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As we move further into 2018, signs point to a synchronized, though uneven, upswing in global growth. But which regions and sectors could peak first?
The investment professionals at American Century Investments discuss themes they believe will have the most impact on investors going forward. For each theme, they provide portfolio positioning ideas for investors to consider.
The market continued to reach new peaks in January 2018. While volatility increased in February, U.S. equity valuations are still relatively high. In this environment, investors should consider the level of risk they're willing to take in the equity portion of their portfolios.
U.S. equity valuations remain high by many measures, yet there’s an argument that these valuations are justified by near-term tailwinds such modest growth, low inflation, low interest rates, and healthy corporate profits. It’s certainly possible that those conditions could persist for some time, but we believe there is more uncertainty than perhaps markets are prepared for.
Investors don't have to abandon equities; we see opportunities in sectors that haven't seen the same level of performance as the information technology sector and other market darlings.
For example, financials and energy struggled in 2017, but we believe these two sectors are not likely to be repeat offenders. Financials may have more stability in their business models due to conservative balance sheets. While still relatively lower-return businesses, many of these companies could benefit from interest rate normalization, relaxed regulatory costs, and corporate tax rate changes. We believe energy companies can still return to historic profitability levels without higher oil prices. Specifically, efficiency gains and cost-cutting, which reduce production costs, can boost profits.
"The energy sector is adjusting to a new normal of oil and natural gas prices."
CPM, Global Value Equity
Cash return on capital invested (CROCI) measures the cash profits of a company as a proportion of the funding required to get them. Higher CROCI generally indicates more effective and efficient use of invested capital.
Energy companies generally had good returns on capital from 1991-2002, when oil prices were relatively low.
As the U.S. rally matures, we expect inflation, interest rates, and volatility to rise. It’s during these times that the market starts to differentiate between high- and low-quality companies. Early in market cycles, lower-quality companies tend to do well; government fiscal and monetary stimulus is especially beneficial to businesses that survived the previous downturn but emerged with high debt loads, weakened fundamentals, and depressed stock prices.
As the bull market matures and governments withdraw stimulus, quality becomes more important. We look for higher profitability, strong management, and durable growth potential. These characteristics are key in a market downturn. Investors will likely seek companies with the fundamental strength to withstand the economic and business challenges of a bear market. We are not making a market call, but we believe this is an environment that accentuates the benefits of actively differentiating between high- and low-quality companies.
"High quality has enduring benefits and can be an essential element of investment portfolios."
CPM, Global Growth Equity
Growing market share can indicate strong competitive positioning.
Cash flow return on investment (CFROI) measures value-added potential by comparing the company’s average economic return to the cost of capital. CFROI generally indicates whether the company is adding or losing value.
The higher the cash flow as a percent of earnings, the greater the probability that earnings quality is high.
The debt-to-asset ratio illustrates how much leverage a company is employing. The lower the ratio, the stronger its equity position.
The MSCI USA Index measures the performance of the large- and mid-cap segments of the U.S. equity market. The MSCI USA Sector Neutral Quality Index is designed to measure the performance of securities with stronger quality characteristics relative to peers in each sector.
Similar to growth and value, quality goes in and out of favor depending on market conditions. Historically, quality has won over time.
Thanks to the extended bull market, retirement account balances are hovering near record highs. But our view for stock returns is slightly negative relative to bonds over the intermediate term. Another market downturn from here could mean years of lost income for investors in or near retirement. Our latest analysis suggests a slight reduction in equity exposure may be prudent for late-career and in-retirement investors. Moving to a potentially greater level of risk management is most critical near and in retirement.
The attractiveness of stocks versus bonds is changing. In this comparison of earnings yield of stocks and the 10-year U.S. Treasury yield, we see that the difference (yield differential) is approaching the historical average after favoring equities for the last decade.
We may be in the midst of a synchronized upswing in global growth, but investors need to think in terms of cycles, or stages, of growth. The U.S. is in a later stage of expansion than are many European countries. Monetary policy around the world also is at various stages, which has important implications for returns across and within asset classes and geographies.
We believe a global economic recovery will continue, with broad growth (gross domestic product, or GDP) and corporate earnings still improving in developed and emerging markets. The eurozone is enjoying better growth and consumer confidence, while Japan’s economy is healthier than it has been in a long time.
The U.S. has been at the forefront of global growth but is in later innings than other economies. In Europe, economic expansion and ongoing central bank accommodation continue to drive earnings gains. Emerging markets are benefiting from ongoing global growth and improving local demand.
