Equity Outlook

Navigating the Return of Volatility

Bill Belichick, arguably one of the greatest coaches in professional football history, is renowned for his detailed planning and uncompromising demand for discipline in his players. However, if anyone has ever watched the five time Super Bowl winning coach on the job, the characteristic that stands out most is the pinpoint adjustments made during the game. The text book example is Super Bowl LI when the Patriots, down 28-3 in the third quarter, overcame a 25-point deficit to mount the largest comeback in Super Bowl history. The relentless in-game analysis by Coach Belichick and his staff, and the ability to adapt to new information led to a monumental shift in the game and ultimately the victory.

Adaptability is the key to success not only on the fields of friendly strife, but also in practical areas such as investing. While the return to a normal level of volatility has generated a challenging market to navigate, we can take lessons from great leadership of the likes of Coach Belichick and apply them to this market. 

From a valuation standpoint, there has been a major shift. S&P 500 earnings for the first quarter of 2018 grew year-over-year by over 25%, however, market prices have only increased by 1.7% year-to-date, through the end of the quarter. As a result, U.S. stock valuations (i.e., Price/Earnings ratios) have fallen to levels much closer to the historical average. While many investors were concerned about high valuations at the end of 2017, much of that worry in the U.S. has dissipated on robust earnings growth. Foreign stocks have not seen that same catalyst for growth.

Lastly, the political scene in Europe has added a bit to concerns there given the emergence of “Eurosceptic” leaders in Italy and Angela Merkel’s challenges in dealing with immigration in Germany.

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Sending the U.S. in Motion

During 2017, the benefits of global diversification finally came to fruition as foreign developed markets (MSCI EAFE) returned 25.7% and emerging markets (MSCI EM) returned 37.8% in 2017 versus the 21.1% return of broad U.S. equity market (Russell 3000). However, conditions benefiting foreign equity exposure may be waning such that domestic equities could once again be poised for better relative performance. The cut in U.S. corporate and personal tax rates enacted in December has boosted domestic growth and allowed U.S. companies to use the “found money” from tax cuts to execute stock buybacks, pushing domestic earnings per share higher.

Last year, foreign equities enjoyed attractive valuations versus domestic equities and their own short-term history. As global growth gained momentum, foreign stocks and U.S. companies with large foreign exposure reaped the rewards. Perhaps more importantly, after peaking at the end of 2016, the dollar faded throughout most of last year - despite the Federal Reserve being ahead of other foreign central banks when it comes to tightening monetary policy. All other things equal, a weakening dollar adds to the return realized by U.S. investors from foreign equity holdings where the currency has not been hedged. However, this year that divergence in monetary policy has seemed to make a difference as we’ve seen a decided reversal of trends sending the dollar higher.

Playing Small Ball

Led by the year-to-date double digit returns of mega-cap tech companies like Facebook, Apple, Microsoft, Adobe, NVIDIA, and Cisco Systems, as well as consumer discretionary giant Amazon, large-cap stocks have done well.

Strength in the energy sector, thanks to a recent surge in oil prices--$74.15 per barrel for West Texas Intermediate light sweet crude at the end of June 2018. In turn, the energy sector rebound has also helped large-cap performance. Despite the strength in these sectors, the breadth of the large-cap rally is worrisome given that performance outside of technology, selected consumer discretionary stocks, and the energy sector has been only slightly positive or even negative of late. Also, large-cap U.S. companies derive a large percentage of their revenue from foreign sales and the resurgent dollar is becoming a drag on those foreign sales.

Small-cap stocks, on the other hand, are getting the most lift from the cut in corporate tax rates and they are impacted to a lesser degree by foreign sales since nearly 80% of U.S. small-cap revenue is domestic in nature.

We have been concerned about frothy valuations in the small-cap space (e.g., the P/E on the Russell 2000 Index hit 35 near the end of 2017), but thanks again to very strong earnings, those valuations have dropped closer to the long-term average of 26 times forward earnings.

Finding the Open Man

The trend has been that good quality companies are outperforming regardless of style. Growth companies that can generate strong revenues independent of cyclical growth (e.g., technology companies) and value companies that outperform during periods of cyclical expansion (e.g., financials), both have pockets of strength that make them compelling. Energy stocks in the value space area doing well with the surge in oil prices driven by decreased oil supply and increased global demand while several technology stocks in the growth space continue to innovate and deliver impressive earnings quarter after quarter. 

Expanding the Playbook

Finally, with regard to “other” asset classes, investors should continue to find value in diversification and seeking low correlated assets.

REITs have rebounded lately as the yield on the 10-year Treasury has fallen from a peak of 3.1% to 2.9% (as of Quarter End), but given the expected, slow grind rise in inflation and the Fed’s bias to continue raising short-term rates, REITs, like utility stocks, should be considered as a hedge.

On the other hand, infrastructure companies, typically held as Master Limited Partnerships (MLPs,) may be poised to do better. As long as energy prices remain firm, the need to develop more transportation and storage facilities in the domestic petroleum and natural gas industries should be beneficial to well-run companies. Industry changes, as many of these companies have chosen to move to more traditional C-Corp structures, have also been a tailwind for investors due to simpler accounting and thus better access to capital from a broader investor base.

“Absolute return” investments that offer low correlation to long stock and bond positions may be compelling in some instances, but Treasury Bills now yielding 2% or more seem to be a viable substitute for absolute return

On To Victory

When it comes to how the equity markets will perform over the second half of 2018, the only predictable likelihood would be a continuation of the more normal levels of volatility that we’ve seen in the first half of the year versus the incredible and illogically low volatility enjoyed in 2017. Beyond that, one could perhaps expect the equity market to be a little soft or sideways during the seasonally tepid summer months. Equities often perform their best late in the year, but midterm elections amidst our politically charged environment this time around could affect that pattern.

One other major issue which remains unresolved is the ongoing trade negotiations. This loose end could go any number of ways. One could easily see a scenario where trade negotiations, which have caused so much angst and volatility, are resolved uneventfully. Just as easily, if the trade war becomes hot, strong growth that would otherwise be expected could be scuttled. Although, if a trade war does proliferate and slow global growth, there might be a small side benefit in that the Federal Reserve could be less compelled to hike interest rates. Regardless, the actual final disposition is probably somewhere in the middle with a multitude of potential outcomes. Please read the Q&A section of Market Outlook for more color on trade negotiations.

Lastly, the scenario that investors seem to be giving the least amount of respect might be the most likely one. It’s the scenario whereby the “Goldilocks” environment continues – i.e., interest rates rise steadily as the result of strong growth, but coupled with only marginally higher inflation. Corporate earnings continue to explode to the upside, and consumer and business optimism propels renewed personal spending. These conditions result in an increase in capital spending that would likely invigorate even more productivity gains than have perhaps begun to emerge. Finally, the dollar loses steam as foreign growth accelerates.

Field Marshal Helmuth von Moltke (The Elder) is credited as saying, “No plan survives contact with the enemy.” That concept emerges repeatedly in quotes credited to many individuals, one even by General Eisenhower, which is often recited by Coach Belichick when asked about making adjustments. Regardless of which scenario plays out, rest assured we remain committed to helping our clients achieve their financial goals and aspirations, and we are fully prepared to make adjustments and adapt out outlook as we move forward.

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BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).