Even as US large caps benefit from increased capital expenditure, the time is right to be more defensive.
More From Our 2018 Mid-Year Global Market Outlook
Heading in to 2018, we anticipated an equity market correction sometime during the year, as valuations in certain sectors looked extended, and that is exactly what we saw in Q1. Our big question for the US equity market was how much of the fiscal stimulus had already been priced into stocks or whether the potential of increased capital investments could extend the nine-year US bull market even further. Investors finally began to reward US companies toward the end of the first half for one of the strongest earnings seasons on record, with 24% year-on-year growth.
Meanwhile, the immediate expensing provision of the new tax rules has dramatically boosted capital expenditure, especially at US tech companies, driving productivity growth higher. In Q1 alone, capex spending by S&P 500 companies was estimated to have risen by 24%, the highest year-over-year growth in seven years.1 While there is some evidence that shares in companies that invest heavily in capex tend to underperform the broader stock market, higher spending could alleviate worries that profit growth at S&P 500 companies might have peaked. With concerns growing about a lack of workers as the economy marks decade slow levels of unemployment, investments in automation could help companies bridge those labor gaps and lengthen what is already a very long business cycle.
In other developed markets, Europe and Japan have struggled to repeat the stellar performance of 2017, as sentiment data softened in the first half. Following a year in which its stock market was one of the best performing in the world, Japan’s Topix was down by 8% in the first quarter in dollar terms and by 2% in yen terms. As we discuss in our macroeconomic outlook for the second half, Japan seems to have reached its growth peak, mainly due to its severe shortage of workers. Still, our investment team continues to find attractive companies to invest in, as the Bank of Japan keeps monetary policy loose and company earnings reach all-time highs.
Heading into the second half, European stocks found new sources of strength after a weak start to the year, as earnings improved, the euro declined and the US showed signs of calibrating its trade policy with China more carefully.
That announcement was good news for China and emerging markets in general, whose stock markets have been buffeted by higher currency volatility and rising oil prices. Higher oil prices are good news for oil exporters but less so for emerging countries whose economies are more energy-intensive than developed markets. We remain constructive on emerging market equities, especially China, though we are closely watching political events in potential hotspots like Turkey, Venezuela, Argentina and Brazil. Figure 2 shows relative valuation across global equity markets as of the end of May.
Figure 3 shows the equity sectors most exposed to rate risk such as real estate and utilities with negative correlations, while financials and energy correlate more positively. The correlation dispersion between utilities and financials has ratcheted up considerably in the last few months. This can be problematic for highly defensive portfolios, which often contain bond proxies such as utilities.
Health care and financials remain our two most favored sectors for 2018, though we recognize that cyclical sectors like energy and industrials now face favorable tailwinds for the second half as oil prices move higher (Figure 4). Within the tech sector we prefer less crowded innovators.
Because large-cap benchmarks are so disproportionately skewed by tech names, the extremities of factor performance across growth, value and sentiment (or momentum) manifest themselves dramatically in those large-cap indexes. Apart from less exposure to potential trade disputes, small-cap and mid-cap names are less affected by factor skewness. For example, value has diverged much more severely in large-caps than in small-caps, as well as between emerging and developed markets.
While we will not hazard to call the top of the equity markets, we know we are closer to the end of this cycle than to the beginning. That is what drives us to be more cautious and take some risk off the table. While we still maintain an overweight to US large caps, we are underweight to Europe and retain a small overweight to both Japan and emerging market equities. With the increased capital expenditure in the US, we see the potential for lengthening the runway for US stocks. But there are enough uncertainties still around geopolitics, trade protectionism and inflation risk for us to adopt a more defensive approach and deploy our teams’ stock-picking skills to identify attractive, late-cycle opportunities.
1“Capital Investment Soars at Firms,” Wall Street Journal, May 16, 2018.
A company with a market capitalization of over $10 billion.
A company with a market capitalization between $2 billion and $10 billion.
A company with a market capitalization of less than $2 billion.
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