The performance of equity markets during the last quarter was very polarised – both geographically and by sector. Whilst the Dow Jones Industrial Average was up nearly 9 per cent, all other major regions were down in US dollar terms.
It has therefore been very difficult for active global equity managers to outperform the world index unless they have had at least 60 per cent of their portfolios invested in North America – arguably not an easy thing in the fourth quarter of 2016 for anyone who was remotely concerned about the US presidential election.
MSCI World index performance in 2016
Source: FE Analytics
There is no doubt that the focus on shareholder value in corporate America tends to be higher than elsewhere and the region’s exposure to high growth technology companies is unrivalled: this justifies a higher valuation for US equities than other parts of the world.
But one cannot ignore the fact that US equities, on a trailing PE multiple of over 20 times and a forward PE multiple which is at its highest since 2000, are now looking expensive relative to their own history and therefore vulnerable to disappointment if the anticipated boost to earnings growth doesn’t materialise.
Of perhaps greater relevance to stock-picking fund managers was the polarisation in sector performance which took place in 2016, especially during the last quarter.
Looking at the year as a whole, the recovery in oil and metals prices together with a general move away from a deflationary mindset has turbocharged resources stocks, which are typically highly cyclical in nature and have low returns on capital across the economic cycle.
The last quarter has seen another cyclical sector, banks, roar upwards on the back of the US interest rate rise and Mr Trump’s election.
Higher interest rates should be beneficial to bank profitability, a more robust economy will mean lower bad debts and the mooted repeal of the Dodd-Frank Wall Street Reform and Consumer Protection Act would be a boon for the sector.
Defensives, ‘bond proxies’ and technology have underperformed
Conversely, long duration assets such as highly rated technology, healthcare, consumer discretionary stocks and ‘bond proxies’ such as real estate and utilities have all underperformed.
We have for some time been concerned about the valuation of bond proxies and consumer discretionary stocks – the former because we have been nervous about bond yields and the latter because we do not believe the valuation of companies like Proctor & Gamble, Coca-Cola and L’Oréal is justified by the earnings growth being produced by these entities.
Defensive (i.e. non-cyclical) sectors have been pushed up in price on the perception that they represent a safe haven from worrisome and volatile equity markets. We do not believe this gives due consideration to the valuation risk inherent in these stocks in the event that bond yields rise and/or earnings growth disappoints – a lesson that should have been learnt after the tech bubble of 2000.
Ironically, the latest surge in the US stock market has bypassed many of the companies and sectors which were at the epicentre of that boom and bust a decade and a half ago.
Companies like Alphabet, Facebook, Baidu and Shire have been materially de-rated in recent months in spite of their superior current and projected earnings growth.
This sector rotation explains why the Dow Jones Industrial Average, which is a concentrated index of just 30 stocks largely representing traditional corporate America, has so strongly out-performed the wider US stock market in the form of the Standard and Poor’s indices, which contain hundreds of companies across a broad range of sectors.
It is notable also that value managers have outperformed growth managers for the first time in a long while (prior to 2016, the last calendar year in which the MSCI Global Value index outperformed the Global Growth index was 2006).
MSCI World Growth vs MSCI World Value performance in 2016
Source: FE Analytics
Much will depend on Donald Trump’s first 100 days and Theresa May’s stance on Brexit
The big question is whether this marked change in sector leadership is the beginning of a new trend, or an aberration. In favour of it being a new trend would be a sustained rise in bond yields, inflation and economic growth plus a deregulation of the banking system; against would be a continuation of low growth and interest rates, or a cyclical downturn.
Backing ‘cheap’ and lower quality companies at this juncture does require a certain faith in sustained economic recovery because usually the returns made by deep cyclicals are transient in nature and do not cover the cost of capital over the cycle.
Conversely, quality growth stocks, whilst they can be subject to periodic (often quiet savage) falls in valuation and sometimes remain out of favour for a considerable period of time, should be able to ride out economic and market storms if the nature of the industry in which they operate and the quality of management enables returns on capital to be preserved.
Our natural tendency is towards ‘quality growth’ over ‘cyclical value’ and we believe that the former will come back into vogue as soon as the recent euphoria in the US dissipates and bond yields stabilise. Thus far, the observed equity re-rating (most prevalent in the value orientated sectors) largely represents ‘hope value’.
Presidents and prime ministers seem determined to keep markets in suspense about the crucial elements of policy which will govern returns in the coming years.
What we hear from companies in the first quarter of 2017 earnings seasons and what we see from the Trump administration in its first 100 days will play a big part in determining sector leadership from here. In the meantime, we concentrate our cyclical exposure on quality names and we remain suspicious of high risk plays like lower quality European banks.
Algernon Percy, managing director at Waverton Investment Management. The views expressed above are his own and should not be taken as investment advice.