Growth Stock Volatility Persists
After the previous period of elevated volatility in growth stocks (in May 2018) we emphasised that, although equity draw-downs are never pleasant, growth stocks tend to outperform equity markets in the long run. This notion has not changed. Growth stocks by their nature can exhibit very high volatility during periods of market anxiety or adverse “sector rotation” (temporarily favouring more defensive stocks such as utilities over growth). Short-term market timing is almost impossible as the duration of periods of under-performance in growth stocks cannot be predicted with any level of accuracy. Investors in funds characterised by exposure to structural growth trends can be confident, however, that periods of under-performance are temporary and, although stretching investors’ patience at times, represent attractive “investment windows”.
Hitting a “Wall of Worry”?
Over the last three weeks equity markets have been faced with three separate trends which have conspired to depress sentiment: International trade tensions, the outlook for the Chinese economy, and the risk of a recession in the industrial world. All three feature prominently in the list of investors’ worries.
1. Trade Disruption
US trade policy is supervised by the US President and some commentators suggest that the recent mid-term election outcome could lead to (even) more drastic policy proposals by the US government. Typically, in trade disputes, all parties involved suffer. So, China, as well as the US, is already noticing the effects of recent trade measures. There appears to be no end in sight to the “tit-for-tat” and the tariff on $200bn of Chinese exports to the US will increase from 10% to 25% on 1st January 2019. The US also threatens to impose tariffs on the remaining $210bn of Chinese exports.
The estimates of the expected economic effects of these protectionist measures vary widely but all point towards a meaningful negative impulse to all trading parties involved. Credit Suisse estimates, for instance, that the tariffs will reduce China’s economic growth by 0.9% through reduced investment activity.
It seems that Chinese authorities are orchestrating the devaluation of the Yuan and implementing a mix of other policies in order to offer a boost to the economy in the wake of the introduction of tariffs, although compensating for export tariffs on a business level will not be straightforward and could have additional unintended consequences; it is also difficult to predict the effect of these measures on international capital flows.
International trade is only one of China’s economic issues. Preceding the current trade conflict there has been significant accumulation of debt in the economy. The authorities have addressed previous episodes of economic weakness through increased debt-financed investments. As a result, China’s debt has been rising steadily and reached nearly 260% of GDP last year. With the increase in outstanding loans, debt servicing costs have also shown a significant increase and a number of commentators now suggest that China’s debt levels have reached an unsustainable level. However, the Chinese debt burden is not as alarming as the headline numbers suggest: China is, after all, still a country with a high household savings rate and experiencing a growth trend, which should be better able to deal with rising debt servicing costs than, for instance, Italy. With the macro debt statistics in mind it is easy to see that the scope for further economic stimulation to compensate for the economic effects of tariffs is limited and one can expect the “China debt” issue to continue to make headlines for a prolonged period.
3. An Imminent Recession?
The word recession has appeared more frequently in market comments in recent weeks. Pure logic tells us that, by definition, with every day that passes investors move one day closer to the next recession. That does not imply, however, that a recession is imminent. In fact, the probability of a recession occurring in the next 6 to 12 months remains low based on a range of leading indicators.
Higher interest rates, analysed in isolation, are of course never good news. It is important to note however, that rising interest rates are the logical consequence of the Fed’s policy “reaction function” and only occur as a result of improving economic conditions. Low interest rates have also contributed to US company EPS growth through lower interest payments and reduced finance costs of share buybacks.
The recent US tax cuts are projected to have an additional positive effect on economic growth next year (boosting GDP growth by 80 basis points) as well; it remains to be seen, however, if these tax cuts will be made permanent.
Based on various recession indicators, the next US recession seems most likely to occur in the second half of 2020 according to Credit Suisse, which suggests that the US equity market could peak a year before, in late 2019. Judging the timing and probability of a recession is more complicated than normal because there are a relatively large number of “unknowns” which can have a significant influence on the ultimate economic outcome.
One of the main “unknowns” is the pace of wage growth in the US economy: the year-over-year rate of increase for average hourly earnings has been locked in a rather narrow band of roughly 2.5% to 2.8% since the end of 2015. It has seemed as though every time there was a surprise to the upside, it was reversed in the following month or so, turning any unexpected gain into a "false start." However, over the last three months, the annualized gain has twice hit the 3% threshold, and in October increased by 3.1%. It is too early to draw conclusions but investors may finally be witnessing the long-awaited positive momentum in wages. The more positive assessment of US wages further reduces the risk of an imminent recession.
