Economic Outlook for December 2018
November was a volatile period for equity markets worldwide ending on a somewhat positive note with the S&P 500 gaining 1.8% and the Nasdaq a mere 0.3% during the month. Uncertainty regarding monetary policies, the trade tensions with China and a general unease regarding economic prospects for 2019 conspired, once again, to feed global anxiety during most of the period.
The uncertainty surrounding global equities was, however, not justified by corporate profit trends as reported during the month. The superior profit trends of growth sectors have, in the course of the month received more media attention and by the end of the month there were signs that market sentiment was recovering, with the last week of November seeing the S&P recover by nearly 5%!
So, are global investors now driving a turn-around in the performance of growth sectors and can one expect that the favourable performance of growth stocks will continue during the remainder of the year and into 2019? Predicting short term equity market performances has consistently proven to be virtually impossible, but the long term positive relationship between profit growth and equity performances is well-established: the economic growth trends and corporate earnings dynamics bode well for a continuation of the recent recovery of growth stocks and the Global Trends portfolios into next year.
Ecommerce: Superior Earnings vs. Poor Sentiment
In the midst of a significant sell-off of growth stocks the profit expectations of US growth companies dimmed in the course of the year. Contrary to market reactions however, the 2018 third quarter earnings season has not been poor for stocks within Dominion’s Ecommerce portfolio (which, at times, has a high perceived association with the US technology sector). Reported sales growth was broadly in line with consensus expectations (missing by only 0.6%) while earnings beat by more than 10%. The average sales and earnings growth of the companies within the portfolio was +22.7% and +32.3% respectively, showing robust fundamental trends in regards to both sales and profits.
Despite comparatively solid earnings, investor sentiment had taken a downturn this year. This could be explained by a number of factors that were weighing on perceptions of growth sectors. They included:
- The semi-conductor sector feeling pressure as Apple lowered its orders, and some technology stocks (such as Nvidia) no longer benefiting from a craze in Bitcoin mining.
- US-China trade war concerns, and its effects on Chinese growth
- The widely predicted and expected raising of US interest rates
- Increased international regulatory pressure on certain large technology players
- Heightened perception of geopolitical risks, including: President Trump, Saudi Arabia, Iranian Sanctions, Italian budget, and Brexit.
Each of the above reasons, excepting interest rate increases, affects a different part of the Ecommerce sector; but, taken together, they have caused a rotation out of the whole sector. The simple explanation was that the constant release of negative headlines, even as many companies report solid earnings, had turned sentiment for growth sectors negative.
While this pullback has occurred across the whole market, the growth sectors have been disproportionally affected (and most notably technology). The recent correction has behaved differently being larger in magnitude and longer in duration than other volatile market episodes over the last 12 months. Thus, one must look further back to find parallels. At the start of 2016 a similar correction could be observed: a peak-to-trough decline in the MSCI World and NASDAQ of -14.5% and -17.3%, respectively, over a more-than two month-duration from the end November 2015 through to February 2016. Notably, one could also observe a rotation away from growth stocks and the technology sector during this period. This pullback was also driven by fears around the growth of the Chinese economy (specifically trade data), and oil and commodity price slumps. A year after the correction, the MSCI World and NASDQ indices had appreciated by 23.5% and 34.4%, respectively.
With respect to the market valuation for the technology sector (using NASDAQ as a proxy), one can conclude fairly comfortably that it does not look onerous: the MSCI world and NASDAQ indices are well below their 3-year average Price to Earnings (P/E) ratio. One can observe a similar phenomenon in the Global Trends Ecommerce Portfolio, where the average P/E ratio is some 17% below where it was at the turn of the year – even as the portfolio has average sales and earnings forecast growth of around 20%.
Managed Fund: Attractive growth exposure
Despite weak market and fund performance in November, this quarter’s corporate results were positive for the DGT Managed Fund. On average for the Fund’s portfolio names, reported earnings beat expectations by 12% percentage points, a very strong performance and evidence of the continued strong growth exposures of the portfolio. The recent weakness in market sentiment has been driven by concerns about the ongoing US-China trade dispute, potential for a turn in the business cycle and rising interest rates in the US. These factors have combined to hit growth stocks particularly hard. This more negative sentiment has not translated into weaker fundamentals for portfolio constituent companies, however. One could continue to see a strong growth outlook across the portfolio and the ongoing market weakness has made valuations more attractive. Some portfolio names with more cyclical end market exposures are now trading on free cash flow yields of between 8% and 12%, despite reporting strong earnings growth through 2018 and a favourable long-term growth outlook. Long-term investors tend mostly look through short-term fluctuations in sentiment and remain focused on these long-term fundamental trends. This makes current valuations for the Managed portfolio names relatively attractive. The average P/E ratio for the DGT Managed Fund is now 13% below the level at the start of 2018, while the average 2019 sales and earnings growth forecasts are for +10% and +12% growth respectively.
Luxury Fund: Focus on pricing power
Since the start of October, the DGT Luxury Consumer Fund has declined by 14 % in US$. Over the same period, MSCI Textiles Apparel and Luxury Goods index has declined by 14.5% and the MISCI world Index by 10%. Against a background of falling valuations third quarter results of the Fund’s constituent companies were in line with expectations. It showed consistent growth being maintained, especially in terms of (free) cash generation, which is expected to accelerate from mid to high teens into 2019 as one-off extra investments to adapt distribution networks to ecommerce tail off. Equity market reactions often reflected macro concerns – primarily over falling bond markets/rising yields and escalating US-China trade tariffs, rather than fundamental trends at the portfolio constituent companies. Expected underlying growth trends for portfolio companies, given the favourable results season, have not resulted in significant changed expectations (2018 expected revenues’ growth has slipped -70bps to +7.2% and EBITDA -100bps to +14.4%). Share valuations consequently have mostly de-rated, in particular for the fastest growers and often best performing stocks. Across the period, the portfolio’s prospective P/E ratio has fallen to 21 times earnings from over 23x, while the weighted Free cash Yield has risen to 3.74% against 3.51% at the end of September.
During November the Fund’s exposure to Tier 1 Traditional luxury companies was increased – in particular Kering, which had been unduly marked down on subsequently unsubstantiated media reports, which had suggested that Asian luxury demand is primarily cyclically/politically driven. Recent results from Hermes, LVMH and Kering (Gucci), clearly show that underlying demand remains robust and driven by long term structural trends but that Ecommerce, foreign exchange dynamics and customs duties have shifted where, geographically, the precise point of sale is! Throughout the sell-off period the focus of the portfolio remained on companies which are able to set prices in a manner that is relatively free of growing regulatory interference. With ecommerce allowing luxury consumers almost limitless choice and near perfect pricing information we see such “Tier 1” companies continuing to reap rewards at the expense of weaker peers/brands. This adds to their underlying growth rate and profitability. To accommodate a greater focus on price-setters the Fund removed some new consumer technology-driven companies (Zalando/CTRP) that continue to pass all benefits from breakneck growth to the consumer! The market’s negative correction seems to have marked an end to the “grace” periods that investors had granted for a number of companies to demonstrate their wealth creation capabilities in a global marketplace increasingly dominated by ecommerce practices.
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The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Fund Management Limited. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.