As investors reassess the global economic outlook, how should a stock picker react to the October equity market sell-off?
At the beginning of October, the chairman of the US Federal Reserve reiterated positive comments about the strength of the US economy, suggesting that interest rates would need to be raised further. Global bond yields increased sharply, triggering the start of the October sharp sell-off in global equities. As the sell-off continued, investor sentiment shifted amid widespread concerns about the possibility of an economic and corporate earnings slow-down.
Early reporting in the third quarter earnings season further stoked these concerns, with a number of widely watched companies reporting slower growth in revenues or faster growth in costs. At the market low point near the end of the month, the MSCI World index in US dollars had fallen 9.5% in October, taking down price-to-earnings multiples to levels not seen since early 2014.
How should stock pickers react to these market concerns? Should we hunker down and prepare our portfolios for a serious economic slowdown, or should we take advantage of what could be very attractive buying opportunities in companies that have been sold indiscriminately? As ever, in the Active Equities team we follow the evidence and allow it to guide us through swings in market sentiment.
Reflecting on the third quarter earnings season thus far, there are clearly some areas of macroeconomic concern that a few companies have been highlighting:
However, despite these areas of concern, the overall picture for third quarter results was strong. On average, revenues grew at about 8% a year for US companies and almost 5% for non-US companies, led by the energy and materials sectors and US technology companies. A similar or better proportion of companies beat consensus forecasts than normal and, in aggregate, guidance for the fourth quarter was in-line with market expectations.
In broad terms, the data that we track to understand what is happening at the micro level and our conversations with companies reinforce our view that economies worldwide will continue to grow, supporting corporate revenue and earnings growth, albeit at a slower rate than at the beginning of the year. Management teams remain confident about business prospects and their growth and investment plans are largely unchanged. Our interpretation of the evidence matches what economists are telling us – economies were experiencing unsustainable, above-trend growth at the beginning of the year and are now slowing towards trend growth rates.
As such, based on the evidence we are seeing, we are not significantly changing our bottom-up forecasts. Despite the big shift in market sentiment, our models are telling us that there are many good quality cyclical companies that are now more attractively valued than before October. Using our disciplined investment approach, we are taking advantage of these valuations.
What could change our minds? Economic and corporate cycles can turn quickly and we need to keep observing the evidence and testing our forecast assumptions for signs that a more serious slowdown is on the way. For us, a warning sign would be if we observe a change in corporate confidence and see management teams making plans to cut costs or curtail investment plans. That would tell us that animal spirits have been broken and a serious economic downturn could be on the way. For now, we can’t see that – but we will keep looking.
Five months is a long time in Italian politics. Back in June, we observed that Italy was too big to fail, but also too big to bail. We were also waiting for the almost inevitable clash with the European Commission over the budget. That has now arrived and we have started trading Italian risk in the new higher range for spreads.
* (Bubbling Tensions in Politics)