain health care services companies, particularly those that help to control costs.
Watson: To follow on what Will just said, for the past couple of years I’ve been really impressed with progress in the pharmaceutical industry, but less enamored of valuations. Over the past 12 months, this area has been under a lot of pressure and there have been pipeline disappointments. With the help of Capital Group analysts, we’ve worked to uncover situations where the clouds don’t seem as dark as investors fear, and I have been adding to both large and small drug companies lately.
What else is in your portfolio, Steve?
Watson: There are two big aircraft manufacturers. One is based in the U.S., and the other in Europe. Here’s another case where global investing allows you to be selective: both are great companies, but the one in the U.S. is significantly more expensive than its European peer. As a value guy, guess which one I’m buying.
Are you finding more opportunities outside the U.S. in general?
Watson: I don’t construct the portfolio that way but, stepping back, I am buying more internationally, given valuations. Because Capital Group has analysts on the ground all over the world, we are often able to find interesting companies abroad that few others understand or even know about.
Greg, what interests you?
Fuss: The predominant themes in my portfolio go by different names but are close cousins: the Internet of Things, deep learning, artificial intelligence and virtual reality. I express this in the portfolio through everything from companies that make sensors and software to semiconductor manufacturers and certain Internet and cloud storage companies. Ultimately, we’re going to a world where efficiency is increased. This is a very long-term theme, and the clear winners have yet to emerge. But to the extent we get these companies right, they could be enormous opportunities over time.
Any other areas you like?
Fuss: Discretionary travel is becoming a huge global trend. Certainly, commercial aerospace is part of that, but I’ve also been increasing exposure to cruise lines. Longer term, we think the Chinese travel market is going to be very vibrant. In the past year, I’ve even been adding to a travel accessories company.
Najah, Greg pointed out earlier that lower taxes in the U.S. should lead to more consumer spending. You cover European luxury goods. Do you share Greg’s optimism?
Najah Abouelafia: Certainly, it will help U.S. retailers, but the big story is what’s happening in China. About 40% of luxury goods are purchased by Chinese consumers. Sales of luxury goods in China boomed from 2008 to 2012, with consumption growing at double digits every year. We then saw a slowdown in the wake of a big anticorruption campaign in which very expensive luxury goods were often used as political favors. The big growth now is among those in the middle class making around $30,000 a year.
That doesn’t seem like a lot of income to be shopping at a luxury store.
Abouelafia: Here’s what’s interesting: Chinese consumers aren’t looking for $10,000 handbags. They want $200 ties or wallets with the luxury brand logo as a status symbol. These smaller-ticket items are highly profitable for luxury goods makers. When you produce cheaper items in large quantities, the margins are much bigger.
Cheryl, tell us what you’re focused on.
Frank: I want to find investments I can hold for 20 years, where company management has control over its destiny. That visibility comes from long asset lives, good brands and market penetration opportunities. I also like orphan stocks that fall between the cracks and can be bought for attractive valuations.
You’ve covered health care as an analyst for many years. President Trump has vowed to repeal and replace Obamacare. How might that impact the sector?
Frank: The process will be messy and take some time. The insurance companies have not made any money from the individual plans offered on the Obamacare exchanges, so they have little to lose if the Affordable Care Act goes away. The biggest beneficiaries have been hospitals and private Medicaid operators. Long-term we are likely to see more private market involvement in Medicare, which is good for Medicare Advantage providers. And while Trump has made comments about pharmaceutical pricing, it’s unlikely we’ll see any action on that front until health care affordability becomes more of a crisis again, which is probably three to four years away. So for now, I think it will be business as usual for most of the drug companies.
Gerald, you’re next.
Du Manoir: A lot of Japanese companies pay dividends now, and interest rates in Japan are very low. The Japanese stock market tends to be based on earnings today as opposed to what they may be in the future. The lesson is that earnings forecasts are based on a yen that has gone down a lot. If we see a global industrial recovery, which the Japanese market is very exposed to, some of these companies could do extremely well. They are also not well covered, so that’s of interest. In addition, I find certain insurance stocks to be attractive and I continue to be a great fan of the industries Cheryl alluded to, particularly those with life-changing technologies.
Jan, you oversee the research portfolio. Are there any other themes on your radar?
Inscho: I get to hear investment ideas from all of the analysts around the world and, as Gerald mentioned, Japanese companies are becoming more prominent. In addition to valuation, Japanese companies have really improved corporate governance. Many have massive cash on their balance sheets and have increased both dividends and buybacks. As Greg noted, there is also a lot of interest in the whole area of travel and tourism. This is expressed throughout client portfolios in many different ways. For instance, we hold a company that owns and operates airports in Australia, as one unique example. Around 75% of inbound passengers come from other countries. This company collects revenue on shopping, food and landing fees, all of which are increasing due to these trends.
Greg, what will you be watching most closely as we move into 2017?
Fuss: Interest rates and policy mistakes. If interest rates get too high, it may choke off what otherwise could be some really nice earnings gains. Policy mistakes could be fiscal or political. One or both might jeopardize the rapid growth rate the markets seem to be anticipating. But what I’m most excited about is the flip side of that. If you look at the types of stocks that have done well in recent months, it’s largely been financial, commodities and lower-quality companies. These stocks traditionally do well early in a cycle. If that signal is right, we are about to enter a period of more rapidly expanding GDP both in the U.S. and around the world. That should be a pretty good environment for equities.
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