Market and Economic Commentary
We found this series of word clouds in a recent research piece from J.P. Morgan (JPM) and thought it served as a simple, eye appealing summary of views that we at RAA share as well.
For those not familiar with word clouds...the larger words are intended to stand out as a matter of importance or significance. Therefore, JPM believes the best opportunities are in the Financial sector and the Emerging Markets (EM). Further, they believe that the worst opportunities are potentially in the Semiconductor sector and Bond Proxies (defined later). Lastly, they feel that the biggest risks are Trade War, the unwind of QE (quantitative easing) and hyper-inflation.
Let's start with the best potential opportunities. We have had our portfolios invested with a tilt towards the Financial Sector and Emerging Markets for many months. They both have been successful investments.
Here are a couple of snippets from JPM that summarize our current stance on Financials and EM.
Financial stocks continue to merit a high weighting in many of our equity strategies. The sector, which languished after the global financial crisis, has partially returned to favor in the last couple of years, but valuations are still sensible. Profitability is improving at a healthy clip, helped by better economic conditions and the recent rise in U.S. interest rates. And with tougher capital standards largely met, profits are flowing back to shareholders in stock repurchases and higher dividends.
We continue to believe emerging markets will offer the best returns in the next couple of years. So far, the upswing in emerging markets profits is less mature compared to the U.S.; market valuations are reasonable on all the measures we analyze; and the interesting, longer-term secular case for many of these markets is not really priced in. To be fair, Turkey and Russia are currently experiencing economic weakness and some stocks (for example, many Indian consumer companies) are pricey. On balance, we are inclined to add to our emerging market holdings during this period of trade uncertainty, and during this period of US Dollar appreciation, which usually poses a short-term challenge to developing markets.
As we have discussed in previous newsletters and certainly have made mention of on our client meetings and local presentations, rising interest rates is the biggest potential fly in the ointment. We simply don't think the average investor is prepared to deal with losses in their bond funds after many, many years of positive returns. Conversely, many investors have sold bonds and plied into what we call "bond proxies". This scares the heck out of us. "Chasing dividends" can be a dangerous strategy when interest rates rise. Now please don't get me wrong, we love dividends. There is, however, a right way and a wrong way to go after dividends. Utilities, for instance, are the most common bond proxy. In times of interest rate volatility, utility stock prices move very sharply...enough to make you sick. Another very common proxy for bonds are consumer staple stocks. Look at Pepsi or Proctor and Gamble recently. They are both down close to 20% just since the beginning of the year! Ouch! Fortunately, we don't own either one.
We believe the threat of rising rates is for real. Many will find themselves scratching their heads wondering what happened. At RAA, we look to avoid risks that do not have a margin of safety and the prospects for growth.
Here is JPM's view on interest rates...
At a macro level, the prospect of a sharper than expected transition to higher interest rates remains the biggest threat to the world’s equity markets. Yes, stocks are still attractively priced vs. bonds in all regions; even in the U.S., where rates have risen meaningfully this year, the earnings yield of the S&P 500 is still about one percentage point above the yield of the average corporate bond—which itself is fairly generous by past standards. But the gap has narrowed, suggesting less margin for error than was previously the case. And higher rates would eventually threaten the expansion itself, while U.S. companies are set to enter the next downturn with high levels of debt by most measures (the financial sector is a notable exception). With the gradual winding down of quantitative easing and the need to finance enormous deficit spending in the U.S., we are mindful of the risks of higher rates and cautious about companies with high debt levels, especially when (as is often the case) secular trends are pressing on the underlying profitability.
It should come as no surprise to tell you that technology stocks have had one heck of a run in the past couple of years. It is very understandable to think that it may come to end a soon. JPM seems to think that it’s too soon to call it but they have raised the caution flag. Here is what the have to say...
Within the markets, one concern is whether technology stock prices are sustainable or have reached a level of excessive exuberance. The gains have been spectacular and relatively new companies now occupy the top positions in market capitalization, in both the U.S. and Asia. If Internet stocks have performed very well, so have their businesses; valuations, at least for the major companies, don’t yet look excessive. This view rests on the assumption that profits are sustainable—and regulators may yet have their say. Semiconductor companies have been enjoying a spectacular cycle, yet even as current trends remain very strong, the sustainability of their profits appears more questionable. So we are keeping a watchful eye on emerging excesses but are not ready to call an end to the trend of technology sector outperformance just yet.
