During the fourth quarter of 2018, the business news was dominated by global trade wars, geopolitical tensions, the partial shutdown of the U.S. government, central-bank policies and interest rates. At the same time, investors worried about the impact that slowing global economic growth would have on individual companies.
Previously, as major U.S. equity indexes had surged toward all-time highs during the spring and summer of 2018, a relatively small number of technology and internet-related stocks had led the way. The most-popular of these were the so-called FAANG stocks—Facebook, Inc. (FB), Apple, Inc. (AAPL), Amazon.com, Inc. (AMZN), Netflix, Inc. (NFLX) and Alphabet, Inc. (GOOG), parent of Google. In the market reversal that was to follow, these same stocks would lead the way down.
Under the right conditions, a speculative advance in asset prices can take on a life of its own. In mid-2018, the FAANGs rose because fundamental investors wanted to own them for the companies’ long-duration growth prospects. Momentum investors, on the other hand, wanted to own the FAANGs simply because the prices were rising. With fewer stocks participating as breadth narrowed in the overall market, the FAANG group was the place to be. The futures of these companies seemed bright, and the lofty stock prices weren’t alarming for many investors as long as those prices kept going up.
That sense of eternal optimism was pierced in July, and stock-price momentum started to reverse. In response to a series of setbacks and business challenges, the share prices of Facebook, Netflix and Alphabet began to decline. In hindsight, the breakdowns in these stocks were warnings that investors in general were becoming more price-conscious and cautious. Amazon’s stock price peaked in September, while Apple’s followed in October. The Nasdaq Composite Index, of which the FAANGs are components, reached its all-time high in August.
Investors had good reasons to be optimistic about the FAANGs as businesses. These are innovative, growing companies with attractive future prospects. However, the prices of their stocks had become disconnected from the underlying fundamentals. By the end of 2018, Facebook and Netflix, respectively, had fallen -40% and -37% from their previous highs. Apple, Amazon and Alphabet experienced respective declines of -32%, -27% and -19%.
Although the FAANGs were the poster children of the fourth-quarter market rout, losses were broad-based across sectors and countries. As a result, these losses were strong reminders of how important it is to pay attention to a company’s stock price in addition to focusing on its fundamentals and long-term growth prospects.
During the few years prior to 2018, there was much discussion of synchronized global economic growth on the order of 3% to 5% in real (inflation-adjusted) terms. Central banks around the world were engaged in very accommodative monetary policies with extremely low—or even negative—interest rates and outright purchases of government and other securities.
More recently, the U.S. economy and corporate earnings got a significant boost from the Trump administration’s initiatives to lower taxes and reduce regulations. In addition, inflation remained low and employment continued to be robust.
But during the latter part of 2018, the economic news became less encouraging. Looming global trade wars battered emerging markets—particularly China, which was already experiencing slower growth. Challenges surrounding Brexit weighed on the United Kingdom. In Europe, the leaders of Germany and France faced growing voter dissatisfaction, and Italy saw intense political and budgetary divisions. Even Japan, which had been growing nicely, experienced a third-quarter decline in gross domestic product (GDP) that was the steepest contraction since the second quarter of 2014.
On December 19th, the U.S. Federal Reserve (Fed) raised the benchmark federal-funds rate by a quarter-percentage point to a target range of 2.25% to 2.5%. The Fed also signaled the likelihood of two more increases in 2019. In doing so, the Fed indicated that the U.S. economy was still performing reasonably well. Similarly, monetary policy at the world’s other central banks also became less accommodative. One exception was the People’s Bank of China, which eased monetary conditions in the face of slowing economic and credit growth.
In evaluating global economies, here are the positives in general terms: Employment has been strong. Consum-ers have been spending at a healthy clip. Corporate earnings have been growing nicely. And inflation has remained relatively low.
Still, based on the viewpoint of David Powers, our Global Value portfolio manager and co-author of this commentary, economic growth rates around the world are falling. For example, many world-wide purchasing managers’ indexes have declined. And the expectation for real global economic growth is around 2%, down from 3% to 5% in recent years. In the U.S., the rates of increase in corporate earnings are also likely to come down with the waning effects of the 2017 Tax Cuts and Jobs Act.
So if economies and corporations around the world are still growing, albeit more slowly, what are the causes for concern? A global trade war is certainly one. Geopolitical tensions and the partial government shutdown in the U.S. are also unsettling.
But perhaps the main cause for concern over the longer term is that world-wide debt levels are relatively high. And if interest rates rise, the debt would become increasingly difficult to manage—which could cut into consumption. Moreover, a slower-growth economic environment could exacerbate the problem.
There’s also the prospect for an inverted yield curve, which describes a situation in which short-term interest rates are higher than longer-term rates. Historically, inverted yield curves have tended to precede recessions—although the exact timing of a recession is always difficult to predict. Recessions, by the way, aren’t all bad because they help correct excesses that build up during economic expansions.
While an inverted yield curve is a reasonable possibility and a recession could follow, we wouldn’t be surprised to see the economic mood improve with better news on global trade and politics, and with pronouncements from the Fed that future interest-rate policies will depend on data coming from the economy.
While we understand that Fed officials and other central bankers around the world are looking to normalize monetary policy after years of accommodation, we hope they’ll move slowly. In the U.S., for example, the housing market is fragile. And many families, especially less-affluent ones, still need low interest rates in order to afford a home in a market that remains quite underbuilt.
