After years of strong gains, the U.S. stock market seems to have lost some momentum. In 2015, the index lost 0.7%, and through June 24 of this year, stocks were down 0.32%. Despite the relatively small losses, there have been some big moves: the sell off following the Brexit, the steep drop in January and February of this year, and the losses in August and September in the wake of China's currency devaluation. In between, there have been periods of optimism, fueled by signs of economic health in the U.S. and accomodative monetary policy abroad.
But what’s next? And how can you prepare?
Viewpoints Inside/Out brought together investment professionals from Fidelity, BlackRock, and PIMCO to get their perspectives on how to survive and prosper in today’s markets. Here we highlight their ideas on managing risk, finding pockets of growth, generating income in this rate environment, and sectors and countries that could outperform—and underperform—in the months ahead.
In the wake of the Brexit vote, investors were reminded once again of the volatility of the markets. So how are these experts managing the risk of volatility without giving up on growth? They are playing defense through a variety of strategies. Among them: defensive sector tilts, minimum volatility portfolios, and a focus on companies whose fortunes are not tied to the economic cycle.
Heidi Richardson: There are some big picture things you have to consider with the markets: the British vote to exit the EU; the U.S. elections; and, of course, central bank policy from the Fed, the European Central Bank, and the Bank of Japan.
Bill Bower: From a monetary policy perspective, central bankers are kind of backed into a corner—policy has supported low rates, but it’s not stimulating much demand or consumer confidence. When you couple that with relatively high valuations on an absolute level for many stocks, investors are skittish.
Denise Chisholm: I think that the key theme of 2016 is profit contraction. On a median basis, profits are down by about 5% relative to last year. It’s not just energy: 7 out of the 10 sectors have seen a decline in median earnings.
The problem is the slowdown in global growth. In 2009, we had too much debt in the developed world, and working through that debt has weighed on growth for a long time. Unfortunately, now you’re seeing the same problem in emerging markets. That’s been driving the earnings slowdown.
Leading indicators aren’t suggesting a rebound in earnings. That doesn’t mean an economic recession is imminent, but historically speaking, the market’s response to a period of profit recession is a skew to the defensive sectors: consumer staples, health care, telecom, and utilities.
Bill Bower: With broad economic growth so hard to find, I have focused on those select companies with durable earnings growth—companies that don’t depend on the economic cycle or interest rates to grow their earnings. If they have great product cycles, I believe they grow faster than the market.
One example is Novo Nordisk (NVO). Some 90% of its business is diabetes treatments, and it dominates that market. Novo Nordisk's focus means its diabetes-related R&D budget is twice its competitors’ combined, so it’s positioned to grow faster and take market share.
Heidi Richardson: Investors are looking for ways to maintain exposure to growth while also managing volatility. Low-beta stocks offer one way to do that. At BlackRock, we have built what we call “minimum volatility portfolios,” which diversify across sectors but primarily hold stocks that have had lower historical volatility. They may lag the market during a big rally, but our research has shown that, historically, a portfolio of those types of stocks has tended to match or even outperform the overall market over full cycles, with lower volatility.
Jerome Schneider: Fixed income investors need to remember that the purpose of owning a bond portfolio is not only to provide income but also to balance overall portfolio volatility.
My team’s goal is to find assets within the fixed income universe that help mute that broader volatility and create ballast for the overall portfolio. We’re favoring high-quality, corporate, commercial mortgage-backed securities, and secured floating-rate loans that provide a yield advantage over Treasuries.
We are entering yet another period where there will likely be substantial volatility in rates—so just owning a Treasury, which could be oscillating in terms of price, may not be the best value proposition given that there is low or no yield associated with it. The key is to make that “income” part of fixed income work constantly over time, when maybe the price appreciation alone isn’t enough to provide protection.
Global economic growth may be stuck in slow motion, but some companies and cyclical sectors could still offer the potential for upside and outpace the market. Our experts suggest a focus on innovative companies that can make their own breaks, and sectors that can do well in the face of slow growth, like consumer stocks, tech, and health care, and European mid- and small-cap stocks.
Bill Bower: It’s a tough world out there. Growth is hard to find, and cyclical growth is practically nonexistent. Companies need to be able to make their own breaks.
I really like to focus on fundamentals, and companies that can generate their own growth through better products, patents, research and development, and through capital spending. Today in particular, I have been finding those opportunities in health care, the consumer sectors, and technology.
