CIO Roundtable: 2019 Mid-Year Market Review

MESSAGE FROM OUR CIO

The bull market, now in its 11th year, continues to be supported by strong fundamentals. Valuations remain reasonable, and corporate cash flows and earnings are at all-time highs. The labor market is strong with growing wages and a decades-low unemployment rate. As cash continues to build on corporate balance sheets, companies have been increasing capital expenditures and returning capital to shareholders, with both stock buybacks and dividends on the rise.

Importantly, as I have said many times and continue to believe, there is no sign of the euphoria that generally precedes a bear market. I am very confident in the long-term outlook for this bull market. 

-Neil J. Hennessy

What is your outlook on the U.S. markets?

Stephen Goddard: I believe the S&P 500® Index’s price-to-earnings ratio (P/E) remains at reasonable levels relative to interest rates. At the current level of interest rates, I believe stock prices have continued room to expand, where P/Es could grow to 20-25x earnings.

Ira Rothberg: I agree with Steve. When you look at the correlation between 10-year rates and P/E multiples, one could argue that stocks should be trading at 20-25x earnings. And while the current economic expansion has lasted nearly 10 years, GDP percentage growth from the trough is still well below previous recoveries, which suggests the economy and market still have room to move nicely higher.

Peter Greig: Yes, multiples could expand because rates should stay relatively contained or go lower. Also, there’s no reason the economic cycle should end anytime soon as the Federal Reserve won’t likely negatively impact the cycle.

Dave Ellison: Earnings matter. The strong corporate profits we have seen allow companies to deploy cash to reinvest, repurchase shares, or increase dividends. The U.S. unemployment rate of 3.6% is at a 50-year low and when people have jobs, they can save, spend and/ or borrow money. For these reasons, I believe the current economic expansion will continue.

Ryan Kelley: I am optimistic as well. The S&P 500® Index had a total return of approximately 14% per year for the decade ending May 31, 2019, and some wonder if that’s too far. However, there have been six bull markets since World War II, and three have had higher annual returns. Valuations continue to look attractive given where interest rates are and given some of the headwinds that the market has faced.

Josh Wein: P/E multiples could certainly expand given the current level of interest rates. Importantly, the quality of earnings is impressive. We’ve seen operating margin expansion and, among larger companies, modest financial leverage trends. In fact, for the S&P 500^® the ratio of net debt to operating cash flow is less than half what it was 10 years ago.

David Rainey: In the second half of 2018, the Fed raised rates too high and too quickly. With the Fed now pausing rate increases, risk is greatly diminished. I believe we should continue to see good earnings growth and margin expansion with companies continuing to use “cheap money” to buy back shares.

What is your perspective on your specific sector?

Masa Takeda: The current Japanese market looks more attractive compared to the market in 2017 and the first half of 2018. Since the beginning of Abenomics in late 2012 through the first half of 2018, earnings per share and the Japanese stock market rose in tandem. However, in the second half of 2018, those numbers started to decouple as corporate earnings decelerated from high single digits to low single digits and the market dropped even further. As of May 2019, the market trades at about 12x this year’s earnings, the lowest levels we’ve seen in many years.

Japan remains largely an export-driven economy as incremental growth comes from overseas, so currency is a significant factor. However, at 107/108 yen to the dollar, companies are comfortably profitable and generating strong cash flows, which are being reinvested into core business activities, creating a virtuous cycle. In addition, the labor market remains strong with a 2.4% unemployment rate—a 26-year low—although wage growth is only a fraction of a percent and consumers have yet to shake off a deflationary mindset. To build confidence, Japan continues to roll out structural reforms, but change takes time.

Tim Dumois: We are very optimistic about the U.S. energy sector and see strong tailwinds as evidenced by significant free cash flow growth and compelling valuations. Technology has been a key driver to the U.S. energy industry’s ability to generate and deliver a larger supply of crude oil and natural gas to the global marketplace.

Ryan Kelley: I agree with Tim. The advances in drilling technology and demand growth have been positives, particularly for the natural gas industry.

Dave Ellison: In the Financial sector, it’s not just about interest rates. Company fundamentals do matter, and banks have been enjoying healthy earnings and revenues in part because they have been able to maintain their low deposit costs.

What is your outlook on U.S. interest rates?

Gary Cloud: While consensus views on interest rates have varied in 2019, I believe there is a greater likelihood of declining interest rates in the U.S. Disinflationary forces are in place and the U.S. economy is unlikely to overheat. Globally, U.S. rates remain high on a relative basis. The U.S. remains the world’s favored reserve currency with many countries, such as China, owning U.S. debt.

In Q4 2018, the Federal Reserve continued its policy of measured interest rate increases, but now they remain at least on hold for 2019 or may lower rates. The market has responded favorably and reached new record highs. As a result, the Federal Reserve doesn’t want to be perceived as a barrier to economic growth.

