Government policy has heavily influenced investor confidence this year — and not in a good way.
Despite an improving economy and extraordinary earnings growth in the first quarter, a cloud of concerns about rising interest rates, inflation and the possibility of a trade war has cast a shadow over the market. As a result, volatility has increased, valuations have compressed, and returns have dissipated.
On the heels of a banner year for U.S. equities in 2017, the market appears to have stalled.
In our view, however, headlines focusing on risk (see chart, below) are largely overlooking policy’s upside potential. In a market that has been clouded by monetary, fiscal and trade policy, it helps to separate the signals from the noise. When examined from this perspective, the climate may appear a lot less daunting.
Our approach to this market rests on four high-conviction beliefs, each of which is supported by clear market signals and solid economic data, as well as an objective look at the potential pros and cons of government policy.
1. Strong earnings support equity prices
Tax reform contributed to a remarkable 26% improvement in earnings and 12% boost in cash flow in the first quarter of the year. Even without the lift of tax reform, earnings advanced 16% for the quarter. But many investors are wondering if earnings growth has peaked. Forecasts are calling for a healthy improvement in earnings of around 19% in 2018 and 10% in 2019.
In addition, companies have announced plans to spend $650 billion to repurchase shares this year, which would be an all-time high. If buybacks meet expectations, investors could be rewarded with a “buyback yield” of roughly 2.8% (calculated as $650 billion divided by the S&P 500’s
market capitalization of $23 trillion) in addition to the S&P 500’s dividend yield of 2%.
2. Financials benefit when rates rise
Economic growth has broadened out beyond U.S. borders, setting the stage for gradually rising interest rates and reflation in developed markets around the world. This environment has driven bond yields higher and presented competition for equity sectors such as such as utilities and consumer staples, which offer steady dividend payouts. With this backdrop in place, we continue to avoid stocks in “bond proxy” sectors that pay high dividends but show little or no price appreciation.
On the other hand, this environment is generally favorable for financial services, especially banks. When economic activity is strong and rates are rising, the demand for loans typically picks up and banks earn higher interest rates on the loans they issue. We have already seen indications that cash flow is improving while debt for financial firms remains steady.
The regulatory environment is also improving. Banks that are considered Systemically Important Financial Institutions (SIFIs), or “too big to fail,” have faced tighter regulatory controls since the financial crisis, including a 50% increase in capital requirements. But the threshold to qualify as a SIFI has been raised, relieving some regulatory pressure on banks and making it easier for them to issue loans and pay dividends. We expect much of this capital to flow into the broader economy.
Banks could return more profits to shareholders this year. On the following chart is trailing 12 months free operating cash flow as a share of total debt, March 2003 through 2018. Financials are in blue, S&P 500 in gray:
3. Industrials, technology see stronger demand
Encouraged by tax reform, consumer spending improved at its fastest pace in five months this April. Businesses are also reinvesting in new equipment and facilities, boosting their spending by 20% in the first quarter and on track for a 10% increase for the year. This pickup in spending is one reason we favor cyclicals, which tend to see stronger demand for their products and services when consumers spend more and companies are reinvesting for future growth.
We are especially encouraged by potential growth for industrials and technology. While recent trade tensions have weighed on valuations in these sectors, we continue to view the threat of a full-blown trade war as remote. In addition, industrials could benefit from a recovery in capital spending in the energy sector, government spending on infrastructure, and an uptick in M&A activity. In the technology sector, which typically benefits from both cyclical and longer-term secular growth trends, we could see stronger demand for products and services that boost innovation and drive efficiencies.
For all these reasons, we have been leveraging recent price weakness in these sectors to increase our exposure at valuations we consider attractive as buyers.
4. Tech sector regulatory fears are overblown
In the same way that policy is influencing different industries in different ways, the regulatory environment is creating new opportunities for some sectors and presenting challenges for others.
While regulations are easing in the banking industry, it appears they may be tightening for technology companies. But we believe investors may be overestimating the government’s ability to quickly roll out a regulatory framework that effectively addresses complex issues such as data security, personal privacy and freedom of speech. These are complicated issues that often conflict with one another, which makes developing regulations difficult and time-consuming.
The tech sector is also healthy and vibrant, fueled by innovations in areas such as artificial intelligence and manufacturing automation, and we are seeing strong demand for digital content and data analytics.
While we continue to monitor the potential pros and cons of government policy, it appears to us that the market is over-emphasizing the risks and overlooking many of the potential benefits.
When the policy-related clouds that are hanging over the equity market fade, we expect investors to refocus on fundamentals, the potential benefits of “healthy” inflation, and the buying opportunities presented by market jitters. Investors who remain disciplined and focused on quality today should reap the rewards for their patience in the future.
Carin L. Pai is director of portfolio management and head of equity strategy at Fiduciary Trust Company International.