A good example is a multi-format retailer called Inditex, (ITX) from Spain. Much of its growth has been driven by a store called Zara. Zara focuses on high-turnover fast fashion, which it designs and manufactures internally. Zara can get its merchandise into its stores quicker than anyone in the world. And because of that, the company has a low discount rate—it sells a larger percentage of products at full price compared with competitors. It’s a unique business model that has been working better than its competitors, and the company can continue to roll it out geographically. Its second-biggest market is China, and it has been entering the United States.
Denise Chisholm: In general, I am favoring defensive sectors. But history shows you often want to own one cyclical sector, even in a downturn. Of the cyclicals, consumer discretionary is the most intriguing to me. Earnings and stock prices in that sector have performed relatively well during profit contractions over time. Stock-pickers should be aware, though, that the sector’s defensive qualities usually come from relatively few stocks. So although I think the sector overall could offer an attractive risk-reward balance during earnings contractions, individual consumer discretionary stocks may not.
Heidi Richardson: In the United States, I think the technology sector may still offer opportunity. While the global slowdown could threaten the bull market, the U.S. economy has proven resilient. Overall, technology valuations are in line with the S&P 500® Index, but the sector offers much higher return on equity. I think many tech companies may benefit from the slow and steady economic growth that we have now. The tech sector has net cash, which could help insulate those companies from rising rates, and allow for continued share buybacks, dividends, and M&A.
Income investors find themselves in an unusual environment these days. The global picture has helped to keep rates low and prevent Fed tightening. Most recently, the Brexit vote has lowered the odds of a rate hike in the near future, despite signs of economic progress in the U.S.
Our experts suggest steering clear of short-term Treasuries and emphasizing higher-yielding U.S. corporate bonds, floating-rate bank notes, mortgage-backed securities, preferreds, and dividend-growth stocks.
Jerome Schneider: At PIMCO, we have been focused on the problem of the Fed trying to reconcile the technicals in the global financial markets with the economic fundamentals. Central banks in the developed world used to have zero interest rate policy (ZIRP). Now Europe and Japan have both gone to negative interest rate policy (NIRP), at the same time that the Fed has started its tightening cycle. That brings us to what I’m calling RAIRP, or relatively attractive interest rate policy.
RAIRP makes U.S. dollar assets attractive from the standpoint of what I call “relative hedged yields.” This is not just a short-term phenomenon but more of a secular trend driving global investors to seek assets that can provide positive returns. Such technical dynamics create a lot of demand for U.S. fixed income assets, which in turn depresses interest rates.
On the other hand,despite the recent volatility from the Brexit vote, the U.S. has seen modestly positive fundamentals overall—retail sales pointing positive, housing remaining a relative bright spot, the continued but slower trend of job creation, and upward pressure on wages. While the Brexit may delay the pace of rate hikes, I still think the current environment points to an increase in interest rates through 2017 and beyond, albeit at a slow rate and with a ceiling of about 2%.
Another key, perhaps obvious, point is that geography matters…a LOT. More than ever, investors need to incorporate a wider geographical lens to ensure that they are not overexposed to certain regions where yields are low and/or negative. This is another element to portfolio diversification that all investors—U.S. as well as international—should embrace, as it balances good defense with occasions to be opportunistically balanced in fixed income. The emerging demand for U.S. dollars presents some solid tactical upside situations, specifically for U.S. investors.
Heidi Richardson: If we do enter a rising rate environment creates both opportunities and risks. I like some short-duration credit portfolios, because their additional yield over government securities can support returns when rates rise. I like floating-rate bank notes as well. They’re yielding more than 1%, with very low volatility. These provide some protection as rates rise, and they are investment grade, so they don’t present as much credit risk as floating-rate bank loans.
I’m also looking at other income-producing sectors. Preferred stocks are interesting; they offer yields around 7%, with much lower volatility than common stocks. I like dividend-paying stocks as well—particularly dividend growth stocks, as opposed to high-dividend stocks. Many of the stocks with high dividends, such as utilities and telecom, fund their payouts through debt. That may be problematic as rates rise. By contrast, many technology companies are funding growing dividends through cash on hand. In an environment of slow earnings growth, investors are likely to pay up for these kinds of high-quality stocks.
