A Growing Global Economy Creates a Positive Backdrop for Equities
The past year was a rewarding one for stock investors, as solid economic expansion in nearly all corners of the world resulted in higher corporate profits and a string of record highs for equities. The U.S. economy gained steam, while Europe and Japan showed surprising strength. At the same time, the developing world maintained its vigorous growth, leading to impressive returns for the emerging markets.
The prospects remain bright for 2018, according to our Equity Roundtable panelists, though markets will have to contend with a variety of challenges, including elevated valuations and rising interest rates.
For more on this year’s outlook, we spoke with Capital Group Private Client Services principal investment officer Will Robbins and Capital Group portfolio managers Cheryl Frank and Tomonori Tani. Below is their take on what to watch in 2018 and a look at how they are investing right now.
Were you surprised by the impressive run-up in global equity markets in 2017?
Will Robbins: I was a bit surprised by the considerable strength, but on reflection there are several reasons stocks did so well. A primary factor is that we’re witnessing synchronized growth in economies around the world. This was a bit uncertain at the beginning of the year. Europe, for instance, was expected to grow only mildly, but it expanded well above expectations. In addition, monetary policy around the world has remained accommodative, and the U.S. tax bill should contribute to higher corporate earnings. All of this led to a solid environment for equities.
Cheryl Frank: The market’s rise has been driven by record corporate profits, led by information technology companies. We’ve also seen an easing regulatory environment, particularly here in the U.S., and that’s been very helpful for business confidence.
Tomonori Tani: This is the first time we’ve seen synchronized global growth since 2010. Growth estimates are actually still being raised, especially in the emerging markets. Yet, long-term bond yields remain lower than the beginning of 2017, despite a few rounds of Federal Reserve rate hikes.
Indeed, emerging markets posted very strong returns in 2017, as did the broad international market index. In fact, international equities did better than U.S. stocks across the board. Do you expect this trend to continue?
Robbins: It’s true that although the broad U.S. market as measured by the S&P 500 index did very well, international stocks fared even better in dollar terms. However, when measured in local currencies, most foreign indices actually lagged the U.S. Coming into 2017, we were very excited about opportunities in non-U.S. markets, in part because of favorable valuations outside the U.S. If anything, U.S. valuations have become even more stretched by comparison. That’s not to say we’re bearish about the U.S., but developed international and emerging markets are still very attractive from a valuation perspective.
Tani: For the portfolios I manage, I actually began boosting exposure to emerging markets about 18 months ago, and remain quite positive due to the still-large output gap after several years of macroeconomic adjustments. I’m focused on companies that generate a lot of free cash flow and can keep growing without diluting shareholder interests. I’m finding such opportunities in varied countries, including Argentina, India, Brazil and China.
Will, the U.S. economic expansion is now in its ninth year and, as you pointed out, equity valuations have become elevated. Does that give you reason for pause?
Robbins: Keep in mind that bear markets and, ultimately, recessions aren’t caused by old age. They’re a result of excesses built up in the economy. From my perspective, the U.S. economy doesn’t appear to have a lot of excesses at the moment. Valuations are important and something we monitor closely. But valuations in and of themselves do not cause stock prices to decline or corrections to occur.
Frank: The market has come a long way, and stock prices do, on average, look somewhat expensive, particularly in the U.S. It does make me wonder what could possibly get better and whether the favorable economic outlook is already priced into stocks. We are, after all, at all-time highs in corporate profits and profit margins. But underneath the surface, you see a different story. Though the aggregate market may be at peak margins, that’s not the case with every sector. For example, industrial, financial and energy stocks are well below past peak margins, and there is still room for certain parts of the economy to do better. The key is to be selective in choosing stocks, which is exactly what we’re focused on when building client portfolios.
Please tell us more about your approach to finding investments in the current environment.
Frank: While we do think about the broader macroeconomic context, we do fundamental research on companies from the bottom up. I spend 90% of my time on the fundamentals of individual companies and their management teams, income statements and balance sheets. I think about their futures and the outlooks for their industries. I try to filter out all the noise and short-term dynamics that may seem important in the moment but don’t matter much over the long run. I take a very long view. I’m not looking out over the next one or two years, but more like 20 years. In general, I believe equity investing will offer attractive returns over the next two decades, though we’re likely to see plenty of volatility along the way. Therefore, I want to build a portfolio of the very best companies our research has uncovered.
