Q2 2018 Quarterly Review and Outlook
Provided by the ACM Investment Committee.
Part 1: The Macro Environment
The stock market performed fairly well in the second quarter, with the S&P rising 3.4%, after a more volatile and difficult first quarter. Yet the gains were highly concentrated. Three companies, Amazon, Netflix, and Microsoft, accounted for 71% of the market’s increase through early July. Add in three more companies, Apple, Alphabet, and Facebook, and just six stocks accounted for an incredible 98% of the total market advance. The concentrated outperformance of this select, small group of companies is already changing. Netflix and Facebook were crushed following their releases of second-quarter earnings and reduced forward guidance. Neither report was horrible, but their stocks were priced for considerable unfettered growth, a rather high and even unrealistic hurdle to overcome indefinitely. Still, these reports were enough to undermine the market’s infatuation with these stocks and they were repriced essentially overnight.
Overall, market valuations remain very attractive. Second quarter earnings are actually coming in above the expected 20% gain even as 2019 estimates are being increased. The S&P is currently trading just below 16 times expected 2019 earnings, in line with its 50-year average, despite a nearly 30% appreciation over the last two years.
Source: Factset Research Systems, July 20, 2018.
The economic backdrop also remains very favorable for ongoing expansion of corporate profits. GDP growth above 4% in Q2 was impressive. Nonresidential capital investment (buildings, factory equipment, etc.) was solid at 7.3%. The largest surprise came with regard to household savings. After historical revisions, the savings rate was revised from 3.4%, a low level that raised concerns in some quarters that consumers lacked the ability to finance spending growth, to 6.7%, implying that households retain plenty of firepower to continue spending.
The savings rate calculation was revised and now more accurately captures the genuine savings rate in the U.S. and shows that savings levels have returned to levels last sustained in the mid-1990s. Even if growth moderates in the second half of the year, as is widely expected, 2018 should still experience a very solid advance.
There’s no doubt that the fiscal stimulus package passed at the end of last year is stimulating economic growth this year. While a distinct positive on one hand, it also boosts the Federal budget deficit and comes at a time of labor scarcity on the other hand. It should continue to provide a strong tailwind to growth for at least the balance of the year and even beyond, although it should also boost interest rates and inflation, undesirable effects that haven’t become visible quite yet. Forward-looking measures, such as job openings, suggest the economy enjoys considerable momentum. The corporate tax reform should also continue to aid U.S. companies and has the potential to act as a positive economic driver for years into the future. There’s simply no visible end to the expansion, as yet.
The battles over trade policy are likely to remain in the news for some time, and the rules and issues seem to change on a daily basis. Major threats and bluster appear to be the weapons of choice in this battle. The concern among investors goes beyond the sectors thus far named as targets for U.S. protection or foreign retaliation. The fear is that a prolonged trade war with ever higher, tit-for-tat trade barriers could eventually compromise broader economic activity. While the trade war has begun in earnest, we are still far from that sort of debilitating outcome, even though that’s highlighted by the media every day. For now, we’re likely to see a more limited engagement since China has far more to lose as it strives to support its slowing economic growth by pushing its products more broadly into international markets. This is already evident in the performance of its stock market, which is the world’s worst performing major stock market this year.
Source: http://www.wsj.com/mdc/public/page/2_3022-intlstkidx.html
During this earnings season, however, companies are hedging outlooks because of this threat, so guidance appears to be more cautious than is typical. It’s possible that the upcoming midterm elections will force a more reasonable trade settlement than the market fears, but the interim is likely to remain noisy, and the ultimate outcomes are highly uncertain.
Internationally, there are issues almost everywhere, although this is commonly the case. Brexit is unresolved and the U.K. could be unable to find an acceptable agreement with the E.U., so a “hard” Brexit may become the default solution, although it is increasingly possible that Brexit doesn’t happen at all. Italy will soon find out if it can also provide fiscal stimulus to its economy without undermining its ability to finance its fiscal deficit or offending its neighbors in the E.U. Several emerging markets are really struggling. While Greece continues its slow recovery, a positive development, Venezuela will soon join the Weimar Republic and Zimbabwe as the countries having experienced the highest inflation rates ever recorded in human history. Its oil exports and economy are collapsing, while its leader blames its enemies for conducting an economic war against it, so it can avoid blaming itself. Brazil and Argentina are not doing well. Both are trying to overcome legacies of corruption under prior governments. China’s growth is slowing, albeit gradually. And no one thinks peace will suddenly break out in Syria, or with North Korea or Iran. The world remains full of nasty places. By contrast, Democrats and Republicans are getting along really well. (Yeah, right.) Lacking a calm, productive geopolitical environment, we’re fortunate to enjoy a healthy domestic economy that is continuing to create new jobs at a solid clip.
