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Market View

Can stocks post further gains after a strong performance in the first six months of the year? We asked three Lord Abbett experts for their views.

 

In Brief

  • For the second half of 2017, careful portfolio construction will be essential to make sure risk exposures are intentional and well considered.
  • Giulio Martini, Lord Abbett director of Strategic Asset Allocation, believes the current environment of low volatility and positive sentiment toward risk assets likely will endure.
  • Brian Foerster, Lord Abbett investment strategist, says it is difficult to view higher-growth stocks as expensive in the current rate environment, particularly with improving corporate fundamentals among technology, healthcare, and Internet retail companies.
  • Joseph Graham, Lord Abbett investment strategist, Calibrated Equity, emphasizes long-term strategic allocations and believes companies’ focus on dividend adoption and payout, underpinned by well-honed operational and financial discipline, helps to support valuations among large-cap equities. 

 

With continued modest economic growth, relatively low interest rates, increased capital investment, and declining unemployment, equity markets generally have performed well in the first half of 2017. Can investors expect more of the same for the balance of the year? Addressing the prospects for multi-asset strategies, growth/smid-cap equity, and dividend/large-cap equity, respectively, are three Lord Abbett investment professionals:  Giulio Martini, director of Strategic Asset Allocation, and investment strategists Brian Foerster, CFA, and Joseph Graham, CFA.

Asset Allocation Strategies
Giulio Martini
A surprisingly robust global earnings recovery and receding inflation risk propelled global equities, and risk assets more broadly, higher in the first half of 2017. Thus, investors who looked past potential political risks in the United States and elsewhere were rewarded with a near double-digit increase in global equity prices and a continued narrowing of credit spreads. Moreover, in another surprising development, the U.S. Federal Reserve (Fed) was able to execute two more interest-rate increases, bringing the total to four in the current tightening cycle (which began in December 2015), and sketch out a plan for transferring some of the risk the central bank took onto its own balance sheet during the financial crisis back to the markets without shaking investor confidence.

“Investors may be giving asset prices the benefit of the doubt, because they believe that, ultimately, if further support is required, central banks are prepared to maintain monetary accommodation for as long as necessary,” said Martini. “Thus, while the Fed has asserted that if its expectations for economic growth and inflation are met, it likely will tighten by another 100 basis points by the end of 2018, [although] markets are only priced for another 25–50 basis points worth of hikes.”

The divergence in rate views is a consequence of investors forecasting inflation below the Fed’s 2% target over the next five years, despite the economy having grown enough to be very close to full employment (with the jobless rate currently at 4.4%). If economic growth remains moderate and inflation remains below 2%, then bond yields could continue drifting lower—the yield on the 10-year U.S. Treasury note, for example, dropped, from 2.45% to 2.30%, in the first half of 2017, according to Bloomberg—supporting current market valuations and opening up more upside as earnings improve.

In a reversal from 2016, non-U.S. developed equity markets outgained the U.S. markets in the first half of 2017. “The success of mainstream political parties in Holland and France increased confidence in eurozone stability, and hints of improving corporate governance bolstered equities in Japan,” Martini said. “Meanwhile, emerging equities* rose nearly 19% in the first half of 2017, fueled by the announcement that Chinese A shares would be included in the most widely followed benchmark indexes for the first time.”

But, more important, a sharp improvement in global trade volumes and falling commodity prices delivered large benefits to emerging exporters, especially in Asia. This went hand in hand with the turnaround in market leadership, from commodity producers and financials in 2016 to technology companies in 2017.

According to Martini, the outlook for the second half of 2017 will continue to be conditioned by global growth, inflation, and the response of economic policy to evolving fundamentals. If central banks truly are data dependent, then monetary policy should continue to be supportive of asset prices.

“With inflation pressure surprisingly subdued throughout the developed world—with the exception of the United Kingdom—policymakers can afford to tap on the monetary brakes lightly, if at all,” Martini said. “Meanwhile, with the crucial five-year Communist Party congress in China in autumn 2017, there is a premium on maintaining economic stability until it adjourns, at a minimum.”

As a result, many of the key eurozone- and China-based risk factors that bedeviled the markets at various times in recent years seem to be in abeyance. Thus, in Martini’s view, it appears likely that the current environment of low volatility and positive sentiment toward risk assets is likely to endure.

[Note: Non-U.S. equities generally pose greater risks than domestic securities, including market, political, and currency risk.]

Growth and Small-/Mid-Cap Equities
Brian Foerster, CFA
Increasing risk appetites in U.S. equity markets were certainly evidenced by the surge in biotech stocks and small-cap equities in the final weeks of the first half of 2017.

Following a rocky start to the new U.S. administration’s policy agenda, investors deemphasized the so-called “Trump trade” following congressional failure of the first attempt at healthcare reform. That disappointment unwound the high expectations for subsequent approval of fiscal stimulus legislation to sail through Congress this year. Investors instead turned to secular growth segments of the market, such as technology, biotech, and Internet retail (see Table 1), and slowly began to wean themselves off some “bond proxy” equities in expectation of higher interest rates.  

