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Why the US equity bull market could keep running into 2019
We have seen volatility return to the equity markets this year after an unusually calm 2017. The synchronised global growth environment that prevailed for the last two years has started to show some cracks, with many global markets seeing growth moderate.
The United States is bucking the trend when it comes to growth.
US gross domestic product (GDP) growth has accelerated in 2018, hitting 4.1 per cent in the second quarter. This is the fastest rate in nearly four years. This rate of growth is impressive, but the combination of tax cuts and increased federal spending may have pulled some of this growth forward, meaning it may be hard to replicate in the future.
MAIN PILLARS OF US ECONOMY LOOK SOLID
Even with policy changes that may have accelerated growth, when we look deeper at the foundation of the US economy - the consumer and corporate earnings - we see a healthy backdrop. These two pillars have both been performing well and are not showing signs of stress that we would consider indicative of the economic cycle nearing a negative inflection point or recession.
The US consumer continues to benefit from a very strong employment market, continued low inflation and low interest rates by historical standards. This is keeping consumer confidence (and consumer spending) healthy despite moderating global growth and increasing trade concerns.
On the corporate side, earnings for companies in the S&P 500 Index were up more than 20 per cent (year-over-year) in the second quarter of 2018.
While lower corporate tax rates provided a lift, the resulting higher profits will likely drive increased capital spending. In our view, this should add life to the ageing economic expansion as profits are reinvested and the capital expenditure cycle drives improved productivity. For many companies, we think these benefits could last well into 2019 or 2020.
BULL MARKETS DON'T DIE OF OLD AGE ALONE
There's been a lot of discussion about the duration of this current US equity bull market. While we don't expect markets to keep climbing forever without corrections, history has shown us that bull markets don't generally die of old age alone.
Historical triggers that typically have heralded the end of a bull market have included rapidly rising inflation or interest rates, the buildup of speculative excesses or bubbles, or a geopolitical shock that impacts demand. Above all, economic recessions usually mark the death-knell for bull markets.
The current US economic expansion has certainly been long by historical standards, but investors should remember it has also been very shallow and slow compared to past periods of economic expansion. This slower rate of growth is a result of the severity of the global financial crisis a decade ago, but also the low-inflation, low-interest-rate environment that followed.
Given the modest rate of growth in the nine years post-crisis, it is not surprising to us that the recovery has lasted longer than many expected and has not generated levels of excess that typically begin to appear this late in the cycle. At this time, we don't see any of the classic signs the economic cycle is turning, or that a recession is on the horizon.
At the macro-economic level, we are watching trends in inflation, interest rates, employment and credit-default levels for signs of change. As bottom-up investors, we are also constantly talking to individual company management teams to get an assessment of end-market demand, global competition and the health of their customers.
We still think the US economy is strong and equities have the potential to do well in the coming years. That said, preparing for an economic downturn or market pullback is something that is done over time, as we build our portfolios stock by stock.
Our rigorous, fundamental research focuses on companies that are not just growth businesses, but also those which meet our quality criteria. We seek to invest in companies with strong competitive positions, solid financials and innovative management teams. We believe these types of high-quality companies can outperform the market over the economic cycle and are more likely to prove structural winners over time.
THE BIG THREE RISKS
Tariffs and trade restrictions continue to be in the news and probably are the biggest uncertainty for the markets right now - with potentially significant impact on economic growth. We are watching these developments cautiously and constantly working to understand the potential exposure of the companies we invest in.
Not to diminish the risk, but we think trade tensions should be viewed through the lens of American politics: A trade dispute or tariff threat may be more of a means to an end of scoring political points with a targeted set of voters.
We see a low risk of an all-out trade war, or a serious erosion of the trade regime that has underpinned the rise in global prosperity since the end of World War II.
