Will Business Spending Hold Up?

Large-Cap Growth Stocks

Will Business Spending Hold Up?

Despite a rocky third quarter, growth stocks are up 23.30% for the year, well above our expectations coming into 2019.


Market Overview

Rising risks turned investors defensive in the third quarter, with the largest stocks managing gains while overall market performance was mixed. The S&P 500 Index advanced 1.70% during the quarter to hold onto a 20.55% return year-to-date. The Russell 1000 Index added 1.42% while the Russell Midcap Index rose 0.48%. Growth stocks rallied late in the quarter to retake leadership from value stocks, with the benchmark Russell 1000 Growth Index (+1.49%) besting its value counterpart by 13 basis points for the quarter and 549 bps year-to-date.

From a sector standpoint, real estate (+7.50%) and consumer staples (+5.98%) were the strongest performers, reflecting a rotation into defensive stocks. Information technology (IT, +2.58%) also outperformed the benchmark while communication services (+0.85%) and consumer discretionary (-0.48%), the other areas of the market home to momentum stocks, lagged. Health care (-2.56%) and energy (-7.73%) were the worst overall performers.

Volatility spiked over the last three months on the ebbs and flows of U.S.-China trade tensions, attacks on Saudi Arabia’s energy infrastructure and increasing signs of a global economic slowdown. Mindful of these risks and the potential impact of weakening U.S. manufacturing activity, the U.S. Federal Reserve (Fed) cut short-term interest rates 0.25% at both its July and September meetings. Following the September move, Fed Chairman Jerome Powell noted that a still strong U.S. economy and low unemployment are being offset by heightened uncertainty that has hurt business spending.

Momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented companies rich in free cash flow.
Margaret Vitrano and Peter Bourbeau
Outlook

From our perspective, the biggest risk for the rest of 2019 for large, multinational growth companies is that the fragile support of easing monetary policy will collapse and the global business slowdown already in place will spread to U.S. consumer spending. Companies we speak with have been communicating a lack of visibility on final demand for the last several months, with tariffs and an impending U.S. profits recession causing managements to delay capital spending (capex). This anecdotal evidence is now showing up in government data on manufacturing, with U.S. industrial activity contracting in August and September.

When businesses had no incentive to spend in 2015, the equity market sold off. We are concerned that the market is not currently pricing in the risks of reduced capex and a myriad of other uncertainties.

Low, and in many cases, negative interest rates have so far masked the full impact of a global economic slowdown. Should the manufacturing recession continue, this will impact company hiring and wage increases, with a knock-on negative impact on consumer spending. In this environment, momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented companies and those with rich free cash flows.


Definitions:

Capital expenditures (Capex) , also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Free cash flow (FCF) is measure of financial performance calculated as operating cash flow minus capital expenditures. It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

Growth refers to stocks of companies whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects.

An initial public offering (IPO) is the first sale of stock by a private company to the public.

Momentum refers to an investment approach that aims to capitalize on the continuance of existing trends in the market.

The Russell 1000 Growth Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation.

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 1000 Value Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their value orientation.

The Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represents approximately 25% of the total market capitalization of the Russell 1000 Index.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

Value refers to an investment approach that aims to select stocks that trade for less than their intrinsic values.

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