Optimism Amid Trepidation
Equity Commentary – Q2 2019
- Solid US economic data and recent positive China Purchasing Managers Index keep us optimistic US Equities will trend higher, albeit at lower annualized returns than the past decade.
- Within equity sectors, we are most bullish on technology and healthcare. We believe communication services, financials, and REITs are the least attractive sectors.
Optimism for Equities
The US economy continues to move forward with slow, sustainable growth based on the indicators we watch. The US Purchasing Managers Index (PMI) of 55.3 for March was better than 54.2 for February and 54.5 for consensus. New orders, production, and employment indicators were also higher month over month. Backlogs and new export orders were lower. We will continue to watch economic indicators for how they will impact stocks in client portfolios .
We believe the biggest risks to the US economy and stocks are mostly sentiment driven, with fundamental risks mostly from outside the US as the global backdrop is less robust. Around the world, global growth has slowed and the concern is that some of this fallout may reach our shores. European March PMIs were firmly in contraction territory. While China remained at the forefront of concerns about a global growth slowdown, there were some hints that policy fine tuning may be starting to gain traction. China’s manufacturing PMI for March rose to 50.5, above 49.2 in February and consensus of 49.6. This is the first time in four months that China’s PMIs moved back to expansion. While potentially a positive sign that government policies are stabilizing the economy and potentially fostering more robust growth. Additional positive data points will be needed.
Meanwhile, stocks have been fairly resilient in the face of slowing economic growth. The Fed has removed the monetary policy risk that lowered risk appetites late last year, and better economic data of late are easing recession concerns. Importantly, after plummeting over the last several months, forward earnings growth revisions are now stabilizing, providing fundamental support for equity prices. While the pace of equity gains experienced during the first quarter is not sustainable, expectations that the Fed will be flexible with regard to interest rates—perhaps even lowering them later this year—allow for measured optimism. Therefore, we envision further gains as economic and earnings growth begin to improve.
The technology sector has a wide variety of companies well positioned to dominate specific end markets and drive revenue, earnings, and dividend growth above the S&P 500. Additionally, technology stocks are often more impacted by company specific factors than by macro factors or sector rotations. Hence, our bottom up portfolio construction results in a material sector overweight. At a sector level, we note that IT spending growth of five to six percent in 2019, though down from eight percent in 2018, still exceeds growth rates of most other GICS sectors and is approximately two times GDP growth.
Healthcare will likely remain volatile and continue to be impacted by headlines and political commentary given concerns over rising medical costs. Consolidation continues as a major theme, and we expect further deals to emerge. The increasing importance of scale on the service side and the need for continued innovation on the drug and device side are driving acquisitions. We believe strong innovation in the sector and expansion into emerging markets will likely aid earnings increases, providing a growth component to what is traditionally a defensive sector.
We are least bullish on Financials, and particularly banks, as the yield curve dramatically limits net interest income, about70% of revenue for the average bank. Low long-term yields continue to create a more challenging environment for insurance companies. We believe the good news from regulatory reform is priced into the stocks.
Communication Services is also a challenged sector, particularly for dividend paying stocks. Google and Facebook (non-dividend payers) constitute about 50% of the sector and will likely drive most of the sector returns given advertising revenue share gains. However, in our view many of the remaining telecom, entertainment, and media stocks face challenging industry and/or company fundamentals that include slower growth, higher costs, and increased competition.
REITs are likely challenged as development yields are declining, demand shifts away from brick and mortar as the consumers order more online and the workforce become more mobile, and interest rate backdrop is less advantageous.
We continue to favor high quality companies with reasonable valuations. For more risk adverse clients, we favor companies with the capability to increase the dividend over time and stocks with lower betas. For clients with a growth objective, we favor companies with strong competitive positioning and the capability to drive above benchmark revenue and EPS growth.
For further perspective from the Boston Private Investment Team Read More
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