We can evaluate the potential for growth in various markets by comparing forecasts for corporate earnings. Here we show annual earnings-per-share (EPS) forecast changes for the U.S., non-U.S. developed markets, and emerging markets. While the U.S. has enjoyed rising EPS estimates for some time, developed and emerging markets forecasts are rising for the first time since 2011.
See Glossary for definitions of S&P 500 Index, MSCI EAFE Index, and MSCI Emerging Markets Index.
Increasing Consumer Activity
Manufacturers of luxury goods, such as high fashion, jewelry, and premium-brand spirits
The Move to Digital Platforms
Online advertising firms, companies that facilitate digital exchange of payments, online travel planners, media providers
So-called “Amazon-proof” companies that provide unique products or superior customer service or have distinct distribution models
Producers of robotics, software, measuring equipment, sensors, and other products aimed at improving efficiency
New Age in Biotech
Companies that provide gene-sequencing technology, firms that perform sophisticated analysis of medical records in electronic format, companies that develop innovative new treatment therapies
Despite the prolonged runup in emerging markets (EM) stocks that began in early 2016, we see room for EM stocks to continue to gain. The catalysts of synchronized global growth and improving local markets are sustaining the rally and helping companies generate earnings growth. Importantly, EM growth forecasts continue to be revised higher, which may widen the EM-U.S. growth differential in 2018.
While valuations have moved higher, we believe the potential for upside remains strong:
"The emerging markets rally is supported by underlying fundamental improvement. This is not a late-cycle change."
Because monetary and fiscal policies created the spectacular rise in China’s GDP growth, it's logical to assume recent monetary and regulatory tightening will create the opposite. We expect a modest slowdown in the cyclical components of China's economy, but tightening should not have a material impact on the rapidly growing non-cyclical sectors, which are a bigger part of China's earnings bucket. China's market has evolved dramatically over the past decade, as illustrated by sector market capitalizations.
Long-term bond investors have enjoyed an extended period of positive performance. While we see few reasons to expect big changes in bond market fundamentals (at least in the near term), one challenge stands out: finding value among bonds.
Among major developed market central banks, the Fed remains furthest along in its normalization efforts, slowly raising rates and reducing the size of its balance sheet. Meanwhile, the Bank of Japan is maintaining its stimulus program, and, though it has begun tapering, the European Central Bank may extend its easing program beyond its September expiration. Inflation concerns prompted the Bank of England to hike rates for the first time in 10 years in November 2017, but overall central bank policy remains accommodative.
Against a backdrop of moderate economic growth, contained inflation, gradual Fed tightening, and tax reform, we expect U.S. rates to trend upward.But absent robust growth or significant inflation—and given the likely equity market volatility as the 10-year yield approaches 3%—we don't expect rates to move significantly higher than our ranges. There remains the possibility of U.S. and/or global political risks triggering a safe-haven trade, which could push rates to the lower ends of our ranges.
We believe economic fundamentals support moderate U.S. GDP growth (between 2% and 3%), which is in line with the Fed’s expectations. We also believe U.S. tax reform will slightly improve employment and growth, a sentiment the Fed recently echoed in its latest economic growth forecast.
U.S. rates remain higher than rates in other developed markets, creating wide spreads. With global growth improving—particularly in Europe, where 2017 GDP growth exceeded that of the U.S.—we expect rates to eventually converge and spreads to narrow. Long positions in U.S. Treasuries and short positions in European government bonds may be beneficial in this scenario.
Among the greatest challenges for fixed-income investors is finding decent returns while maintaining an appropriate level of risk. The low-rate, low-volatility environment that’s persisted for several years has led to growing demand and significant outperformance for higher-yielding segments of the global fixed-income market, including corporate bonds and emerging markets debt. However, these sectors are typically higher risk. We believe investors should exercise caution; investing in higher-yielding securities should be part of a well-diversified, professionally managed portfolio.
Bunds and gilts are government debt securities issued by Germany and the United Kingdom, respectively.
Tax reform may make municipal bonds (munis) more attractive. The new law leaves the highest tax brackets intact, so we expect continued demand from higher-income taxpayers. The elimination or reduction of high-profile deductions, such as state and local income taxes and property taxes, is likely to lift demand for tax-advantaged munis, particularly from investors in high-tax states.
At the same time, other provisions of the bill likely will reduce the supply of certain munis. A tighter supply could create the potential for muni outperformance versus other higher-quality fixed-income securities.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Diversification does not assure a profit nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.