US equities continue to be supported by strong growth and contained inflation. While it’s prudent to watch out for volatility in the US dollar and oil prices, we believe there will be attractive opportunities in the months ahead for skilled stock pickers.
As we head into the second half, our core views for the year in Step Forward, Look Both Ways remain intact. Robust growth, notwithstanding some signs of softening outside the US, and contained inflation continue to provide a supportive backdrop for risk assets. Meanwhile, protectionism and geopolitical uncertainty remain the major downside risks. Still, we see enough late-cycle signs of tightening labor markets, quickening inflation and elevated valuations to recognize that this is the time for investors to be more cautious than usual about managing a turn in the cycle. A more selective and defensive approach is needed as valuations become more challenged and volatility returns to more normal levels.
Despite fundamental strengths supporting equities, markets remain acutely sensitive to changes in Treasury yields, as we saw when the US 10-year breached 3%. While the yield curve has flattened, it is still comfortably in positive territory with no signs of a pending inversion (an indicator of recession). With consumer sentiment strong, we believe the current rise in yields looks more grounded in economic growth prospects than the last time it approached 3% in 2013. One could argue that the rise in Treasury rates was overdue, given the positive outlook for global growth and higher inflation expectations. Our view is that the 10-year real rates are now at a cyclical peak.
As we discussed in detail in our recent investment magazine, Life After Easy Money, transitions to new monetary and fiscal regimes are marked by higher volatility and uncertainty. That is especially true as US President Donald Trump makes good on his campaign promise to behave differently from previous administrations and overturn long-standing norms around trade, immigration and security alliances. We also know that historically global equities are usually challenged during periods of rate normalization. Heightened geopolitical risk as well as any sign of faster-than-expected inflation unsettled markets in the first half of the year, and we expect markets to remain on edge, carefully weighing up the cyclical and structural forces that could lengthen or curtail the current cycle.
Following a stellar Q1 earnings season in which S&P® 500 companies were on track topost nearly a 25% increase in earnings compared with last year, investors finally rewarded companies in early May as the US equity market retraced its losses from earlier in the year. Meanwhile, there are growing signs that the immediate expensing provision in the US taxreform is indeed driving strong capital investment, as US companies reporting by the end of April indicated capital spending increased by 39%, the fastest rate in seven years.1
For some, that strong showing raises concerns over potential overheating in the US economy, with so much fiscal stimulus at a time when unemployment is at a 17-year low.Yet recent language from the Federal Reserve (Fed) seemed aimed at reassuring investors, suggesting a readiness to be patient, letting the stimulus take its course and raising rates only gradually — even if the economy overshoots the Fed’s 2% inflation target for a while.
The debate continues over why we have not seen even tighter labor markets in the US and other advanced economies lead to persistent wage and price inflation, or what economists refer to as a continued flattening of the Phillips curve. US inflation expectations have shifted upwards, but are still lower than they were four or five years ago.
One reason might be the increased use of automation. A striking theme in our fundamental teams’ Q1 conversations with companies about the difficulties of finding workers was a consistent reference to technology-driven approaches to bridge labor gaps at companies like Walmart and Kimberly Clark. McDonalds, for example, is introducing self-order kiosks while Starbucks is using robots in its distribution centers. Many of the business leaders our analysts spoke to expressed their own astonishment that they had been able to introduce automation so quickly and effectively in ways they had not thought possible several years ago. Moreover, given the tightness of labor markets, the increased capital expenditures made by US companies will feed directly through to improvements in productivity growth, providing a natural cap on inflation. Still, we believe at a certain point, labor shortages will begin to push wages higher, as we are beginning to see in select areas of the economy like trucking. But that will take time and does not, in our view, pose a risk to persistent inflation in the second half.
In other advanced economies, there appear to be signs of faltering growth, with momentum waning in Europe and Japan’s much more severe labor shortages constraining its highwater mark for growth (for every 100 Japanese job seekers, there are 159 vacancies, with unemployment at nearly a 25-year low). A softening in UK data no doubt played a role in the Bank of England’s decision to forestall an expected rate hike in May.
Meanwhile the US dollar’s volatility and increased oil prices have been a double-edged sword for emerging markets. The recent dollar strength coupled with rising interest rates and higher oil prices provide distinct challenges to emerging markets. Our view is that we could see continued dollar strengthening for the remainder of the year.
Oil prices also look likely to stay elevated for the rest of the year as a result of supply constraints. This could add inflationary stress to oil-importing countries, but will likely have only a temporary effect on the US, given the supply of domestic production and the less energy-intensive nature of the US economy.
In terms of regions, we now prefer the US over Europe given the fundamental strengths that could extend the cycle. In terms of global equities, we recognize the defensive advantages small-cap stocks dependent on the domestic economy will have in the case of escalated trade tensions. We continue to favor global banks, less-crowded tech innovators, healthcare and deep value stocks in the industrials, materials and energy sectors.
For our tactical positioning in fixed income, we are underweight US intermediate investment grade bonds and global government bonds outside the US where long-term rates relative to fundamentals are misaligned. We are neutral in both intermediate and longer-term investment grade credit as spread compression suggests limited gains in these sectors as the cycle extends. We have reduced our allocation to high yield as we believe this is the time to begin paring back on credit risk and to seek higher quality opportunities further up the capital structure. Despite the recent sell-off in emerging market debt (EMD), we believe investors can still find select opportunities in local currency EMD that is less sensitive to US rate rises and dollar fluctuations.
We have also increased our allocation to commodities to hedge rising inflation expectations, though we do not expect a persistent spike in inflation for the remainder of the year.
As we move to a more volatile and uncertain stage in the global capital markets, we believe this is the environment in which skilled managers are likely to find fertile ground for new growth and value opportunities, while seeking to steer away from the biggest drawdown risks.
1 Lu Wang, “Trump Tax Windfall Going to Capex Way Faster Than Stock Buybacks,” Bloomberg, 26 April 2018.
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