Before the surprising outcome of the Brexit vote we would have argued that the fundamental U.S. economic outlook was little changed from last quarter. The pattern of slow growth, low inflation and low interest rates that has characterized the post-2008 recovery was intact and appeared likely to remain so. But the Brexit vote has introduced an element of uncertainty into the equation and increases the risk of an economic slowdown in the U.K. and Europe that could have spill-over effects in the U.S.
The popular discontent behind the “leave” vote is not unique to Britain. It exists throughout the developed world and has potential political ramifications which, by definition, have unpredictable outcomes. One could argue that the Brexit vote changes everything and will send the U.K. into recession and through contagion will tip Europe and ultimately the U.S. into recession as well. On the other hand, one could argue that according to Article 50 of the Treaty of Lisbon, the U.K. will not be able to exit the E.U. for at least two years, during which time sober heads will negotiate the necessary trade deals and other terms to keep the U.K. and E.U. economies functioning as they were before the vote. If that is the case the Brexit vote will have only minor economic consequences. It is not possible to say definitively which way things will go.
In all probability we believe the impact on the U.S. should be minor. The pound and the euro have dropped relative to the U.S. dollar. This could hurt U.S. exports but should keep U.S. inflation under control. Thus interest rates are likely to stay lower for longer, allowing the U.S. economy to continue its sluggish, low inflationary expansion. Nonetheless, there are some growing headwinds for corporate profits.
During the first few years of the recovery following the 2008 meltdown, corporate profits grew rapidly as companies reaped the benefits of earlier cost cutting and had the ability to refinance debt at lower interest rates. Profit margins surged to record highs. Recently, however, profit margins have begun to face headwinds as wage gains accelerated but productivity gains stagnated. So while our basic forecast of anemic, low-inflationary growth remains much as it has for the past seven years, we worry that profit growth may be entering a less robust period. Given that equity valuations are somewhat elevated, this suggests the stock market could face some air pockets.
Stocks are not cheap by historic standards, but given the low levels of interest rates they are by no means truly expensive (assuming earnings do not collapse). In today’s low interest rate environment, P/E ratios may have considerable room to expand. The following table illustrates this.
In light of the uncertainties occasioned by the Brexit vote and its potential for disruption, we are positioning portfolios somewhat defensively. First, we believe it is prudent to maintain a somewhat larger cash position than normal. The stock market has enjoyed seven-plus years of a bull market and stocks are no longer dirt cheap. At the same time there are clear earnings headwinds in certain sectors, so keeping some extra dry powder seems sensible.
Second, we are laser focused on companies that we think can continue to grow despite the current headwind from a strong dollar and weak non-U.S. demand. These tend to be more U.S.-centric companies, particularly those that dominate a niche, industry or sector. In a stressed environment, companies with strong balance sheets and better cost structures have the potential to gain market share and grow at the expense of their weaker competitors. We are trying to avoid weak also-rans like the plague.
Third, we are emphasizing companies with very strong or rapidly improving balance sheets and/or the ability to generate copious amounts of free cash flow. Such companies have the financial wherewithal to better withstand difficult economic conditions and potentially take advantage of others’ distress.
Fourth, in the current slow growth environment where bonds have low yields, we believe stocks with growing dividends are more attractive. Therefore, we are trying to identify rock-solid businesses that can grow their dividends at above-average rates. Such companies could prove to be rewarding investments in this low interest rate environment.
Despite all the negatives we have touched on in this Outlook, the fact remains that the U.S. economy is still expanding, inflation and interest rates remain low and numerous companies are still growing their earnings. To the extent we can correctly identify such companies and invest in their stocks at reasonable valuations, we believe we should be able to produce favorable investment returns over time. Even in this challenged environment, really strong market leaders continue to grow and increase dividends. Our job is to identify them and exercise discipline in how much we are willing to pay for them.
John Osterweis Matt Berler
(1) Figures on 6/30/2016 in Bloomberg.
(2) Based on daily data through 6/30/2016 in Bloomberg.
(3) Based on the last three S&P 500 peaks (7/16/1990, 3/24/2000, 10/9/2007) in Bloomberg.
Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index includes the reinvestment of dividends. The index does not incur expenses and is not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted Earnings Per Share.