By Carmel Wellso
Forecasters of Doom Are Probably Two Years Ahead of Reality
About 80% of S&P 500 Index companies reported first-quarter earnings that exceeded analysts' estimates. Yet the U.S. stock index dropped 1.2% in the year through March as investors grew worried that a recession was imminent.
The trigger was a return of implied volatility, as the CBOE Volatility Index (VIX) briefly surged to 37 in February after averaging 11 in the previous 12 months. While the S&P 500 rose or fell by more than 1 percentage point only eight times in 2017, already this year it has swung by that magnitude on 35 days. That's led some to question whether 2019 will mark the end of the second-longest bull market.
But there are just about optimal conditions for active stock pickers, with rates rising, real gross domestic product (GDP) growth of 2.2% in the first three months of 2018 in the U.S. and core consumer price inflation at the same level.
Sure, there are risks, such as higher gas prices and health-care inflation. On a macro level, the main uncertainty surrounds trade talks between the U.S. and partners including Canada, Mexico, China and Europe, but it's perhaps more likely that the political to-and-fro should give pause rather than be seen as the harbinger of an outright correction.
Buoyed by tax cuts and the ability to repatriate overseas cash at attractive rates, U.S. companies are investing for growth, particularly through increased capital expenditures, and mergers and acquisitions. The benefits of this have yet to be felt.
The U.S. consumer is also showing confidence. In April, 163,000 homes were authorized for construction but not yet started, 16% more than a year earlier, indicating demand is holding even after seven interest-rate increases by the Federal Reserve since December 2015 and as material and labor costs rise.
That's a boost for companies such as PulteGroup, Inc. (NYSE:PHM) which trades on a 2020 price-to-earnings (P/E) ratio of 7 compared with a two-year forward P/E of 14 for the S&P 500. Pulte targets high-growth sectors such as first-time buyers and boomers downsizing.
As always, there are potential pitfalls.
Retailers face margin pressure because of an inability to pass through rising costs due to online competition. But while consumer staples show little upside potential versus their downside risk, select discretionary names look more appealing. Home Depot, Inc. (NYSE:HD) is well-placed to take advantage of the strength in housing and higher disposable incomes feeding through to remodels and upgrades, plus it has the bonus of being more Amazon (AMZN)-proof. (Who orders a bag of cement online?)
Others in the consumer discretionary space that may enjoy a boost from rising disposable incomes include travel-related companies such as Norwegian Cruise Line Holdings Ltd. (NASDAQ:NCLH).
As interest rates and inflation rise, momentum can tip to some value categories. Rising net interest margins and less regulation may boost banks such as Citigroup Inc. (NYSE:C), JPMorgan Chase & Co. (NYSE:JPM) and Bank of America Corp. (NYSE:BAC) while increased volatility may help trading revenues at the likes of Goldman Sachs Group Inc. (NYSE:GS).
Other value players in long-unfancied industrial sectors - such as Rio Tinto plc (NYSE:RIO), Siemens AG (OTCPK:SIEGY), Caterpillar Inc. (NYSE:CAT), and Japanese semiconductor wafer makers Shin-Etsu Chemical Co Ltd. (OTCPK:SHECY) and Sumco Corp. (OTCPK:SUOPY) - are enjoying greater pricing power because of capacity constraints and rising demand. Indicators of this include a 3 percentage point rise in U.S. industrial utilization since December 2016 to 78% of capacity, causing longer wait times for raw materials.
Back on the growth front, select technology stocks continue to appeal because of strong revenue and earnings, despite often elevated valuations. We're at the outset of a decades-long digital transformation of the economy, driven by artificial intelligence, cloud computing, mobile connectivity and the internet of things (IoT).
That potentially creates a powerful tailwind for semiconductor makers such as Taiwan Semiconductor Manufacturing Company (NYSE:TSM), Xilinx, Inc. (NASDAQ:XLNX), and Microchip Technology, Inc. (NASDAQ:MCHP); semiconductor-equipment makers such as ASML Holding NV (NASDAQ:ASML) and Lam Research Corp. (NASDAQ:LRCX); connectivity providers including Amphenol Corp. (NYSE:APH) and TE Connectivity Ltd. (NYSE:TEL); and the large cloud computing platforms Alphabet Inc. (NASDAQ:GOOG) (NASDAQ:GOOGL), Amazon.com Inc. and Microsoft Corp. (NASDAQ:MSFT).
Outside the U.S., every European Union member state expanded in 2017 for the first time in 10 years, giving the bloc its fastest growth since 2007. Following a bump in the first quarter on problems including currency appreciation, bad weather, strikes and capacity constraints, growth is forecast to strengthen again in the three months through June. Exporters such as Germany, France, Italy and Spain may get a boost from a 4.4% depreciation in the euro against the U.S. dollar since March 30 after the single currency surged 17% against the greenback in the previous 15 months. Being a few steps behind the U.S. in its recovery, Europe perhaps has a longer runway than many anticipate.
There is also little to indicate trouble in China, where GDP is rising at 6.8% annually and where technology companies such as Alibaba Group Holding Ltd. (NYSE:BABA) and Tencent Holdings Ltd. (OTCPK:TCEHY) continue to merit their valuations on growth expectations, even as both stocks doubled last year. Alibaba forecast a 60% leap in revenue for the year through March 2019, and Tencent delivered a 61% surge in net income in the first quarter.
All of which suggests it's premature to talk of a recession this year or next.
Carmel Wellso is a portfolio manager and director of research at Janus Henderson.
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