The S&P 500 Index saw declines of 1%
or more on 22 days this year, with
four in the past month. While the index is
down 2.9% for the year to date, it lost 6%
in August. Still, investors may want to
consider riding out the bumps—if not view
the volatility as a potential buying
opportunity—according to Paul Quinsee,
chief investment officer of JP Morgan’s
US equity group. “Every year, corrections
happen,” he explains. Since 1980, the S&P
has averaged a maximum intrayear
drawdown of 10.7%. “We still think we've
got several years of growth left in this
cycle, because the starting point was so
depressed,” he says. Quinsee recently
spoke with Morgan Stanley Wealth
Management Senior Markets Strategist Jon
Mackay. The following is an edited
version of their conversation.
JON MACKAY (JM): What are your US
economic growth expectations for the
remainder of this year and into next year?
PAUL QUINSEE (PQ): We are
reasonably optimistic. When we look at
the fundamentals and talk with companies,
it seems that although we are now several
years into a recovery, some of the parts of
the economy that have been most
depressed, like housing, are really only
just getting going. We believe there still
are several years of growth left in this
cycle.
We have started what we call
“recession watch,” which is looking at a
bunch of things to indicate when it's time
to start to become more cautious. None of
these indicators are giving us any warning
yet. When we look at employment trends,
housing, consumer demand, all of the
latest data points seem to be getting just a
little bit stronger. So we are reasonably
constructive.
JM: A common refrain is that valuations
are rich—that even if we get a positive
growth environment, equities are going to
struggle. How do you feel about US
valuations, and how do you feel about US
valuations relative to global stocks?
PQ: I would say US valuations are
pretty full, but not ridiculous. There's no
question in my mind that the tremendous
run that we've seen in the S&P 500 over
the last five years is coming to an end. We
have a compound return in the S&P of
about 14% a year for the past five years.
That's an incredibly strong result by
historic standards.
Returns have to moderate because you
don't find too many times in history when
the overall market multiple has been much
higher than the mid-to-high teens. You've
got to go back to the craziness around the
internet boom of the late '90s to find a
much higher overall market multiple.
On the other hand, when you think
about the main investible alternative—
fixed income, for most investors—stocks
[would] continue to look positive, even if
10-year Treasury yields were a full
percentage point higher.
What does that look like in a global
context? Well, I think it is: America is the
high-quality, lower-risk, lower-reward
choice. In many ways, the path of the US
is much clearer.
If you look at debt to GDP, China is
probably about 20th in the world, and the
growth rate has been fast and concerning.
But the majority of debt is held by the
government or government-controlled
companies. Privately owned companies
have actually been deleveraging.
Unlike in the US, the medicine to fix
the debt problem in China is not going to
be broad deleveraging, which strangled
credit access for the small and midsize
companies that drive the US economy. It's
going to be another round of reform of
state-owned enterprises, and it shouldn't
affect the private companies that account
for 80% of employment—and all the new
job and wealth creation. Fixing the debt
problem may lead to more volatility and
steadily slower growth, but I don't see a
crisis or a hard landing.
JM: What potentially could go wrong?
PQ: The ill wind that's blowing from
the rest of the world could get worse and,
although that doesn't make so much of a
difference to the US economy, it makes a
big difference to the stock market. As we
all know, American companies have been
enthusiastically expanding their businesses
in the rest of the world for the last few
decades, so it matters that much more.
The big rise we see in the dollar is the
worst thing that's happened for corporate
profitability in America since the
implosion of the financial system in 2008.
It's a big problem and a very serious one
for some companies. I think that the more
pessimistic view that China is not a superhigh-
growth economy that can just sort of
cruise along at 7%, 8%, regardless, is now
being widely accepted. A lot of that’s in
the prices, but it could still get worse.
You've also always got to point to
interest rates as a potential risk, but it feels
to me like, (a) everyone is saying that the
increases are going to be very modest and
slow; and (b) we haven't really seen any
kind of aggressive borrowing activity in
recent years that makes companies or
consumers vulnerable to a rise in interest
rates. In fact, it's been much more about
reversing the sins of the previous decade.
The one exception to that, of course, is the
energy sector, where now we are seeing a
pretty painful credit cycle, not because interest rates have gone up, but because of
the collapse in commodity prices.
What’s Ahead for
US Stocks?
T
Please refer to important information, disclosures and qualifications at the end of this material. September 2015 13
For the long run, our research team sees
corporate profits being sustainable and
able to grow at a 7% to 8% compound rate
in the next several years. What I'm
watching for is any kind of unwinding of
the benefits of globalization, which our
analysis tells us has been one of the huge
drivers of profitability. Globalization has
created new markets; it's created great
ways for companies to reduce their costs.
