The recent divergence in returns between US stocks and equity markets across the rest of the world continued in the third quarter. US stocks enjoyed a terrific quarter, with the S&P 500 hitting new record highs, while equities elsewhere struggled. The long dominance of the growth style over value also continued to play out in global stock markets. Why? We think several forces are in play.
First, there’s the sustained strength in the US economy and corporate profits. The second-quarter earnings season was one of the strongest we can recall, made all the more impressive when considering that we are a long way into this cycle and the fact that profits have been growing nicely for several years.
Second, there’s the pressure exerted by a robust US economy on the rest of the world via higher US interest rates and a stronger dollar. This is always a sign of trouble in emerging markets.
Third, there’s a growing list of political issues for investors to fret over that tend to weigh more on international markets and value stocks. These concerns encourage money to keep flowing into tested market leaders where profits growth appears unassailable.
As US rates march higher many investors are understandably feeling more cautious overall given that economic and profits cycles are already long by past standards. The weakness in markets in October may well be a sign that the momentum trade is ending but there’s still evidence of sufficient growth in profits to keep the markets going in the face of higher interest rates. And after October’s setback, valuations in many places look quite attractive.
Despite worries over interest rates and trade, our research suggests that profitability remains pretty healthy across the equity world. Earnings in the US remain impressive and although growth is likely to cool next year as the impact of tax cuts fades, the business cycle seems in good health and is standing up well to the gentle rise in interest rates so far.
In terms of regional trends, US stocks have led strongly this year. Europe has been pretty dull and emerging markets quite weak. On a style basis, growth has led value, and by industry, health care stocks have joined technology at the top of the leaders list (see chart below), with more cyclical industrial sectors falling far behind.
Emerging market (EM) equities offer a level of opportunity that justifies the risk, despite the poor performance so far this year. Our fundamental analysis suggests that EM stocks are now priced to provide above-average returns if not quite at the levels we have seen in the depths of past crises.
European equities have once again disappointed.
Aside from the endless political uncertainties, a lack of dynamism in the European corporate sector leaves many problems unaddressed. This has contributed to the long-term underperformance of profits and stock prices in the region when compared with the US or much of Asia. However there is a price for everything and European stocks do look very out of favour again while in the near term earnings are growing at a decent rate. Some of the most cyclically exposed companies look very cheap–while the higher quality banks also look interesting.
Indeed, a number of US financial stocks continue to appear attractive. The industry now seems well positioned, with profits rising and capital return to shareholders in full swing. Outside the US, the outlook is convincing but there are plenty of good long-term growth prospects in the better developing market financial companies. There is also real value in European banks for those who can do the research to avoid the value traps.
As the spread between value and growth stocks continues to widen, it is very tempting to make the call that investors should be buying value. But there are a couple of caveats. First, the returns from the value style have been weak only in a relative sense–after all, the Russell 1000 Value index has compounded a 9% annual return over the past five years. And there are some significant structural issues facing many industries that represent important weightings in value indices. The message of historically very wide discounts on value stocks vs. the broader market is one too strong to ignore, but investors should probably not expect any dramatic returns in the near term.
US growth stocks were on a tear until the recent bout of weakness in October. As prices have risen some of the classic warning signs of excess have begun to appear although comparisons with the 1999 bubble in growth stocks are arguably overdone. Businesses these days are far stronger and also much less overpriced. However the outperformance of US growth may well have gone on long enough and, at this stage, some caution toward the most popular growth stocks seems prudent.
It’s also important for investors to take note of high levels of debt building up in many parts of the US corporate sector. Financial services companies and cash-rich technology companies are the notable excep¬tions, but elsewhere debt has accumulated steadily as firms have borrowed at very low interest rates to repurchase shares. There is nothing to worry about for now, but when a harsher economic environment appears and interest rates have moved higher, some companies will find themselves in an uncomfortable position.
Trade and tariffs are on the list of risks for equity investors but the issue is tough to analyze and even tougher to forecast. The boom in world trade over the past 30 years has had a disproportionately positive impact on the corporate sector and is a key support for historically high levels of profitability. Since a partial reversal will have a much more acute impact on company profits than on overall economic growth, investors will have to watch this one closely.
Paul Quinsee, global head of Equities at JP Morgan Asset Management