After the optimism and strong returns of 2017, volatility has stalked equity markets in 2018 as risks emerge. While the US economy appears to be strong, talk of synchronised global growth has waned and the investment outlook for 2019 is less certain.
As the US Federal Reserve began to steadily hike rates on a path towards monetary policy ‘normalisation’, the market has started to digest the impact of higher yields and withdrawing liquidity on asset prices. For companies trading on high multiples with hefty growth assumptions, the market can be unforgiving in the face of tightening monetary conditions and higher yields. Indeed, US dollar strength and tightening monetary conditions have already impacted emerging markets, where we have seen volatility, in particular in the Argentine peso and Turkish lira. Further risks remain in more fragile emerging markets, where tighter dollar funding conditions are likely to prove challenging for weaker borrowers.
Beyond liquidity withdrawal, investors face a long list of macroeconomic risks. Commodity price volatility, technological disruption, changing demographic trends, escalating trade wars and tariffs, and global debt levels can create challenges for markets.
Going into 2019 against this uncertain backdrop, we believe focusing on structural, rather than cyclical, growth will be key. The fortunes of external factors, such as commodity prices, interest rates, or the economy, cannot be relied upon to sustain growth.
We strive to uncover quality business models that are exposed to attractive categories, and structural growth drivers. Some of the themes embedded in our portfolio include:
Meanwhile, we are aware of the potential threats that exist to the dominant market positions of certain quality companies. For example, we pay close attention to disruption in the consumer staples sector. While the impact of the ‘infinite shelf’, made available by e-commerce, is lowering barriers to entry and supporting smaller brands and private label penetration, this impact is not felt equally across all categories. Therefore, the impact will not be felt evenly across companies. In many cases it will likely provide opportunities as well as risks, requiring careful stock selection.
Quality companies can reinvest cashflows for future growth. In sectors such as IT, healthcare and consumer discretionary are capital-light, cash-generative businesses that typically spend the most on research and development (R&D). This investment in R&D allows companies to innovate, which in turn entrenches competitive positioning and ensures the sustainability of growing cashflows.
In aggregate, Global Franchise companies vastly outspend the market as a whole, investing nearly four times more – as a percentage of sales – on R&D.
Figure 1: Aggregate R&D spend by sector
Source: FactSet, based on constituents of MSCI ACWI, as at 31.08.18.
Despite this heavy investment, these companies still generate far superior margins and returns on capital than the broader market.
Figure 2: Superior margins and returns on capital
Source: FactSet, Investec Asset Management, as at 30.09.18.
Considering the macroeconomic and geopolitical risks, and the uncertain investment outlook we have highlighted, it is now more important than ever to invest in companies which are not dependent on cyclical drivers or economic conditions.
We believe that carefully selected quality companies, with long-term structural, rather than shortterm cyclical growth drivers, should be well placed to perform in 2019. We will continue to focus on finding these attractively valued quality companies, with demonstrably enduring competitive advantages that are able to grow their cashflows into 2019 and beyond.
As we progress further into an era of reduced central bank support and tightening liquidity, we believe that while fundamentals and valuation will play a role, market price behaviour will remain the key driver in 2019. We still see good opportunities for investment in some credit markets, but increased bouts of volatility are likely to become the norm. The stage is set in the year ahead for the nimble, and well positioned investor, to take advantage of the move from quantitative easing to quantitative tightening (QE to QT). Below we use our ‘Compelling Forces™’ framework, segmenting credit market drivers into Fundamentals, Valuation and Market Price Behaviour, to examine these themes in more detail.
Going into 2019, the general fundamental backdrop remains sound. The auto sector aside, the robust growth experienced through much of 2018 is slowing rather than turning negative. As such, we think the threat of a very near-term recession is small. This macroeconomic strength has largely fed through to corporate earnings, particularly in the US. This has also translated into a continuing moderation in corporate leverage levels, which currently stand at elevated, but not overly aggressive levels. However, this varies somewhat by market.
It is notable, however, that certain subsets of the economy have recently shown signs of weakness. We have started to see a moderation of momentum in several of the traditionally more cyclical sectors, such as autos, industrials and homebuilders.
As individual issuers within these sectors have reported weaker financial performance, we have typically seen aggressive repricing of their equity or credit spreads, as illustrated below by the equity and bond prices of global chemicals manufacturer Trinseo (Figure 1). This asymmetric price reaction on any earnings miss clearly illustrates the increased value of selectivity.
Figure 1: Trinseo: equity and bond prices compared
Source: Bloomberg, 30.09.18.
However, this localised stress has yet to filter through into broader measures of market health. As such, default rates have continued to moderate, alongside continued positive ratings drift (more upgrades than downgrades) momentum.
Figure 2: Default rates are moderating
Source: Moodys. As at 31.10.18.
In a year of more divergent performance across the credit market subsets, the relative attractiveness of different credit markets is currently quite variable. Certain subsets, such as US high yield, are trading close to post-crisis lows. Other segments, such as European high yield, have repriced wider since the start of the year. Figure 3 provides a snapshot of the large developed market bond markets, illustrating the variability of these valuations in the context of each asset classes' history.
Figure 3: Current corporate bond spreads, percentile against history
Source: Deutsche Bank, FactSet (ICE BAML). 30.09.18.
The reasons for this valuation divergence differ from case to case. They can be idiosyncratic in nature (e.g. Italian political risk) or down to particularly supportive market technical factors (e.g. US high yield). We believe it is too difficult to generalise in terms of the attractiveness of valuations given the multitude of factors which need to be considered when assessing each market subset.
While we still see potentially attractive risk-adjusted returns across various subsets of the market, we think the year ahead is less about reaching for returns and more about preservation of capital. In this vein, dynamism and selectivity are going to be key to avoiding the more susceptible areas of the credit market.
In our view, market price behaviour will continue to be the main driver of markets in 2019. The ‘safe havens’ may not necessarily be where investors expect them, given the impact of extreme monetary policy over the last decade.
Credit markets, along with most financial markets, have benefited significantly in recent years from a wave of central bank liquidity. Easy money has rippled through all credit market subsets, providing a strong tailwind for tighter valuations, supported by improving underlying fundamentals. However, the recent shift from QE to QT, in our mind, is likely to have a material impact on market momentum. The retrenchment of tourist investors (tactical allocators), who don’t consider credit a mainstay of their investing, leaves some areas of the market susceptible.
As such, understanding the behavioural dynamics of individual market subsets is a key theme for us and further illustrates the need for selectivity. We believe this dynamic, along with issuance levels and fund flows, will likely have a meaningful impact on market direction in the year ahead.
We believe there are still attractive risk-adjusted returns on offer among the different subsets of the credit market. However, we believe selectivity is going to be key in the year ahead, not only in terms of individual credit selection, but also in selection of subsets of the credit market. We also believe dynamism in both these regards is going to be critical in 2019.
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, issued November 2018.