Notwithstanding the above very real concerns, it isn’t all bleak overseas. Ireland and Spain are recovering very nicely from their severe recessions. France’s new government is trying to loosen highly restrictive labor practices to enable its economy to become more dynamic. Growth in the core of Europe is very solid. Japan has resumed slow growth, even if it’s been unable to get inflation up to the central bank’s modest 2% target. Between the core of Europe, Japan, China, and the U.S., the world economy has more than enough powerful engines to maintain its solid expansion. Countries that fail to participate in this growth mostly have their own poorly considered domestic policies to blame.
We remain positive on the outlook for the U.S. economy, especially with regard to the profits outlook, but wary over wage and price inflation risks. The pace of growth is meaningfully above the economy’s potential growth rate, so unemployment will continue to fall and wage pressures will mount further. It is likely that some of this pressure will become manifest as higher inflation, which will exert further upward pressure on long term interest rates and induce two more rate hikes by the Fed in September and December. On balance, we remain positive on the outlook for stocks and commensurately negative on the outlook for bonds.
Part 2: Sectors, Themes, and Income
Technology & Beyond
The technology sector—one with particularly strong long-term structural growth potential—will likely have seen earnings growth of over 22% in 2Q. Next quarter, the group appears poised to see 15% growth, and next year, 11%, yet many technology stocks have been hammered—some because of slowing growth prospects, but many others because of uncertainty surrounding the trade tensions between the U.S. and China. U.S. tariffs, and foreign retaliation, are more likely than not to be temporary – at least in the context of time horizons relevant to the current technology boom. From hardware to semiconductors and software, the technology sector is enjoying several multi-year expansion drivers. Quite familiar to all is the explosion of smartphones and smart homes. Behind all the data now flying around the internet lies a massive infrastructure expansion. Globally distributed server farms must handle those data flows and all the related analytics. The pressure from exponential data growth is forcing upgrades to those systems. We are in the middle innings of this build up.
Facebook, Amazon, Netflix, and Google may be the most visible investment opportunities, but investors needn’t own all these—and live with uncomfortable and risky high multiples—to gain exposure to these multi-year growth forces. We are finding investments behind the scenes among the companies supplying the pieces needed to make it all work. We are also seeing the technology advances born of the internet and smartphone age spilling over into different areas. One of these is the auto industry, where electronics are playing roles far beyond infotainment systems. Another is in health care, as medical devices, diagnostics, and patient monitoring are increasingly augmented by connected, smart internal components. Looking beyond FANG stocks opens the door to GARP (Growth at a Reasonable Price) investments, which combine the appeal of value investing with the potential for appreciation created by secular growth drivers.
Housing
June housing starts were down 4% year-over-year, leading some to see a slowdown in the making, even as starts were up 8% for the entire second quarter. This concern has helped cause homebuilder and building materials stocks to drop sharply this year.
But the housing data reflects supply constraints as well as shifting demand patterns, and digging a little deeper indicates a temporary disruption in a market with strong, multi-year secular drivers. Despite the behavior of homebuilding and materials stocks this year, new housing starts are still running below the historical level of new entrants seeking houses. Low inventories have held back sales, but last month saw a slight rise in homes for sale, suggesting that inventories may have bottomed. Headwinds from shortages of labor and lumber and rising input costs more broadly are slowing housing starts, while tax code changes (SALT), reduction in the mortgage deduction, and rising interest rates may be shifting the composition of demand away from higher-priced homes. See our July 2 commentary for more discussion of the visible impacts of the SALT changes.
Many homeowners have also become reluctant to move since doing so means giving up lower-rate mortgages for today’s higher rates. This is serving to constrain the supply of existing homes on the market but does nothing to relieve the demand for new homes among millennials. The strongest growth potential still resides among first-time home buyers, but there remains a shortage of entry-level houses for sale evidenced by a decline in sales of homes worth less than $250,000 relative to last year. Even if existing home sales slow, the demand for new homes will likely continue to tick higher in order to provide housing for a growing population of first-time home buyers. Remember that homebuilders and materials suppliers count on a healthy pace of demand for new homes and could give a fig about existing home sales numbers.
