From Capital Group
Late British Prime Minister Harold Macmillan, when once asked what he was most worried about, reportedly said, “Events, my dear boy, events.”
Investors certainly contended with their share of events in the first half of 2019. Between reports of slowing global growth, abrupt shifts in central bank policy, U.S.-China trade tensions and lingering Brexit uncertainty in Europe, investor sentiment has seesawed from confidence to anxiety and back again.
Despite the daily noise, markets have been remarkably resilient — through June 30, Standard & Poor’s 500 Composite Index has gained 18.54% this year, while the MSCI All Country World Index ex USA rose 13.60%.
What should investors expect in the second half of the year? Time will tell how the trade dispute will evolve, or when the U.K. might leave the European Union. The next six months are sure to have their share of market-moving events and investment opportunities.
Here’s our market forecast for the second half of the year which includes five key investment themes to help you navigate the landscape however events unfold.
1. Stocks have room to run, but prepare for rougher seas ahead
Recession you say? Not long ago the “r” word was top of mind for many investors. Then in January the Federal Reserve made a dramatic about-face in monetary policy by suspending interest rate hikes. Major central banks around the world took similar actions, ensuring that monetary conditions remain supportive of growth.
This policy pivot, along with lower for longer rates, is extending the life of the now decade-old expansion. The U.S. economy grew at a solid 3.1% annual rate in the first quarter. Equity markets have responded positively, notching strong gains in the first half of the year. “With the Fed contemplating a proactive rate reduction, I would expect growth to be sustained or even accelerate,” says Capital Group portfolio manager Hilda Applbaum. “This should bode well for markets, at least in the near term.”
Stock markets have room to run, but make no mistake: Late-cycle conditions are mounting. Lower unemployment and rising wages — while tailwinds for consumer spending — will ultimately pressure corporate profits.
The bottom line: It’s not too soon to prepare portfolios for rougher seas ahead. “We are walking a bit of a tightrope given that asset valuations are higher than they have been for some time. Layer on top of that the ongoing trade tensions and the rope gets thinner,” Applbaum adds. “In today’s market, balance is key.”
Investors should make sure portfolios are well diversified with exposure to a balance of growth- and dividend-oriented equities as well as fixed income.
2. Seek dividend payers with manageable debt
Dividend-paying companies have historically played an important role in helping to mitigate equity market volatility. That’s because dividends can represent steady return potential when stock prices are declining. But not all dividend payers are equal, or sustainable.
Today, thanks to ultra-low interest rates, many companies have been borrowing at extreme levels. At the close of 2018, non-financial corporate sector borrowing stood at 46.7% of GDP, a record high. Much of this cheap debt has been used to fund dividends, share buybacks, and mergers and acquisitions. The problem is, companies that binge on debt are susceptible to dividend cuts when times get tough. That’s why selectivity is essential. The key is to focus on companies that have avoided the worst excesses of the decade-long expansion.
“The longer this expansion goes on, the more attention I pay to company debt,” says equity portfolio manager Joyce Gordon, who has been investing in dividend-paying companies for 40 years. “Those with significant debt face numerous challenges. For example, they may feel pressure to cut their dividend to maintain an investment-grade credit rating.”
When you look at pairs of companies across different industries you can see those with lower credit ratings might be more likely to cut their dividends when times get tough. For example, Nestlé, with a manageable debt burden, hasn’t cut its dividend in decades. Conversely, more highly leveraged Kraft Heinz recently cut its dividend.
3. Look for long runways of growth
Even when faced with market turbulence, nimble companies with strong management are able to adjust to shifting circumstances and thrive, driving potential value for long-term investors. That’s why investors may be well served to shift their attention away from daily news headlines and focus on companies that are proven innovators with long potential runways of growth.
“Innovation improves people’s lives and drives growth and opportunity for companies,” says equity portfolio manager Anne-Marie Peterson.
Consider, for example, rapid innovation in health care. Advances in genomics have decreased the cost of sequencing a set of human genes from $100 million in 2006 to about $1,000 today, making it more practical for companies to develop new therapies derived from genetic testing. Many of these therapies have the potential to extend lives and generate billions of dollars in revenue.
For example, Swiss pharmaceutical giant Novartis earlier this year received FDA approval for a treatment for a spinal disease that is the leading genetic cause of infant mortality. Patients have already begun receiving the treatment, whose cost is reportedly more than $2 million. What’s more, U.S. drug makers AbbVie and Merck, the maker of blockbuster immunotherapy treatment Keytruda, have invested millions of dollars to develop genetic-based treatments for various cancers.
4. Don’t abandon global diversification
U.S. equity market returns have outpaced non-U.S. markets for 10 years and counting, tempting many investors to consider throwing in the towel on international investing.
But today’s economy and markets require a global perspective. Maintaining a portfolio with geographic diversification provides investors with the potential to benefit from extraordinary advances in the world’s markets and economies.
What’s more, when you take a closer look at individual companies rather than countries, the picture is very different. While international stock market indexes have meaningfully trailed the U.S., since 2009 the top 50 companies with the best annual returns were overwhelmingly based outside the United States. That means if you had decided to abandon international investing, you would have missed a shot at many of the best opportunities.
In addition to diversification, non-U.S. stocks offer a number of other potentially attractive traits, notes equity portfolio manager Gerald Du Manoir. Some of the best-run, fastest-growing companies are domiciled in overseas markets. A large number of European and Asian companies offer relatively attractive dividend yields, and for the most part non-U.S. companies have not adopted the culture of share buybacks that is prevalent in the U.S. — and in many cases has led to excessive leverage.
“To have a well-rounded and robust portfolio of stocks, investing in international markets is a must — even if you think the U.S. market in aggregate will continue to do better in the short term,” Du Manoir says.
What’s more, in nearly every sector, there are comparable non-U.S. companies trading at lower valuations than their American-domiciled counterparts. Classic examples include ExxonMobil versus Total and Samsung Electronics versus Apple. Many of these companies have strong balance sheets and solid businesses. Over the long term, company fundamentals drive stock returns, not geopolitical turmoil or a company’s address.
5. It’s time to revisit your bond allocation
In recent years, some core bond funds have prioritized boosting income over diversification and preservation. This can be problematic at a time of geopolitical uncertainty and rising equity market volatility. In this environment, it is vitally important that core bond allocations provide diversification from equity markets.
Recognizing this challenge, research firm Morningstar this year split its largest Intermediate-Term Bond category on the basis of credit risk. Those bond funds with less than 5% high yield were relabeled Intermediate Core, while any with a greater percentage now fall into the Intermediate Core-Plus category.
In light of this change, investors would be wise to revisit their bond allocations. Morningstar‘s decision should help them more easily distinguish strategies that may be vulnerable in stock market declines from those that offer a balance of the four key roles of fixed income: diversification from equities, income, capital preservation and inflation protection. Arguably, core should be the largest fixed income allocation in a balanced portfolio for many investors. Getting core allocations right is essential in a late-cycle environment, because when markets have been unsettled, high-quality bonds have shown resilience.
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