The global equity market appears to be nearing an inflection point. Toward the end of 2015, the market was sanguine, brushing off much of the negative news about the global economic outlook.
However, pessimism grew entering 2016 as investors confronted fresh evidence of deflation risks, excessive debt, and slowing growth. These headwinds were coupled with earnings multiples that we considered to be high, often disguised within simple price-to-earnings1 ratios but visible on a debt-adjusted basis. The broader market began to react accordingly to slow growth, falling energy prices, and the Chinese government's possible missteps in its attempt to regulate its slowing economy.
In this volatile and gloomy environment, we believe that the quality attributes of stocks will become increasingly important, as characteristics such as strong and sustainable cash flow and a high level of return on invested capital may help provide a degree of downside protection. As a result of the market sell-off in the opening two weeks of 2016, many stocks possessing an abundance of these quality attributes appear to be more attractively valued, in our view.
An inflection point may be here
As modest wage growth began to take hold, the U.S. Federal Reserve (Fed) raised interest rates in December 2015 for the first time in nine years.2 However, this policy shift also came as corporate revenue growth slowed; in retail, companies ended 2015 with excess inventory,3 while industrials sector companies and transportation firms entered a slowdown. Profit margins appear to be peaking, and many companies have too much debt, largely as a result of low borrowing costs. Mounting evidence indicates to us that the quantitative easing (QE)4 policies embraced by many of the world's central banks have universally failed to achieve policymakers' growth and inflation targets, while increased debt has led to lower incremental growth. This all raises a pressing question: At what point does the blind faith, knee-jerk reaction of buying risk assets in response to QE become tested? Perhaps the market sell-off in early January was an indication that we have started to reach that point.
In fact, forward inflation rate expectations in the United States have again dipped below 2%,5 a threshold at which former Fed Chairman Ben Bernanke introduced additional QE in 2010 and 2011, as well as launching Operation Twist, a program that began in 2011 with the goal of lowering long-term rates. Today, QE policies, low rates, and negative short-term rates in certain countries are distorting asset prices, causing misallocation of capital, and undermining some industries. We are concerned about the effects these developments are having on asset valuations as investor sentiment shifts and central bank credibility is tested.
Aggressive policy responses
In response to deflationary trends in Europe, Mario Draghi, president of the European Central Bank, recently hinted at his intention to pursue more QE and negative interest rates in an effort to stimulate growth and inflation.6 Such moves could further weaken the euro, making the eurozone's exports more competitive and siphoning off growth from regions with stronger currencies. Japan's central bank may be heading in the same direction as it considers further expansion of its accommodative monetary policies. Across emerging markets, economies are slowing, and return-on-equity profiles are deteriorating as a result of the misallocation of the excess capital that has accumulated in many countries. Combined with a build-up of excess debt-often denominated in U.S. dollars-the slowdown in emerging-market growth has weakened currencies and helped to fuel deflationary pressures in many developed markets.
An emphasis on quality
Despite our long-standing concern about slowing growth and deflationary risks amid this gloomy environment, we continue to maintain that our focus on quality attributes can have a positive impact on equity performance, and we are excited about the equity opportunities that the recent market sell-off has offered. We are upbeat about quality companies that are classic compounders of wealth, and also about companies undergoing transitions that, in our assessment, can enhance long-term value.
Classic compounders of wealth characteristically have wide moats—that is, they possess the ability to protect long-term market share by maintaining their competitive advantages—and are typically in the best position to weather a market downturn. They also tend to have strong balance sheets with reasonable amounts of leverage, stable cash flows, and high returns on capital, and they often operate in industries where demand is likely to remain strong regardless of the economic environment. Companies that are undergoing value-added transitions, such as restructuring or divestiture of non-core businesses, offer the opportunity to invest where the market gives no credit to the positive and accretive changes that we believe a company is making. From a sector standpoint, we see strong opportunities in sustainable, high-quality franchises in healthcare and consumer staples, while we remain cautious about commodity industries and, by extension, emerging markets, as well as European financials. Overall, we are wary of companies with excess leverage, and we will continue to focus on companies with sustainable cash flow streams that appear well positioned to drive profit margins in a low- or no-growth environment.
1 Price to earnings is the ratio of a stock's price to its earnings per share.
2 The Employment Situation, U.S. Bureau of Labor Statistics, December 2015.
3 Manufacturing and Trade Inventories and Sales, November 2015, U.S. Department of Commerce, 1/15/16.
4 Quantitative easing (QE) is a monetary policy in which a central bank purchases government debt or other fixed-income securities in an effort to lower interest rates, increase the money supply, and stimulate economic growth.
5 Bloomberg, January 2016.
6 “ECB raises prospect of March policy easing as outlook sours,” reuters.com, 1/21/16.