Forecasts for growth in 2018 are positive, but many valuations in equities and bonds appear elevated. Still, Legg Mason’s managers see potential to uncover value by taking a selective approach to global markets.
For the first time since 2011, all major economies are expanding. However, the pace of that growth should remain moderate, constrained by high levels of debt. Western Asset notes debt has expanded dramatically since the financial crisis, fueled by low rates.
While major central banks are beginning to pull back from their ultra-accommodative stances, our managers believe that they are likely to continue with a cautious approach in 2018, recognizing that the pace of growth will be less-than-torrid — and therefore helping to moderate the impact of rate hikes on the markets.
The question, of course, is how much future growth is already priced into stock and bond prices. The relatively muted sentiment our managers see relative to stocks now suggests that the markets could have additional room to run, assuming that earnings growth keeps pace. But with that less than certain, the flexibility and selectivity of active strategies will allow investors to target sectors and securities whose prices may not reflect their true potential value.
"Across asset classes…valuations have been grinding higher: nothing is cheap"
- U.S. large caps: As represented by the S&P 500, large cap stocks are trading at price-to-earnings ratios (P/Es) of nearly 22x trailing 12-month earnings and over 19x estimated next years’ earnings. While this is not unprecedented, it is on the high side of normal, and dependent on continued earnings growth. That calls for a selective approach to finding unrealized value. One way is to focus on sectors rich in targets for mergers and acquisitions activity, which historically picks up late in a market cycle, and is still supported by low borrowing costs. ClearBridge Investments notes: “Several sectors are well positioned to benefit from consolidation, including healthcare, where biotechnology stocks offer innovation and growth potential in their pipelines that is attractive to would-be acquirers in the large cap pharmaceutical space. Valuable assets exist in the energy and media sectors that could jump-start activity, while the potential cash windfall from repatriation could also drive deals in technology.” In energy, the firm sees opportunity in “U.S. exploration and production companies that have driven down the cost of extraction”, with the ability to weather current oversupply that it sees as moving to an undersupply by 2019 or 2020.
- U.S. small caps: Royce sees value in cyclical industries, where valuations (P/E) are only 18.5x — vs 26.9x for defensive industries. Strong performance by small-cap Industrials and Materials in Q3 2017 could signal a more widespread shift in the market. More broadly, they state: “Global economic expansion should mean good things for cyclicals with global exposure.”
- International stocks: U.S. equity prices are already elevated, after an average 13.5% annual gain for the S&P 500 since the end of 2009. In contrast, international stocks (MSCI EAFE) and emerging markets (MSCI EM) have returned 6.4% and 4.0% respectively over the same period (with P/Es of 19x and 16x respectively), making global markets outside of the U.S. look more attractive. According to Martin Currie: “Europe, Japan and select emerging markets have more attractive valuations and are at an earlier point in their economic cycle….emerging markets in particular are benefiting from strong growth in infrastructure, ‘plain vanilla’ banking services, e-commerce, entertainment and convenience”. ClearBridge also sees selected opportunities in developed-market stocks ex-US.
Equities outside the U.S. — room to run in 2018?
S&P500, MSCI EAFE, MSCI Emerging Market (January 2008–November 2017)
Source: Bloomberg, December 1, 2017. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment
- Bond credit sectors: Western Asset’s current expectation is that spread sectors should outperform Treasuries and sovereign bonds. For investment-grade and high yield, its focus is careful name and industry selection, given that spreads are already compressed; in investment-grade, it prefers “rising stars” — lower-rated issuers that are working to reduce debt and improve cash flow, moving toward greater creditworthiness. Agency mortgage securities also may offer a source of return with somewhat reduced volatility.
- Emerging markets debt: Both Western Asset and Brandywine Global see this asset as a superior opportunity for return — in particular, debt denominated in local currencies in countries like Brazil and Russia that have high real interest rates, falling inflation and improving growth. According to Western: “Emerging market valuations also look attractive both on a historical basis and relative to developed markets, particularly given a better global recovery, lower risks in China and commodity stabilization.”
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