George Maris, co-head of equities – Americas, discusses the recent sell-off in US equities and what it means for investors.
After months of outperforming global equity markets, US stocks fell sharply this week on concerns about rising Treasury yields and geopolitical concerns. In many ways the pullback is unsurprising given the widening spread in global equity valuations: the S&P 500 Index peaked at nearly 20 times earnings before the recent sell-off, significantly higher than global peers. While US equities performed better than international peers throughout much of this year, the spike in 10-year Treasury yields and increased tensions between the US and China finally caused US stocks to buckle.
Will the market rout last?
For investors, the critical question may be whether this week’s pullback is temporary or the start of a more lasting downturn. Certainly, market fundamentals are showing signs of shifting. In the last Federal Open Market Committee (FOMC) meeting press conference, US Federal Reserve Chairman Jerome Powell adopted a more hawkish tone than anticipated, signaling the Fed’s intent to raise benchmark rates through 2020. While we think Mr Powell was consistent with his message, it appears the market finally woke up to a reality that rate increases will continue. As a result, investors are beginning to incorporate the implications of higher rates, focusing on the rising cost of debt and potential discounts to corporate earnings growth.
At the same time, plenty of technical factors seem to be exacerbating market swings. Volatility-targeting, risk-parity and other factor-based investing strategies make up a significant portion of daily trading activity. When market dislocations occur, these vehicles are forced to rebalance away from equities without respect to the underlying securities. This creates an environment in which equities are sold broadly, without discrimination for differences in quality.
Long term fundamentals: sound
Longer term, we remain positive about the outlook for US equities. For one, earnings season is kicking off, and profits in the S&P 500 are estimated to climb by an average of 19.2 per cent for the quarter, which would be the third-highest quarter of earnings growth since 2011. The US unemployment rate fell to 3.7 per cent in September, its lowest level in decades, and GDP expanded by a healthy annual rate of 4.2 per cent during the second quarter.
With corporate and consumer confidence levels strong, the US economy continues to demonstrate solid fundamentals, and the rise in long-term Treasury yields reflects this situation. Should inflation remain contained – which appears likely at the moment, especially given the Fed’s measured rate hikes – we think such an environment is a positive for stocks. After all, unlike many other asset classes, public companies can pass inflation to customers via price increases, helping generate stable-to-increasing earnings. And a strong economy helps fuel demand for products and services, sustaining further earnings growth.
Focusing on valuation
After strong performance in many equities over the past year, we remain keenly focused on maintaining fundamental investment discipline, which incorporates valuation to varying degrees. We think it is important for investors to find competitively advantaged companies that can navigate short-term disruptions and grow earnings throughout an investment cycle. We are cognisant of geopolitical risks, such as the potential for politics to arrest global trade and midterm elections to result in abrupt policy changes.
As such, stock prices matter. Fortunately, even as growth stocks outperformed their value peers in recent years, we think it is possible to find attractively valued growth companies. Indiscriminate selling in non-US markets and now in the US make valuations more appealing, in our opinion. Many companies with capable management teams, low debt levels and wide competitive advantages declined along with the broader market. Factor-based trading vehicles may have no choice but to rebalance away from such stocks. While these sell-offs can be painful in the short term, long-term investors focused on fundamentals can and should take advantage of these opportunities.
