Broad-based data can obscure positivity beneath the surface sometimes, however. Unfortunately, that is not the case with margins today, as the sluggishness is not sector specific. Nine out of the 11 US sectors have witnessed a decrease in year-over-year profit margins.8 Outside the US, profit margins that hit a cyclical peak in 2019 have been falling for 10 straight months, as shown above. As a result, expect these lofty growth figures— 10.5%, 7.8%, and 13% for US, developed-ex US, and emerging market regions, respectively9 — to come down, consistent with historical trends. In fact, 2020 earnings-per-share growth for US, developed-ex US, and emerging market regions have already been revised down by 1.8, 1.7, and 1.1 percentage points over the past two months, respectively.10 And once again, weakness at the sector level persists. Ten out of the 11 US sectors have lower estimated 2020 growth today than they did three months ago.
The Risk of Finding Value
All this uncertainty surrounding US growth and broad-based valuations plotting in the top 86th percentile relative to history11 mean that the fundamental safety net has a few holes in it. Positive growth, a yield curve in stasis, and overvalued portions of the market may set the stage for a revival for value strategies — a factor style that has been mired in below-market performance for six out of the past seven years. However, while the inkling of a value rally began in September after momentum sold off, downside growth revisions and the broad-based scarcity — and quality — of growth remain the key risks to a full-on value revival.
Constructive valuations outside the US continue to be a siren’s song tempting contrarian investors to look past the sizable geopolitical risk impairing fundamental and economic growth. Yet this risk premium may require investors to put up with some pain along the way, as uncertainty driven by protests, Brexit, and Middle East unrest continues to percolate with widespread effect. After all, on a relative basis, both developed ex-US and emerging market (EM) equities have looked cheap for the past few years, as the US has hit numerous all-time highs while those markets have yet to climb past their 2007 peaks. In EM, perhaps the pain may be worth the premium, given the region’s already small weight in the standard asset allocation mix. In developed ex-US, the pain should be soothed by seeking to smooth volatility.
Dealing with the Fear of Missing Out
Will these issues weigh on future US equity returns? Well, hindsight is 20/20. In 85% of the periods, returns on US equities were positive six months after hitting all-time highs. As shown below, there has been a positive skew to subsequent returns of prior all-time highs. But drawdowns can occur when idiosyncratic events come out of nowhere, with volatility acting as a “drag” on returns.