Peter Greig: Interest rates should stay relatively contained where they are now. If rates were to move significantly higher, it would negatively affect the U.S. budget deficit. There’s far more likelihood that rates move lower.

Dave Ellison: Bank earnings have been bolstered from rising rates, and net interest margins have been rising steadily, reaching 3.5% in Q3 2018, up from a low of 3.0% in Q3 2015. While rates may remain flat or go lower, we believe banks can benefit from the incrementally expanded net interest margins as older loans reprice at higher rates.

Ben Cook: Midstream energy companies would be less susceptible to interest rates given the fact that they have gone through considerable lengths to improve their balance sheets, sell assets, and right-size their cash flows. In addition, typically, higher rate environments are associated with and signal strong economic activity that contributes to greater demand, which translates to a greater utilization of infrastructure.

Brian Macauley: As rates rose sharply in Q4 2018, negative consequences, especially in the housing industry, resulted. In 2018, the 100 basis points or a 1% increase in mortgage rates negatively impacted mortgage demand as affordability levels were affected. Accordingly, new home construction declined.

What are your thoughts on the Trump administration’s trade tariffs?

Gary Cloud: Trade tariffs usually carry negative economic outcomes, yet the impact to U.S. companies may be minimal as they have not waited for a resolution from Washington D.C. Instead, they have been redirecting their operating activities to other supply chain countries such as Vietnam, Thailand, and Mexico.

Dave Ellison: If the market was reacting negatively to the lack of a trade deal, I believe we would have one in place. 

Masa Takeda: The Japan Fund portfolio has no direct exposure to industries that are affected by the tariffs already put in place. However, for many of our holdings, China is an important market. Slower growth in China is having a mild impact on consumer-oriented companies. However, Japanese consumer product companies enjoy considerable brand loyalty in China and operate in markets that tend to experience stable growth in demand. We also expect revenue growth from other regions of the world to offset any short-term weakness from China.

David Rainey: It is disappointing that much of the trade discussion with China has moved away from trade that is free of tariffs. Ultimately, I do believe there will be a trade deal, but likely there will be more back-and-forth discussions between the two countries. Intellectual property theft is an enormous problem for U.S. businesses and a very minor one for their Chinese counterparts. The U.S. should partner with European countries to coordinate enforcement of World Trade Organization rules.

What is your outlook for growth vs. value stocks?

Stephen Goddard: Typically, growth and value leadership cycles last for three to five years, but growth stocks have outpaced value companies for the past nine years. We believe value companies are overdue to take leadership and outperform growth.

Ira Rothberg: The P/E valuation gap between growth and value companies is at its widest differential since 1999. We expect this trend will continue until there’s a market shock that results in a dramatic switch in leadership from growth to value.

David Rainey: If you look at the batch of newly public companies, many of them are businesses without a long history and are priced as a multiple of revenue, rather than a multiple of earnings. Cheap money fuels speculative interest in these new growth stocks.

Josh Wein: Continued global uncertainty may continue to push investors toward value stocks as they potentially offer more stability than growth companies.

Why should investors consider active management?

Trip Rodgers: Managers who are essentially “closet indexers” tend to add little performance benefit to an overall portfolio. Consequently, more attention is being paid to asset managers with concentrated portfolios and high active share who can potentially outperform their respective benchmarks.

Dave Ellison: Many investors are seeking actively managed strategies that include concentrated, “best ideas” portfolios and high active share. The industry has moved past the days of manufacturing portfolios consisting of 100+ holdings.

Josh Wein: Portfolio size is the enemy of performance. Active managers, especially boutique managers such as Hennessy, have the ability to access a broader opportunity set than larger managers, which could provide an excellent backdrop for future outperformance.

Toby Loftin: In the Energy sector, the S&P Energy Select Sector Index is weighted towards two names: Exxon Mobil and Chevron, which account for more than 40% of the Index. For investors to fully access the energy market, they need to look beyond the benchmark and leverage an active manager who can opportunistically invest across the entire energy “value chain,” seeking the best balance of reward and risk across many energy companies.

Masa Takeda: Japan has been an excellent market for active managers as local research remains an efficient way to access the best opportunities. The Tokyo Price Index (TOPIX) is largely inefficient and contains many “sleeping giants.” Additionally, foreign investors struggle with culture and language barriers that we believe provide local asset managers with an information advantage.

Peter Greig: Fixed income still remains an inefficient market, therefore, using a benchmark would not give the investor access to fundamental credit research that can contribute to high conviction investment ideas. Additionally, not all fixed income securities are created equally, which can provide opportunities for an experienced active manager.

Masa Takeda: Japan is a good market for active managers since the market remains under-researched and inefficient. Over the last 10-15 years, 50% of active managers investing in Japanese equities have outperformed their respective benchmarks after fees.