The second challenge is inflation. As US economic growth has accelerated this year, we are seeing a modest pickup in inflation, and the Federal Reserve (Fed) seems to have grown more hawkish as a result. The market appears comfortable with the current pace of interest-rate increases, given the country's economic strength, but there are concerns the Fed could overshoot its targets, especially if growth moderates in 2019.
The last challenge is more political - the US mid-term elections. Elections always bring some uncertainty and volatility as the market reacts to a potential change in the political and regulatory landscape.
The mid-term elections in the United States get a lot of press, but, in our view, a change to a more divided Congress wouldn't likely have a huge fundamental impact on the economy or broad investment landscape. The pro-business, less-restrictive regulatory backdrop that started in late 2016 would likely continue.
We would just have more gridlock in Washington, which, ironically, could actually be good for the markets, as markets don't like uncertainty.
POCKET OF RICH VALUATIONS, BUT TECH BUBBLE COMPARISONS IRRATIONAL
The S&P 500 Index currently trades at about 16.5x next year's earnings, which is right about at the five-year average and modestly above the 10-year average, which covers the depths of the financial crisis.
Valuations have moderated this year, and the US market is cheaper on a price-to-earnings (P/E) basis than it was at the end of 2017. The rapid earnings growth we have seen in 2018 partly explains why that's the case, but the moderation in valuations is also a reflection of the increase in risks being priced into the market.
Overall, valuations for the US equity market appear fair to us at current levels, reflecting the strong economy and the bright corporate earnings backdrop balanced against the risks of trade and rising interest rates.
Looking at valuations in the technology sector in particular, there are some pockets of rich valuations that grab headlines. But when looking broadly across technology stocks, they are trading at a slight P/E premium to the overall market, about 18.6 versus 16.5x for the S&P 500.
We see the technology sector premium as well-deserved, given that technology companies have delivered the best growth over the past three years and should be able to continue registering strong growth in the coming years.
Additionally, from a quality standpoint, the technology sector has some of the highest margins and best balance sheets in the market, according to our research.
It is also worth noting the technology sector has changed dramatically over the past 20 years. In our view, comparisons to the late 1990s' "tech bubble" are not rational. Tech companies today have been highly profitable and are much less levered. Revenue is less economically sensitive and more focused on software and services, which have the potential to bring recurring revenue that would likely be more stable in an economic downturn.
GROWTH AND VALUE INVESTING: IS THE TIDE TURNING?
"Growth" has outperformed "value" as an investment style since the end of the financial crisis. The market has rewarded companies that can produce consistent earnings and cash-flow growth in what has been until recently a modest GDP-growth environment.
The low-interest-rate backdrop has created an additional tailwind for growth equities where investors are often looking out three to five years at a company's growth potential and discounting those profits back to measure a company's fair value today.
In recent months, we have seen performance of value stocks improve, coinciding with the acceleration of economic growth in the first half of the year and the rise in short-term interest rates.
Despite this near-term "value" outperformance, I think many traditional value industries are facing significant competitive challenges from faster-moving competitors or new well-funded entrants. When we look across the investment landscape, we see the pace of disruption is accelerating and many traditional value industries face rapidly changing competitive environments. In my view, much of this risk is not captured simply by a low-valuation multiple, and some investors may risk falling into a trap.
Some examples of old line, traditional-value industries that are facing new competitive challenges include the transportation sector, where cheaper and faster competitors are rethinking how we move people and goods, and the retail sector, where online competition is driving prices down for consumers and in turn limiting pricing power for traditional brick-and-mortar retailers.
In the industrials sector, we are seeing companies embrace digital transformation and the use of data analytics. Robotics and artificial intelligence are shifting long-held cost advantages.
The question is not whether value stocks will have periods of outperformance - they absolutely will. Rather, the question is whether that outperformance is sustainable in a world where many industries are being disrupted at an increasingly rapid pace.
In my view, investors should not be debating "growth" versus "value", but really focusing on sustainability and quality (growth or value) for long-term investments in a diversified portfolio.
- The writer is vice-president and portfolio manager, Franklin Equity Group.