Investors who are concerned about the economic and investment outlooks are increasingly asking us two questions: “Where are we in the cycle?” and even, “Is there still a cycle?” We think these are good questions which have real implications for the way investors should think about their portfolios.
AB’s global economists recently downgraded their growth forecasts for next year but, while the softer outlook suggests that economies and financial markets will be even more vulnerable to the many risks they face, we continue to think a significant recession is unlikely.
For some investors, this is just the problem. It’s been 10 years since the last global recession and the macro-economic and geopolitical risks are intensifying. Against this background, market volatility seems strangely muted. It feels a bit like the calm before the storm.
Small wonder, then, that investors would like some sense as to when the storm will break, or at least some idea of where they stand in the investment cycle, and an assurance that such a cycle still exists!
Market realities being what they are, putting investors’ minds at ease on these points is not a simple matter. It is possible, however, to look rationally at what these uncertainties mean for investment, and to map out how investors might learn to live with them so that they can continue to invest effectively.
Developed markets are a challenge
Part of the uncertainty arises from the fact that developed markets – those with open, manufacturing-based economies such as Europe and Japan – are among the most exposed to the various risks (debt, demographics, low productivity growth and the US-China trade war) affecting the global outlook.
For most investors, developed markets still matter. After all, China is no longer the engine of global growth it once was and India, despite its potential, is unlikely to become a second China anytime soon. While African markets are interesting, their contribution to world growth is likely to be incremental.
Developed markets are mature, however, and tend to grow more slowly than their emerging counterparts. Consequently when, as now, growth and interest rates are low, they are likely to stay lower for longer in developed markets than anywhere else.
This helps make the cycle very muted, but a muted cycle doesn’t necessarily imply an absence of market volatility. In a low-growth environment, for example, it’s not unusual for the economic data to slip into negative territory for one quarter and back into positive territory the next.
A low-growth, high-risk environment can be a febrile one for investors, so it’s not uncommon for a single quarter of negative growth to be interpreted as a harbinger of recession, and for investment markets to react accordingly.
Conversely, a quarter of good economic data might be taken as a sign of recovery – another, albeit different, reason for markets to become volatile. Given that this is the reality investors now face, what sort of stocks should they think about owning?
Earnings, not multiples, expansion
The key, in our view, is to look for stocks with medium- to long-term growth potential based on idiosyncratic characteristics.
In the current economic environment, we think it makes little sense to assess that growth potential in terms of multiples, such as price-to-earnings ratios, as the scope for multiple expansion is so limited. Instead, investors should focus on the potential for earnings growth.
Focusing in this way on a single metric rather than on investment sectors or themes can result in a varied portfolio. Examples of stocks that fit the bill, in our view, are Mastercard, Microsoft and Temenos, in the payments, cloud computing and banking software markets respectively; Alibaba in the Asian consumer markets and Eurofins Scientific and Genmab, science-oriented companies based in Europe.
We think this is a sound approach, but it’s not for investors who are underprepared. It requires an active management style and a small portfolio size to allow for the necessarily close and continuous research scrutiny of individual stocks.
Finally, it needs a manager with the skills and knowledge to pick more winners than losers, the experience to know that inevitably there will be stocks that occasionally undershoot their earnings expectations (even in more benign conditions than those that prevail today), and the ability to learn from such mistakes.
The views expressed herein are those of a specific portfolio management team and portfolio strategy at a point in time and do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams. Current analysis does not guarantee future results.
Mark Phelps, chief investment officer – concentrated global growth, AllianceBernstein
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