Scarcity of Reliable Growth Demands Greater Focus on Quality in Equities

In this Q&A, Portfolio Manager Jeremiah Buckley discusses how shifts in central bank policy and slowing global growth have altered the equity investing landscape and why he feels a focus on quality is important in the current environment.

Key Takeaways

  • Central banks have tried to counteract worries about slowing growth and trade tensions through monetary easing – a shift that has compressed bond yields and made the risk premium on equities look attractive on a relative basis.
  • Against this backdrop, stocks have reached near-record highs, with valuations of some equities now appearing stretched.
  • With so many conflicting variables – high multiples, an uncertain growth outlook, monetary easing – we believe it is more important than ever for investors to focus on fundamentals.

How has the investment environment changed over the past year for stocks?

It is difficult to overstate how dramatically equity markets have shifted over the past 12 months. A year ago, the scenario for equities was far less favorable, with the U.S. Federal Reserve (Fed) committed to raising interest rates. We were also seeing the initial outbreak of the U.S.-China trade crisis, which led to further instability among stocks.

In 2019, however, the scenario has changed. At the beginning of the year, the Fed took a more accommodative policy stance, then lowered interest rates in July and again in September. Now the investing world is questioning whether the Fed could eventually cut rates to zero or even introduce negative rates as worries mount about a potential recession in the U.S.

Are you worried about a recession in the U.S.?

We have been watching economic indicators closely and do believe that growth is moderating in the U.S. But so far, the slowdown appears to be mainly limited to manufacturing at a global level. The U.S. consumer, in contrast, still shows signs of strength, with the unemployment rate dropping to 3.5% in September (a 50-year low) and wages rising. This bifurcation is evident in company earnings: Firms tied to the manufacturing cycle have been more likely to lower earnings guidance or miss expectations than companies in nonmanufacturing sectors. Furthermore, we think the macro picture would be much stronger today if not for the negative overhang created by the ongoing U.S.-China trade war.

How has the shift in central bank policy impacted stocks?

Both the Fed and the European Central Bank (ECB) have tried to counteract worries about slowing growth and the trade war through monetary easing – a shift that has compressed bond yields and made the risk premium on equities look attractive on a relative basis. It has also given U.S. large caps with a strong multinational presence an opportunity to take advantage of low interest rates in Europe to issue debt on enviably low terms. Whether companies use the financing for capital expenditures remains to be seen as the trade war clouds company spending decisions.

What is the takeaway for equity investors?

Against this backdrop, stocks have reached near-record highs, with valuations of some equities now appearing stretched. With so many conflicting variables – high multiples, an uncertain growth outlook, monetary easing – we believe it is more important than ever for investors to focus on fundamentals.

That includes looking for companies that have a track record of delivering GDP-beating revenue growth. Furthermore, a company’s management team should demonstrate the ability to not only generate large amounts of free cash flow but also use that cash in a way that is favorable to shareholders, whether by investing in acquisitions that lead to higher growth, raising dividends or doing share repurchases. Ultimately, we believe taking a quality-oriented approach to equity investing is prudent in a phase like the current one.