Which industries or areas of the market do you believe are particularly attractive?
Tani: I find the outlook for automation-related companies to be quite compelling, especially as the global population gets older. The global population is still growing, but the working-age cohort — people between the ages of 15 and 64 — has already peaked in OECD countries. The decline in the working-age population is especially noteworthy in China. As workers retire, there will not be enough younger people to replace them all. As a result, there will be an increasing need for machines that can perform various tasks. This creates opportunities for companies offering automated solutions. Beyond that, I’m also excited about how our lives will be changed by electronic vehicles, autonomous driving and more digitally connected cars. Among other things, this could create additional demand for semiconductors.
Frank: Over the past six months or so, I have added to some of my energy holdings, which were hurt by the decline in oil prices. There are some very compelling opportunities in this sector, particularly among services companies. Oil prices appear to have bottomed, and if we have a continued strong global economy, there will be solid demand for energy. On the other hand, I’ve been trimming my overall technology exposure. The industry’s long-term outlook is bright, but some companies have had incredibly big runs, leaving them with high valuations and at peak margins. These are really good stocks that got to be big positions in my portfolio, and I felt it was prudent to trim them back a bit.
Will, what areas are you drawn to?
Robbins: I think financials continue to be a reasonably attractive place to invest. Part of that assessment is based on my belief that returns are still not where the competitive dynamics suggest they can go. Financials also offer some degree of protection as a hedge if interest rates rise. Health care is another area I like. We’re in an age of innovation in which important breakthroughs are being made. It’s somewhat analogous to what took place in the tech world. Advances in technology help to increase productivity and add convenience to society as a whole. In health care, we have this moment in time where we’re witnessing enormous innovation in terms of curing what were previously considered to be incurable diseases. I want our clients to have exposure to companies that can benefit from this. I have positions in some large pharmaceutical businesses, as well as in smaller players focused on immuno-oncology, where I believe there are enormous opportunities.
As you look to the rest of the year, what are the biggest risks on the horizon that could interrupt what has been a nearly continuous upward move for both the economy and the stock market?
Robbins: We are starting to see signs of wage inflation, which could push bond yields higher. I personally think there’s a chance we’ll see the yield on 10-year Treasury notes approach 4%. That could be disruptive and is probably the highest risk on my list at this moment. Beyond that, it’s obviously very difficult to predict exogenous events, such as further political tensions with North Korea.
Tani: I’m also watching bond yields closely. We are late in the U.S. economic cycle, and rising wage pressures may prompt more Fed rate hikes. That definitely could increase volatility in long-term bond yields and prove more challenging for stocks.
It’s been more than a year since we’ve seen a market correction of at least 5%. Are you expecting one in 2018?
Frank: No market goes up indefinitely, and we’ll surely have a pullback at some point. Of course, it is difficult to predict the timing of a correction. There are still a lot of positive things happening in the economy, and the markets are reflecting this optimism. Ironically, in some ways, all the good news does concern me. We just passed a big tax bill and everybody feels good. We’ve seen in the past that high levels of euphoria or complacency can foreshadow a pullback. That doesn’t mean a downturn is imminent, but it’s something I think about.
Robbins: It may not be obvious given the upward trajectory of the market overall, but corrections have already occurred in some industries and sectors. Energy stocks, for example, underwent a bruising pullback. The same is true in retail. If you ask the CEOs of Facebook or Amazon or Netflix whether they’re in the midst of a correction, they would naturally say no. But their success has caused pain in some other sectors. That’s part of the creative destruction inherent in the capitalist marketplace. So while we haven’t had a broad correction in the overall market, various sectors have been correcting all along, which is actually healthy in my view.
Given the market’s strong advance, should investors consider reducing their exposure to equities?
Frank: The biggest message I could possibly send to our clients is that the best way to grow wealth is to work with your Investment Counselor to set an appropriate asset allocation and stick with it for the long term. Timing the market, by shifting money in or out, or by moving it from one strategy to another, is not advisable. This doesn’t mean you shouldn’t rebalance your exposure between stocks and bonds if your allocation has shifted due to market movements, or make adjustments as your personal circumstances change. But the best thing you can do is allocate your money wisely and stay invested.
The above article originally appeared in the Winter 2018 issue of Quarterly Insights magazine.