Although monetary policy easing supports economic growth and corporate profitability drives asset price rallies in the long run, a monetary expansion during a late-cycle economy often coincides with a growth slowdown.
As we’ve seen so far in 2019, the global equity market typically struggles in the early phase of easing, reflecting the weakening of fundamentals combined with elevated uncertainty and negative sentiment. In this challenging environment, we see select opportunities in attractively valued, quality stocks of companies with strong balance sheets that offer the potential to provide a measure of downside protection as well as long-term capital appreciation.
The late-cycle economy slows down
Today, investors must consider the reality that we’re in a slowing global economic environment. The U.S. Federal Reserve (Fed) took on a dovish stance at the beginning of 2019, leading to interest-rate cuts in July, September, and October. The August and September manufacturing index reports from the Institute for Supply Management signaled a contraction for the first time in three years, with the September figure dropping to the lowest level in 10 years.1 In light of such data, it’s no surprise that negative sentiment has increased.
From our perspective, the more interesting trend is the growing number of company management teams that we’ve recently engaged with that reported they were preparing for a potential market downturn by conserving cash and delaying capital expenditures, even as they maintained operational stances geared toward a growth environment. This is where equities’ quality characteristics grow in importance as investors navigate through a global slowdown.
Why quality stocks matter now
We define quality companies as those that can produce high returns on capital in excess of their cost of capital and, over time, can sustain and grow those returns. These quality companies are competitive and often have a commanding position in their respective market segments. They also possess proven track records for growing their returns on invested capital and have consistently performed well throughout successive stages of economic cycles. In essence, these companies offer sustainable free cash flow growth and provide the potential for downside protection when the external environment deteriorates.
A strong balance sheet matters because heavy debt in a market downturn can put a company at risk of insolvency. When the global economy slows, revenue growth declines and profit margins decrease, leaving the company with less cash to pay debt obligations and to sustain the business. To potentially avoid such scenarios, quality companies avoid mixing operational leverage with financial leverage.
The current bull market—now more than a decade old—has been driven in part by leveraging financial engineering, which is logical, given the environment of low interest rates that emerged beginning in 2009. It makes sense that companies employed cheap sources of capital to boost their business; however, it’s important to note that some allocated their capital more wisely than others. Looking ahead, we believe that seeking higher-quality companies will be paramount in a late-cycle economy characterized by high debt, high profit margins, and declining operating cash flows.
Profit margins have already peaked, in our view, and we expect that companies in general will have an increasingly tougher time lifting those margins.
Another trend that we view as a warning sign is the growth in nonfinancial corporate sector debt, which has climbed to record levels2—an increase that may put some companies in a vulnerable position as the global economy slows.
Another source of potential pressure is the long decline in operating cash flow as a percentage of reported earnings.3 This decline has left companies in general with less cash on hand to pay down debt obligations and sustain a potential market downturn.
Where's the value?
Quality can be a positive attribute when it comes to protecting capital, and investing in quality companies at a discount to their fair value can be critical to generating strong long-term capital appreciation. In our view, valuations today are at extremes—not only in terms of the divergence of price-to-earnings between growth and value equity styles, but also that growth stocks have recently traded at their highest valuations since the end of the dot-com bubble in 2002.4 Maintaining a value tilt in a portfolio may be prudent going forward, in our view.
We’re also seeing valuation extremes from a geographic standpoint. Largely driven by growth expansion—particularly in the large-cap technology space—the U.S. equity market has recently traded at significantly higher valuations than the rest of the developed world.5 To highlight the extreme nature of the divergence, the MSCI EAFE Index has recently traded near a 31-year low relative to the MSCI USA Index.
The importance of price-conscious quality—and a global opportunity set
During challenging market environments—when the macro outlook is weak, valuations questionable, and margins stretched—we believe high-quality companies possess strengths that enable them to distinguish themselves from their peers. Over the long term, quality investing with an intrinsic valuation focus is generally a solid investment choice—not only for potential capital appreciation, but for providing potential capital protection, particularly in down markets. However, it’s important to note that quality alone doesn’t offer the potential to protect total returns; rather, paying the right price for that quality can be key to potentially generate strong long-term risk-adjusted returns. That is why it can be beneficial to invest in a global portfolio that has the flexibility to seek the best valuation opportunities across geographies.
In comparing U.S. equities with non-U.S. developed markets, the U.S. market has recently traded near a 15-year peak relative multiple versus international markets.6 While international profitability is cyclically high, it remains well below its American equivalent, on average. As a result, the greatest potential value that we see is in international markets—largely in quality companies with global operations. Despite value equities’ performance edge over their growth counterparts during September, value stocks have continued to trade at a substantial discount to growth stocks, in our view. In aggregate, we believe a portfolio is appropriately positioned for strong relative performance if it retains a higher level of profitability as well as lower debt levels and trades at multiples that are cheaper than those of its global peers.
Visit here for more resources on late-cycle investing: explore late-cycle indicators, what investment strategies have proved most effective in prior late cycles, and how advisors are positioning client portfolios today.
1 September 2019 Manufacturing ISM® Report On Business, Institute for Supply Management, 10/1/19. 2 International Monetary Fund, 2019. 3 Jefferies Group, FactSet, 2019. 4 FactSet, 2019. 5 FactSet, October 2019. 6 FactSet, October 2019.