MARKET COMMENTARY

Equities Outlook: Where Are the Equity Market Opportunities?

12.10.2018 - Carin L. Pai, CFA

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Investing in Durable Growth as the Economy Matures

Our outlook for US equities remains positive for 2019, but the environment will become more challenging as the policy landscape shifts from monetary to fiscal stimulus.

Our approach to the market will be influenced by dynamics that have been gathering momentum for some time. On one hand, we expect uncertainty over interest rates and US trade policy to continue weighing on investor sentiment. On the other hand, we also see fiscal stimulus continuing to breathe life into the US economy, contributing to improvements in consumer confidence and corporate reinvestment in technology, equipment and other capital improvements. S&P 500 earnings grew by approximately 20% in 2018 and are expected to advance roughly 10% next year, based on consensus analyst estimates.

While estimates may be optimistic, ultimately we believe economic and corporate fundaments are strong enough to extend this market cycle for some time; but the pace of growth appears likely to moderate.

Managing the risk of rising rates

As the Fed’s efforts to normalize rates continue, we would expect rising rates to increase production and delivery costs, possibly dampening consumer demand. Along with economic growth, we also anticipate a natural level of inflation, which can put additional pressure on corporate earnings and market valuations. But there are ways to manage interest rate and inflation risk in the equity market. For example, one of the factors we look at when researching and selecting stocks is a company’s ability to pass costs on to customers without jeopardizing sales. Strong competitors with proven track records in this area can typically grow their earnings even when rates are rising and input costs are higher.

In the Financials sector, interest rates are often tied more directly to performance. Specifically, banks have seen their profit margins improve over the past few years as short-term rates moved up and regulations eased. But further increases in rates could also bring higher expenses for banks in 2019, including the cost of capital (interest paid on savings accounts, for example) and loan loss provisions (higher rates increase the risk of delinquencies and defaults). Growth will need to come from other sources, such as technology innovation and market share gains.

Tax reform boosts corporate spending

While the US economy may be in the later stages of economic growth, as demonstrated by metrics such as employment, we believe the capital expenditure or investment cycle has legs, propelled by fiscal stimulus. This bodes well for the Industrials sector, as an uptick in manufacturing activity is likely to lift demand for parts, equipment and technologies that make production more efficient. Factories are also modernizing, which is good news for suppliers of automation technologies, and spending has improved across many segments of the defense, aerospace and energy industries.

One of the biggest beneficiaries of tax reform could be technology, as companies use surplus cash to purchase new hardware, software, and cloud-based services. It’s worth mentioning that the S&P recently moved many of our favorite tech categories—businesses at the forefront of the “digital revolution”—into a new sector called Communications Services. This shift reflects the profound impact technology is having in areas such as entertainment, communications, banking and retailing, among others.

Our main focus is on tech companies that are disrupting traditional business models; including suppliers of products and services used in cloud computing, digital payment processing and artificial intelligence. In the consumer market, we are investing in companies that are pushing the boundaries of online entertainment and interactive gaming, including content and platform providers.

Tracking trade policy developments

Concerns about US trade policy contributed to some deterioration of economic and market conditions in Europe, Japan and emerging markets last year. Those concerns weren’t as pronounced in the US, where investors focused more closely on strong economic and corporate fundamentals.

However, we will be keeping a close eye on foreign markets in the coming year because they can influence US market valuations. The average S&P 500 company earns roughly 40% of its revenues outside the US. So, weaker demand from international buyers would be concerning. There is also a risk of contagion for the US equity market. If weakness in foreign markets is dramatic enough, US investors could see it as a sign to take a more defensive, risk-off approach to equities here at home.

Trade policy is already having an impact on automobile manufacturers and consumer goods companies, as tariffs increase the cost of importing raw materials such as steel and aluminum. It has also been weighing on investor sentiment in the tech sector for some time, since high-tech companies (especially semiconductor manufacturers) rely more heavily on international sales and are subject to regulations related to data security and privacy concerns. But, for now, we believe the financial risks they present for the tech sector are limited and market fears are largely overblown.

Multiple contraction should continue

From a historical perspective, US market valuations were high in 2018. But when we look at them in the context of the current landscape—an expanding economy, earnings growth and relatively low rates—they appear reasonable. Still, we believe the contraction in multiples we experienced in 2018 is likely to continue next year because, at some point, rising rates start to weigh on equity market valuations. Historically, that point has been around the time 10-year Treasury notes are yielding approximately 5%, as investors start to find the fixed income market more attractive and are less willing to pay for “expensive” equities. This time around, rates are moving higher from an extremely low starting point, so they could put pressure on valuations sooner than usual, possibly around the time the yield on 10-year Treasuries reaches 3.5%.

How the strongest companies will thrive

While there are foreseeable risks and unforeseeable risks for equities in the year ahead, we believe investors can achieve positive returns by focusing on companies that: 1) can weather rising interest rates through cost-management and pricing power, 2) continuously innovate to navigate an ever-changing competitive landscape, and 3) benefit from capital expenditures via technology or manufacturing. As always, valuations will play a key role in determining returns.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2018, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA and Chartered Financial Analyst are trademarks owned by CFA institute.

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