JM: Is what's going on, with the US
markets related to China? Is that an
earnings story or is it purely negative
sentiment and uncertainty about what
China's going to do?
PQ: I think it's an earnings story. I think
if you look at where the market has been
weakest recently, it lines up with where
companies either have the most direct
exposure to China or where they have
broad commodity exposure, including
energy. I do think that the market is
getting itself into a bad mood.
The underlying fundamentals are not so
bad that we're going to see stock prices
really fall apart. We think that we are
going to experience what I would call a
more typical type of setback—i.e., 8% to
10%—as opposed to really serious
setbacks of 20% to 30%.
JM: Do you think the volatility that
we're seeing in the market is something
investors can expect going forward, and
should they think of bouts of volatility as
buying opportunities?
PQ: There will always be drawdowns. I
would not be surprised if the level of the
drawdowns didn't start to increase as we
move into the later stage of the cycle
because, first of all, that's just mean
reversion and, secondly, prices are higher
now and it's scarier when things start to go
wrong. So I would expect more volatility,
but I would not expect a 20% to 25% drop
until we get closer to the end of the cycle.
JM: How might the Fed rate hike, when
it happens, impact equity markets?
PQ: In terms of what it means for the
market broadly, I just think that's really
tough. There cannot ever have been a more
discussed and more analyzed prospective
increase in interest rates than the one we're
about to have.
Going back to the fundamentals, we try
to model what higher rates will do for
companies. Interestingly, in many cases, it
leads companies to make more money, not
less. In the broader financial sector, higher
rates would be a significant positive. They
had been doing well, relative to the broad
market, earlier this year as investors
looked forward to higher rates. Recently,
however, they've been selling off in part
because people think what's happening in
China will delay that rate hike.
Companies with of a lot of cash on their
balance sheets would look forward to
higher rates as well. As I mentioned
earlier, we don't see too many highly
indebted companies that are struggling to
survive as it is, and couldn't live without
an increase in their borrowing costs.
A rate hike can't come as a surprise to
anyone, I would think. In some ways, I
would be more worried if rates don't go up
because I think investors would take that
as a signal that growth is weak and they'd
worry more. So I hope they do go up, and I
suspect that, if/when they do, investors
will live with that pretty comfortably.
JM: Do you think oil and currencies
will continue to be headwinds, or will they
become less of a focus going forward?
PQ: We're getting to the point at which
energy prices are so low that any drag
from here will be less. If we look at the
earnings of the S&P 500 companies,
energy contributed almost $13 worth of
earnings in 2014. We're down to around
$5 for 2015. Maybe $5 is still too high, but
the base is now so much lower that it can't
do as much damage. I also think that the
positives of lower oil really haven't
showed up yet—and they will.
We have been assuming that the dollar
stays on the strong side. It's been one of
the fastest appreciations of the dollar on
record, but the most violent part of the ride
is over. We're assuming that that those
gains stick around for a while, partly based
on our more optimistic view on the US
economy versus everything else. All of
that adds up to an upward bias to the
dollar, so we have to watch for that. I think
there may be some more pain to come,
particularly for those companies that make
stuff in America and have to export it.
Some of the companies in the capital
goods sector, for example, tell us that
these days, they're suddenly seeing a
whole host of competitors back in the
American marketplace that they haven't
seen around for 20 years. We're cautious
to make sure that's in our numbers.
JM: What do you like in the market?
Which sectors, capitalizations and styles
are presenting attractive opportunities?
PQ: Though stock prices are up 30% on
average from the previous peak in the last
cycle, financials are a part of the market
that still hasn't recovered. We think that
the fundamentals in the financial sector are
slowly going to improve. Higher interest
rates will be a positive; market activity and
M&A are a positive, too. We think
financials have room to outperform.
Other areas that we're focused on are a
little bit more on the cyclical side. We've
been looking at some of the auto stocks,
for example. Housing is also a theme that
we very much believe in, whether it's
home-improvement retailers, suppliers to
the housing companies or even some of
the homebuilders themselves.
We've also got our favorite points
within technology, which is always the
hardest sector to generalize about because
it's so much about individual companies
and where they stand within their product
cycles and stages of development.
We've had a pretty strong focus on
many semiconductor stocks. In particular,
we think semiconductor equipment
manufacturers win, as semiconductor
companies themselves spend more money.
This is an area that is seen as more
centered on what’s going on in China, and
rightly so, but we think there's enough
growth and multiples are low enough that
it's worth sticking with them.
Paul Quinsee is not an employee of
Morgan Stanley Wealth Management.
Opinions expressed by him are solely his
own and may not necessarily reflect those
of Morgan Stanley Wealth Management or
its affiliates.
Please see Important Article Disclosures
© 2015 Morgan Stanley Smith Barney LLC. Member SIPC.
|