Interest Rates: A Short-Term Headwind
The process of interest rate normalisation is generally viewed as a negative factor by most equity observers, particularly those investors who fear the end of a period of strong performance of equities. This fear seems overdone: interest rates have risen but they are not yet at levels that should worry investors; the Fed now states that US monetary policy is no longer accommodative, which suggests that most of the adjustment of interest expectations has probably been absorbed by investors.
Ever since the Global Financial Crisis central banks have provided support whenever the market showed even the slightest signs of weakness. In a normalised world, investors should not automatically count on such support: the fact that market participants do not have to rely on central bank help should be seen as a major positive development rather than a negative market factor. In any case it seems to be clear that market participants can no longer count on automatic support from monetary authorities.
The comparison of current economic conditions with periods that preceded recessions offers reassurance to equity investors. US households are in much better financial shape than in 2007. Corporate balance sheets have become moderately affected by investment expenditures, and if interest rates were to rise significantly and suddenly, a number of expansionary corporates might reach financing limits. Budget deficits are rising in many countries and government debt appears to exhibit an unsustainable growth path in the US, but with the US Dollar being the World’s reserve currency, this global finance structure is likely to lead to US$ currency adjustments rather than a US recession.
Overall it seems that international investors are in the process of adjusting interest rate expectations: once these long-term interest rate scenarios have been absorbed by market participants the attention of investors is likely to refocus on long term growth drivers rather than the immediate economic adjustment path.
Revisiting the Case for Growth Investing
An intensive and critical approach to stock selection is crucial for investors aiming at exposure to structural trends as an optimal portfolio of growth companies can (in the long run) be expected, not only to outperform market equity indices, but also record a positive performance in absolute terms. The reason for this is simple: in the long run, global economic growth is positive which is reflected in overall corporate profit increases (with superior companies outperforming) and positive share price performances.
Important periods of portfolio assessment occur during (quarterly) earnings reports season when fund managers can compare their corporate projections to financial trends and implement portfolio adjustments if required. Superior growth companies also tend to generate earnings surprises (compared to consensus estimates of brokers’ analysts) and the continuous adjustment of earnings forecasts to a positive growth momentum suggests that existing analysts’ estimates of Earnings Per Share (EPS) are often lagging reality. The recent earnings season covering Q3 2018 corroborates the growth trends of the investment strategies of the Dominion Global Trend Funds and show that the investment portfolios continue to generate positive sales and earnings surprises.
Sales and Earnings surprise - Dominion Global Trends Luxury Consumer Fund
Sales and Earnings surprise - Dominion Global Trends Ecommerce Fund
Sales and Earnings surprise - Dominion Global Trends Managed Fund
Identifying “Investment Windows”
Dominion Global Trends Luxury Consumer Fund – Euro I Class
Dominion Global Trends Ecommerce Fund – Euro I Class
Dominion Global Trends Managed Fund – Euro I Class
Temporary rotations within equity markets in and out of growth sectors do not alter the long-term case for growth investing (at a reasonable price) but investment portfolios of growth stocks tend to be volatile. Fund volatility can, at times, be relatively elevated and risk management tools are aimed at managing the Funds’ volatility but shifts in market sentiment and sector preferences cannot always be predicted. This year has been testing the optimistic view of growth stocks in a major way, but in the absence of factors that indicate a decline in growth prospects, investors can be confident that superior growth will not be ignored in the long run. Under normal market conditions growth stocks benefit from their “long duration” profile: investors can look far into the future regarding the earnings potential of these companies and tend to use the discounted value of long-term earnings (and cash flow) streams as a valuation yardstick. As a result, valuations of growth equities tend to be at a premium compared to market averages.
In the current environment of the normalisation of interest rates (led by the Fed in the US) the discounting of future earnings will, in itself, result in lower discounted values (due to a higher discount rate). This is, however, only one aspect of the economic backdrop: as argued above the earnings trend is positive and, more importantly, the improving clarity of monetary policy resulting from the normalisation process should encourage investors to extend the investment horizon further into the future; increased confidence benefits the risk-taking propensity of market participants. It is also worth emphasising that monetary tightening is only reactive to favourable economic trends (and the related positive earnings momentum).
The graphs of the Dominion Global Trends Funds above reflect the volatility of underlying assets and illustrate that periods of over- or under-shooting can last for a few months, but the performance of the portfolios have always reversed to their upward trends in the long run.
Note: All data for graphs was sourced from Bloomberg.
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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.