 

Table 1. Tech and Health Care Topped Energy in the First Half of 2017
Sector returns in the S&P 500 Index, ranked top to bottom, January 1–June 30, 2017 

Source: FactSet.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

“This shift not only reflects higher confidence in risk assets but we also have observed that it reflects a long overdue return among investors to favoring company fundamentals rather than safety metrics such as low earnings volatility and dividend yield,” said Foerster.

According to Foerster, a powerful way of illustrating this shift is to look at one of the most opportunistic segments of the market—small-cap growth stocks—as well as the behavior of investors this year compared with last year. In the first five months of 2016, for example, slow-growth stocks trounced the performance of the fastest-growth stocks, by roughly 16 percentage points, according to Bloomberg. In 2017, the first five months showed a complete reversal, with the fastest-growing companies decidedly returning to favor.

Foerster acknowledged that valuation expansion and broad stock market performance dating from the trough in March 2009 to the present continue to give some investors pause  when it comes to owning equities today. But aside from nominal price-to-earnings ratios, which would at minimum confirm the market isn’t historically cheap, Foerster said it is difficult to factor in current interest rates and at the same time view equities as expensive. Noting the so-called “Fed model,” which compares earnings yield of the S&P 500® Index to the 10-year U.S. Treasury yield, equities, at least on a relative basis, look far more appealing today than government bonds, he added.  (See Chart 1.)

 

Chart 1. Equities Still Look More Appealing Than Treasuries on a Relative Basis
S&P 500 earnings yield versus the 10-year U.S. Treasury yield, January 1, 1960–June 30, 2017

Source: NYU Stern School of Business and Lord Abbett. Shaded area covers the period from the market low in March 2009 through June 30, 2017.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.

 

Foerster also notes some recent attempts to compare the strong returns in technology stocks to the bubble of 1999–2000, and that some market participants believe the recent spurt of volatility in this sector is evidence that a massive sell-off is coming. That narrative falls flat, however, when looking at tech’s profoundly strong fundamentals today, relative to the froth that preceded the dot-com collapse. Using data from The Leuthold Group, Table 2 offers a stark and compelling contrast between those two periods.

 

Table 2. Comparing Current Tech Stock Valuations to the Dot-Com Era Is a Fallacy


Source: The Leuthold Group.
Past performance is no guarantee of future results. For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Foerster concluded that “we are not pounding the table and saying the markets can only go higher and will never fall again.” Instead, he noted, it is important to take a longer-term view of risk assets and a corporate earnings environment that is strengthening by all accounts, in addition to secular growth segments of the market that are thriving, despite the continued low economic-growth environment. From his perspective, if the U.S. economic expansion is indeed moving from a period defined by Fed stimulus, when safety stocks thrived, to a fundamentally driven phase that is favorable to corporate America, “it is very possible that we could see a sustained period of robust returns for segments of the market that are experiencing strong and accelerating revenue growth.” 

[Note: Of course, on an individual basis, small- and mid-cap stocks typically are riskier than large, well-established "blue-chip" stocks. As an asset class, small-cap stocks historically tend to be more volatile and may be less liquid than large-cap company stocks.]

Dividend/Large-Cap Equity
Joseph Graham, CFA
Many strategists are calling for a market sell-off based on extended valuations. But Graham says Lord Abbett generally favors long-term strategic allocations in lieu of market timing, and he doesn’t see valuations as a particularly helpful predictive signal anyway. In addition, equity valuations are well supported by an investor class starved for yield in a low-rate environment. Companies in the large-cap segment have evinced greater operational and financial discipline, which is reflected in their emphasis on dividend adoption and payment, he noted.

“If anything, we find the risk of a blow-off top [i.e., a sharp and rapid rise in prices followed by a steep decline] to be greater than a deep valuation-based correction,” Graham said. “Equities continue to be volatile—the headline numbers just don’t show it. It’s not as simple as the market moving up and down or even risk on, risk off.”

Graham noted a “barbell” performance this year in terms of equity duration—that is, the sensitivity of a stock or group of stocks to changes in interest rates. "This year, high equity-duration stocks in the information technology sector have rallied on the back of strong fundamentals and multiple expansion, and low-duration names in the utilities sector have also done very well as interest rates came down."

Meanwhile, the middle of the equity-duration spectrum—cyclicals, consumer discretionary, energy, and consumer staples—have all suffered by comparison, Graham added. In addition, he noted that the levels of volatility of theme and factor performance are at their highest levels in years, even while total market volatility plummets.

“This can be a difficult environment for active managers caught wrong-footed,” said Graham.

All of which underscores why Lord Abbett takes great care in portfolio construction to make sure risk exposures are intentional and well considered, allowing our sharpest insights to drive portfolio performance.

[Note: Keep in mind equity securities are subject to market risk, which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.]

 

*As represented by the MSCI Emerging Markets Index.

MARKET VIEW PDFs


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