Nearly The End Of The Stock Market Cycle: Favouring Solid Companies
Investment themes 2019: This is the second theme in our 10-part series where we cover our investment themes for the year.
The approach of the end of the cycle in the United States and the overall tightening of monetary policies favour an outperformance of quality securities (high profitability, little indebtedness and low variability of profits).
In the eurozone, companies that generate high and sustainable dividends also offer a good opportunity for quality investments. In addition, we recommend US and Asian corporate bonds with high credit ratings and short durations.
In today's context of a gradual rise in yields and in volatility, companies offering high profitability, healthy balance sheets and little exposure to the economic cycle are well positioned to deliver above-average returns.
This ability to outperform should be a global trend. In the eurozone, securities yielding high and sustainable dividends are also covered in this theme.
This is a core investment for anyone seeking to invest in the equity markets for at least a year. Even when the next recession looms on the horizon, the theme’s attractiveness should remain intact or even increase.
For the bond component of this theme, US and Asian corporate bonds with high credit ratings and short durations are attractive.
Quality stocks have begun a new period of outperformance.
What is a quality security?
MSCI defines a good quality security as follows: its profitability must be high, its indebtedness limited and the variability of profits must be low. We pay particular attention to the return on equity (ROE), capital debt and the low correlation to the economic cycle. Thus, objective ratios are used to assess a quality company.
A winning style in late stages of the cycle
Sir John Templeton said: "Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria." This statement infers that current conditions differ from those of the early stages and do not correspond to those of the late stage.
However, two factors support the view that we are in a late stage of the cycle when describing the current situation: the gradual upward shift in bond yields and the rise in stock market volatility.
These two factors combined create a favourable environment for an outperformance of so-called "quality" stocks. Another factor that favours high investor appetite is the global political context, between protectionism and populism.
A late stage of the cycle, really?
The statement of Sir John Templeton aside, fundamentals and valuation levels show that the global economy and stock markets have definitely reached a late stage of the cycle. The best examples are probably the sharp decline in unemployment rates since 2009, the high level of consumer and business confidence, the high level of corporate debt and the gap between actual and potential output.
Moreover, valuations are high in the US but in line with long-term averages in the rest of the world.
A global theme
We note that economic and stock market cycles in the various regions of the world are not very different. In our view, this is therefore a global theme.
Add in the eurozone's securities with high and sustainable dividends
As interest rates and bond yields continue to remain durably low in the eurozone, the niche of high and durable dividend securities may be included in this quality theme. If a company pays a high dividend and can afford to maintain it at the same level, then it has the capacity to generate a decent level of profit, irrespective of the economic climate.
In addition, in the eurozone, pay-out ratios are below the long-term average and balance sheets are generally strong. Such stocks can be included in the quality theme.
Valuations are already high, but for good reason
Quality securities had already outperformed before 2016 at the global level, owing to the context of anaemic growth. Now that the growth peak has been exceeded, a new period of outperformance is beginning, even though valuations have not returned to attractive levels judging from the ratios since the beginning of the millennium.
Prior to 1999, however, valuations were often in line with today's levels. We believe that they can easily hold up in the environment we foresee in the coming quarters.
An attractive bond pocket
US bonds have become attractive for dollar-based investors in today's context of rising bond yields. This is not the case for investors whose reference currency is not the dollar because the cost of currency hedging is high. We like quality corporate bonds rated between AAA and A and with a short-dated maturity (1-3 years) in order to curb interest rate risk because we believe long bond yields will continue to rise.
We forecast 3.25% in 12 months for the 10-year US Treasury bond yield. We are more cautious on the BBB and High Yield segments. The BBB segment has more than doubled in 10 years and now represents half of the Investment Grade (IG) Index.
These companies are more likely to be downgraded to the High Yield segment by rating agencies when the US economy starts to slow down. The yield spread for bonds in the BBB category (1.05% for short maturities) remains below its medium- to long-term average, despite the correction in 2018, and therefore does not offset this risk, in our view.
Three circumstances could jeopardise this recommendation.
The first would be another acceleration in the world economy. Investors would move away from quality securities, favouring those offering the best exposure to the economic uptrend.
The second would be a decline in volatility or, at least, a sustained and moderate level of volatility. This would imply that investor confidence remains well supported. Therefore, they would have a greater appetite for higher-beta stocks than for quality stocks.
The third circumstance is linked to interest rate risk (if rates were to rise) and the risk of default. The latter is low for Investment Grade bonds.