Economic Outlook for November 2018
Corporate trends remain supportive
According to Credit Suisse: “Nearly a third of the S&P 500 companies have reported Q3 earnings. Earnings are surpassed by 3.9% (compared to 5% over the last three years), with 76% of companies surpassing profit estimates (69% over the past 3 years). The corporate tax reduction contributed 7.5% to earnings. Excluding the tax reduction EPS growth is on pace for 14.0 % growth but jumps to a plus + 21.4% including the tax reduction.”
According to FactSet, of the 150 S&P companies which have reported (and are constituents of the S&P index) 80% have topped analysts’ estimates, but companies are beating expectations less than usual so far.
Monetary Policy to be “normalized”
The tightening path of US monetary policy is a key factor affecting market sentiment in the USA. One of the open market committee members (Kaplan) foresees 3 more US rate hikes. Market consensus suggests that the FED Funds will see yields increasing by 75 basis points over a 12-month period and Yields on the US 10-year government bonds are now expected to reach 3.2% by year-end and 3.5% next year, according to one major investment bank.
Mario Draghi stated the following regarding official rates: “We expect them to remain at their present levels at least through the summer of 2019.” This guidance has been repeated several times. Market observers interpret the ECB language as signalling a small increase in the deposit rate in September next year. Europe can therefore be expected to lag behind the US in terms of interest rates for at least another six months.
International politics: unhelpful
The EU rejected Italy’s draft 2019 budget by braking public spending rules; and it asked Rome to submit a new one within three weeks. Italian bond yields are rising but do not seem to have reached crisis levels yet (Italian government bond yields have risen to 3.6% from 3.4% a week ago).
The stock market also seems to be worried about Saudi Arabia: with American sanctions cutting Iranian oil, it will be up to other OPEC members to compensate for the lost supply.
Also US politics could further upset equity markets: the fear that one of the chambers of Congress could come under Democrat control, which could frustrate some of the deregulatory and pro-business policies.
Economic trends in line with expectations
Some of the economic statistics provide ammunition to the market bears (disappointing US new home sales is being attributed to higher mortgage rates) but overall the incoming economic evidence continues to point towards continued favourable growth trends in the OECD area.
The Markit Euro business survey showed slowing (but positive) growth across the Eurozone which some commentators attribute to reduced trade (the so-called Flash Eurozone PMI Composite Output Index stood at 52.7 in October vs. 54.1 in September – values above 50 indicate expansion).
The US economy remains strong, confidence levels are high, inflation stable and industrial production accelerating. Three new economic confidence lead indicators released for October for the US economy continue to show that confidence remains high, with no indication of any weakening from elevated levels. Also, the latest inflation data for the US for September shows little evidence of a ramp-up of inflation. US industrial production for September accelerated again, up to +5.1% year-on-year (YoY) growth run-rate, this is a 0.3% acceleration in the run-rate month-on-month, and 3.9% higher YoY. This is a strong indicator that US industrial activity is in good health and continues to accelerate. These latest data continue to indicate that the US economy remains in a strong position, with continued elevated levels of economic confidence, stable inflation and evidence of further acceleration of activity growth in the industrial sector.
With respect to the important Chinese economy the incoming economic evidence suggest some slowing momentum along a (largely predicted) growth path: Q3 GDP rose by 6.5% (6.6% was expected), industrial production increased by 5.8% in September (6% was expected), fixed asset investments were 5.4% higher (5.3% expected) and retail sales grew by 9.2% (9% expected). Overall the forward looking picture still indicates a robust Chinese economy, expanding at a solid growth run-rate, but admittedly with some early indicators of some mild slowing in activity.Export trade data for September was strong, +17% YoY in CNY terms and +15% YoY in USD terms, potentially this may indicate stronger exports. Fixed asset investment data for September showed a sequential improvement and remains at robust levels, overall investment growth YoY +5.4% and manufacturing sector fixed asset investments +8.7% YoY. Some of the latest data points are pointing in different directions. On the one hand, the satellite image-based activity metric has been indicating some slowing in overall economic activity growth rate in China since June. However, the latest real activity data points in export trade volumes and fixed asset investment do not show any signs of slowing activity, and actually show some signs of short-term strengthening.
Specific portfolio observations
The third quarter reporting season (currently underway) provided a timely check of the growth characteristics of the Dominion Funds’ portfolios. So far, the companies represented in the three Global Trends portfolios have reported favourable results surpassing market expectations, representing superior growth at a reasonable price (GARP) and justifying their selection as structural long-term investments.
Strong financial fundamental trends and growing ecosystems have characterised the three companies in the Ecommerce portfolio that have reported so far. Netflix, for instance, added 7mln subscribers some +35% above the 5.2mln the market was expecting. PayPal increased its user base +15% to more than quarter of a billion while beating market expectations on both top and bottom line with +21% and +26% growth respectively. While Visa, in its own formidable fashion, ground upwards increasing volumes and revenues +11% and +12% respectively while earnings jumped by 29%, one percentage point above expectations.
The Managed Fund stocks which have reported earnings so far in Q3 have all reported numbers continuing to show strong structural growth and no weakness in the macro environment. The sell-off in the market and our portfolio exposures is not, therefore, driven by any weakening in the fundamentals of our investments. The evidence so far in Q3 is that growth expectations for our investments is rising, while prices are falling, improving the relative value of these investments. Chr Hansen (processed food ingredients) beat expectations and raised guidance, strong revenue growth in all regions, Domino’s Pizza (takeaway food) reported strong growth in all regions, Givaudan (fragrance and flavour ingredients into consumer products) strong revenue growth ahead of expectations in all regions, Eurofins (product testing in multiple sectors) reported strong growth and raised guidance, Assa Abloy (exposure to construction and building renovation investment) beat revenue estimates and reported strong growth in its core markets, especially Asia Pacific and US.
The Luxury Consumer Fund has also seen portfolio constituents reporting results ahead of market expectations. Key portfolio holding Kering, for instance, roundly beat expectations on Wednesday, posting +27.5% sales growth for Q3(North America +36%, APAC +33%, W-Europe+19%). Revenues grew double digit in all regions, across all categories and distribution channels defying hitherto misplaced expectations of a pronounced slowdown. Kering follows LVMH and Remy in indicating that bottom up Chinese demand remains firm as structural factors prevail over perceived cyclicality. Prior to the result shares had been worst hit, severely falling -30% from highs. They now afforded exposure to growth at a very reasonable price (FCFY>5% PE<18x).
The table below shows what the upside of the investment portfolios of the three Dominion Global Trends Funds amounts to if the stocks in the portfolios were to revert to the P/E ratios of a month ago (before the recent sell-off), calculated as both the arithmetical average and weighted average upside across companies within the portfolios.
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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.