Income Investing: MLPs & BDCs
There has been a nice recovery in the second quarter for MLPs (Master Limited Partnerships) and BDCs (Business Development Companies) off the lows hit at the very end of Q1. The acquisition of more limited partnerships by their general partner parents and the restructuring taking place to eliminate incentive distribution rights has opened the sector to investment by mutual funds and others who had avoided investing in entities that issue K-1s. This may have contributed to the recovery in the space, but the rebound in the sector has lifted plenty of companies that have not yet made the commitment to restructure.
The other really interesting development in energy is the emergence of bottlenecks in pipeline takeaway capacity that is now restricting new oil and gas production. Companies that drill, especially in the Permian Basin, simply lack adequate pipeline capacity to bring new supplies to market, even as production volumes keep rising. Several new potential pipeline projects have been announced, but it takes time to get the commitments from producing companies and to garner the requisite government approvals to commence and complete construction. So, these new ventures will not become operational and relieve the constraint on production until late 2019 or 2020. In the meantime, existing pipes are running at capacity.
Interestingly, BDCs bottomed precisely at the same time as the MLPs and have recovered in tandem, although there’s no reason they should move together. They are simply in very different businesses.
BDCs may also be responding to the new legislation passed that permits BDCs to increase their debt to equity ratio from 1 to 1 to just 2 to 1. This increase in leverage will enable firms to increase lending activity and return on equity. Simplistically, Standard & Poor’s threatened to reduce the credit rating of any BDC that approved such a change and two backed off after their boards of directors had initially approved the change. Even so, no others were cowed and the industry seems to be adopting the higher leverage ratio as the new standard. Importantly from a shareholder point of view, a number of these firms also reduced their management fees and explicitly altered their lending criteria so they would make safer loans. Investors have reacted quite positively to these developments and every proposal placed before shareholders was adopted with overwhelming support.
Financials, REITs & Utilities:
Financials, especially the banks, tend to perform well whenever interest rates increased and tend to weaken otherwise. Although interest rates pulled back, banks had a very good second quarter, especially on the regulatory front. All of the major domestic banks passed their stress tests, and another round of dividend hikes and stock repurchases now lies in store for them. Moreover, Congress raised the hurdle for in-depth oversight from $50 billion in assets to $250 billion, relieving a number of banks from assorted onerous regulatory requirements. After a rough first quarter, they performed far better in the second quarter and that better performance has continued into July.
Utilities and real estate investment trusts performed quite poorly earlier this year until they bounced back nicely in late May and June when rates declined. But these fairly interest-rate sensitive sectors are unlikely to perform well if rates resume their ascent, as we see from their behavior in July. Both sectors softened as Treasury yields moved higher and our exposure to them is at its lowest level in the firm’s history.
Income Investing: Bonds & Preferreds
3-month LIBOR increased by 2 bps in 2Q and it has risen more than 1% over the past year. Floating rate securities in the portfolio are providing higher income to investors as coupons reset. We expect a clear path for higher short end rates thru 2018. The increase in rates followed another Fed rate increase and was driven by economic data which continues to support tighter monetary policy. Correspondingly, duration has negatively impacted many fixed income portfolios so far this year, and we believe duration risk remains high in the second half of 2018 as well. Right now the bond market is only paying investors an extra ~0.30% to make a 10-year loan versus a 2-year loan. This is precisely why we are keeping the duration of our fixed income holdings in clients’ accounts exceptionally short.
Credit spreads remain tight, so we continue to favor higher-quality bonds and preferreds as the economic and credit cycle extends since investors are being paid little for holding riskier paper. In the second quarter, corporate credit spreads widened slightly, but remain low by historical standards. Lastly, we have noticed increased investor interest in preferred stocks. While preferreds typically offer much higher yields than investment grade bonds and less risk than many high-yield bonds, not all preferreds are as attractive as they seem at first glance. Preferreds often contain three subtle, but significant risks — duration, coupon risk, and call risk. In order to mitigate these risks, preferred selection is of the utmost importance and these risks underlie our strong preference for selecting individual securities for our clients.
Value vs. Growth Investing
We continue to re-evaluate the investment opportunities available in the market in light of changing economic conditions as part of our normal investment process. Conditions change and we must recognize new developments and invest accordingly. As always, we search for good value, trying to buy either income or growth inexpensively, depending on the needs of each client and balancing these client objectives with the risk we see for each.
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