Jerome Schneider: U.S. Treasuries are what we call hard-duration assets, meaning they tend to be very vulnerable to rising rates. The part of the yield curve that takes the brunt of recalibration to higher rates is the zero-to-five-year section; that’s the eye of the storm. So with Treasuries, I have been favoring bonds with durations of seven years or longer, and steering away from the two-year point, especially at a time when the front-end of the curve looks somewhat overvalued to us and only offers low yields.
To put this in context, think back to the fourth quarter of last year. We had our first rate hike in nearly a decade, and the front-end recalibrated higher. The impact was dramatic—the 1-3 Year Treasury Index was down 0.44%, the average 1-3 year strategy was down about the same, and yet the ultrashort bond category was flat. These are probably not acceptable outcomes for many fixed income investors, so incorporating a defense mindset into strategies is not only a luxury but essential to preserve capital. In contrast, for example, those strategies that had a preference for corporate bonds, as we did, were far more likely to have positive performance in the fourth quarter of last year.
On the short end of the yield curve, I favor U.S. corporate bonds. They can be very advantageous for protecting capital at this stage of the business cycle, because the extra yield provides a cushion in an upward-rate environment and helps generate income while Treasury yields are suppressed. Additionally, the Fed has made it abundantly clear that they will not raise rates unless they believe that the economy is continuing to grow at or above the trend growth rate. In this rising rate environment, the economy and corporations are doing all right, which my team thinks is net beneficial to corporate bonds more so than Treasuries.
From a fundamental perspective, I am sanguine on the U.S. economy. I have been focused on investing companies with superior growth, high barriers to entry, and strong asset coverage. PIMCO’s credit research team is also heavily focused on identifying “rising stars,” or credits ripe for upgrade over our cyclical horizon due to significant free cash flow generation and an ability to de-lever organically in the medium term. Some of the credit sectors we like right now include those tied in a meaningful way to the U.S. consumer, improving housing trends, and health care.
Asset-backed securities, specifically commercial mortgage-backed securities, also offer very good price protection, asset coverage protection, and income. I also see value in secured floating-rate debt, which can provide attractive income and coupons that reset higher as interest rates move up.
Overall, defensive sectors—consumer staples, telecom, and utilities—have been leading the market during the last year. And if earnings continue to slow, defensive sectors may be worth watching more closely. At the same time, the energy sector has seen huge volatility. That has implications for other parts of the market, particularly emerging-market countries that rely on commodity exports, and, to some extent, financials, which lend to companies in the energy sectors.
Denise Chisholm: It’s looking like energy is going to have a long hangover. It’s a story of excess capacity, much like technology after the dot-com bust. Technology lagged for a decade after *that, in part because there was so much excess capacity. Looking at energy right now, it’s not just that inventory levels are high. There’s too much capacity, and it’s not clear if or when it will come offline. Meanwhile, free cash flow in the sector is the worst it’s ever been. So I see the risk-reward balance in energy as quite negative.
Bill Bower: Internationally, I think you have to be cautious when looking at countries that rely on commodity exports. I’m looking for opportunities in emerging markets with expanding economies, great demographics, and growing per capita income.
For example, India looks good from a long-term, structural perspective. My biggest theme there is financials, particularly Indian home mortgage lenders. India has a young population, and home ownership rates there are only around 7%—low even by emerging-market standards. Incomes are rising, and as people get older, they tend to get wealthier. Home ownership is likely to grow, and mortgage lenders should benefit.
Denise Chisholm: In the United States, I’m relatively negative on financials. Financials do tend to benefit from rising interest rates, so they have the likelihood of rising rates in their favor. But the credit cycle tends to be a much more important driver of financials’ performance than interest rates. That worries me. It’s not that credit is getting markedly worse, but the best days of credit are likely behind us, especially given the profit deterioration we’ve seen in the high-yield market. And weakening credit has typically caused the multiples of financials stocks to contract.
The data provided by leading economic indicators suggest that the earnings contraction we have seen over the last year is likely to continue. Historically, earnings recessions correlate fairly closely to market downturns. Those periods have not been good times for cyclicals, including technology, financials, or industrials. Those periods have been relatively good times for consumer staples, telecom, utilities, and health care—the defensive sectors.
- Bill Bower manages Fidelity® Diversified International Fund (FDIVX).
- Jerome Schneider manages PIMCO Short Term Fund (PSHAX) and PIMCO Short Asset Investment Fund (PAIAX).
- Heidi Richardson is the Managing Director, Head of Investment Strategy for U.S. iShares.
- Denise Chisholm is the sector strategist in Fidelity's sector division.
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