Consistent with the dour economic mood, equity markets around the world fell during the fourth quarter of 2018. As described above, it looked like the FAANG stocks signaled a broader market decline that was to come. Similarly, international equities—especially emerging-market names—seemed to portend trouble that would eventually arrive in the United States.
Prior to the fourth quarter, investors had viewed the U.S. as a relatively safe haven because of the country’s more-stable growth. Compared to the rest of the world, the U.S. has larger consumer and information-technology sectors. U.S. stocks had also received a boost from tax cuts and reduced regulations.
By comparison, much of Europe and Asia, and some emerging markets, have significant exposure to banks, exporters and commodity industries—all of which tend to be economically cyclical. Interestingly, Japan has become less cyclical in recent years as the country has seen higher wages and has become more domestically focused and less dependent on exports.
But during the fourth quarter, there was almost nowhere to hide among stocks. Declines were broad-based across countries and sectors. As evidence of this, consider the indexes shown on Morningstar.com. Of the 145 indexes, only 20 were positive for the quarter. And of the 20 that were positive, 17 were bond—not stock—indexes.
The large-cap S&P 500® Index fell -13.52% for the quarter. The technology-heavy Nasdaq Composite Index lost -17.29%. The Russell 2000® Index of small caps declined -20.20%. Growth-oriented small caps performed particularly poorly, with the Russell 2000 Growth Index down -21.65%. Value-oriented small caps in the Russell 2000 Value Index lost almost as much at -18.67%, which was a disappointment to many investors who had hoped that value names would hold up better in a downturn.
As already mentioned, stock markets overseas also fared poorly—although generally not as poorly as in the U.S. The MSCI World ex USA Index dropped -12.78% and the MSCI Emerging Markets Index declined -7.47% for the quarter.
Despite Fed rate increases, intermediate- and long-term bond yields actually fell during the quarter—a sign of a potential yield-curve inversion. Since bond prices move in the opposite direction of yields, bond indexes generally posted positive returns. The Bloomberg Barclays US 20+ Year Treasury Bond Index was up a solid 4.17%. And the Bloomberg Barclays US Aggregate Bond Index increased 1.64%.
Going forward, we’re not necessarily bearish on U.S. bonds because we think extremely low interest rates overseas may help keep U.S. rates from rising too dramatically. Moreover, we think slower global economic growth could encourage the Fed and other central banks to change their plans for tighter monetary policy.
After considering the economic and market conditions outlined above, the question becomes: What do these conditions mean for investors going forward?
Again, from a global value perspective, most markets around the world are relatively late in the investment cycle. During the late part of the cycle, risk and volatility typically increase as investors become more concerned about the macro environment—including geopolitics and central-bank actions—because there’s a sense of less room for error in investment decisions. Investors also become more concerned about the price they pay for a stock because they realize a company’s growth may be more constrained than previously thought. Today’s headlines about global trade, the Fed’s actions and the performance of the FAANGs are all consistent with late-cycle conditions.
Due to the reversing stock-price momentum of the FAANGs, there’s a natural curiosity regarding growth-oriented companies in general. We actually think there will be strong demand for high-quality growth companies going forward because these names will look attractive in a less-robust economic environment. But we also believe investors will want to pay reasonable prices based on the sales, earnings and cash flows that these companies are generating.
Consequently, we expect developed-country stock returns in the upcoming environment to be more modest than during the past 10 years overall. In the U.S. and Japan, we think we can still find companies that will generate reasonable earnings growth. In Europe, the prospects are for somewhat less growth. And in emerging markets, the prospects are for somewhat more. For global value investors, we also expect dividend payments that can be sustained to become increasingly important components of investment returns.
As for traditional (a.k.a., “cyclical”) value-oriented companies, we’re not particularly optimistic right now. Such traditional value companies are typically very sensitive to overall economic cycles. Because there’s relatively widespread concern of a recession within the next two years or so, some cyclical stocks such as banks and industrials aren’t likely to do particularly well. In our view, savvy investors will want to own cyclicals at even better prices when the bottom of a recession and a potential recovery are more clearly in sight.
David Powers and Jim Larkins
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As of September 30, 2018, the Wasatch Global Value Fund, Wasatch Micro Cap Value Fund and Wasatch Small Cap Value Fund did not hold Facebook, Inc., Apple, Inc., Amazon.com, Inc., Netflix, Inc. or Alphabet, Inc. Current and future holdings are subject to risk and may change at any time. References to specific securities should not be construed as recommendations by the Funds or their Advisor.
Someone who is “bearish” or “a bear” is pessimistic with regard to the prospects of a market or asset.
Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.
Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.
Enterprise value (EV) is a measure of a company’s value calculated as market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents. The EV (enterprise value)-to-sales ratio is enterprise value, as defined above, divided by annual sales. The ratio is a measure of a company’s expensiveness.
The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.
Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
The price/earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.
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A Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators—new orders, inventory levels, production, supplier deliveries, and the employment environment.
The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.
The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.
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The Nasdaq Composite is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The Nasdaq was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971.
The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.
The MSCI Emerging Markets Index captures large and mid cap representation across 24 emerging market countries. With 1,150 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 developed market countries—excluding the United States. With 1,013 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
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The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency).
The Bloomberg Barclays US 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.
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