Understand emerging markets opportunities and the American Century advantage.
Sell in May and go away isn’t an investment strategy that we’d recommend for most investors. But during the dog days of summer 2019, some investors might have been happier lying by the pool than worrying about what market volatility was doing to their portfolios. In August, alone, we saw 11 days with market moves of 1% or more amid trade tensions, Brexit negotiations, slowing economic growth and a yield curve inversion.*
Of all factors underlying summer’s turbulence, the trade war cast the longest shadow. We’ve seen its impacts in disappointing employment numbers, especially in manufacturing, mining, truck driving and retail. We also expect the cost of escalating tariffs to begin flowing through to consumers who account for 68% of the U.S. economy and one-half to two-thirds of the economy in most other countries. Our investment teams are reporting that the lack of visibility on trade policy is causing corporate executives worldwide to be cautious in their capital-spending decisions.
The longer the trade conflict remains unresolved, the more it will damage the global economy. We would expect the U.S. dollar to grow even stronger, creating tougher conditions for U.S.-based exporters. Future earnings will be less predictable, making corporations less confident in their decision-making. Similarly, we believe continued uncertainty will lead investors to play it safer, triggering a rotation from longer-term investments to short-term positions they believe are safe havens.
Despite these worries, we don’t see a recession in the immediate future. Our Disciplined Equity team places the risk of recession in the next 12 months at roughly 25%. That view aligns with the U.S. Federal Reserve (Fed), which sees the risk of recession as elevated but not imminent.
As we look ahead to the closing months of 2019, most of the year’s volatility drivers remain in place. With that in mind, we believe now may be the time to adopt a more defensive posture without deviating from your long-term strategic asset allocation. In stock portfolios, this could mean complementing long-term growth positions with holdings in high-quality companies that have sustainable business models and a history of paying dividends. In evaluating your fixed-income portfolio, try to ensure you’re getting the downside protection you would expect from bonds. A way to do this is favoring sectors with less correlation to the stock and high-yield bond markets. Also consider alternative investments, which tend to offer the potential of downside protection with their flexibility to implement hedges and generate returns through short selling.
*Source: American Century Investments, based on S&P 500® Index.
Although the U.S. economy is slowing, it remains more robust than economies in other developed markets. We expect U.S. GDP to moderate to slightly-below-trend levels in 2020 because of tariffs and weaker growth elsewhere. However, we’re not anticipating a recession.
Trade tensions continue to pressure growth in Europe and Japan. After slowing in the second quarter, eurozone growth should stabilize for the remainder of 2019, with Germany and Italy showing the lowest growth rates in the bloc. We expect U.K. growth to weaken and believe a technical recession is possible if a hard Brexit materializes.
Although a dovish Fed remains broadly supportive of growth in developing markets, ongoing trade tensions and decelerating growth in developed markets are threatening EM growth. China’s year-over-year growth rate recently slowed to a 27-year low despite central bank stimulus measures aimed at combating U.S. tariffs.
Headline inflation has stabilized near 1.8%, but we expect it to drift lower during the winter with a lower contribution from the energy component. We expect core inflation to stabilize near the Fed’s 2% target, still supported by a firm, albeit slowing, shelter component. Tariffs on consumer goods may nudge inflation rates higher temporarily, but slower growth should largely offset these effects. Longer-term inflation expectations remain below historical averages.
Despite labor market gains, eurozone headline inflation remains weak, mainly due to pressure from falling energy prices. Conversely, inflation in the U.K. remains at the central bank target, supported by growth in wages.
Japan’s economy continues to struggle with weak inflation. A consumption tax hike in October could boost the inflation rate by boosting general price levels, but the effect likely will be short-lived. The government has implemented several fiscal initiatives, hoping to alleviate some of the tax burden on consumers.
After cutting rates twice to combat global economic risks and muted inflation, the Fed remains divided on the need for additional cuts. We believe the Fed may need to make one additional cut by the end of 2020 to help sustain economic growth.
The ECB lowered its deposit interest rate further into negative territory and launched a new bond-buying effort in an attempt to boost growth and inflation. Brexit uncertainty is keeping the Bank of England on hold. The Bank of Japan likely will launch new stimulus if inflation softens further.
The People’s Bank of China continues to battle the nation’s trade war-related economic slowdown with stimulus policies. China’s central bank has lowered banks’ reserve requirements and gradually cut key lending rates, so far to little avail.
Growing risks to growth and inflation have caused Treasury yields to plunge. Portions of the Treasury yield curve remain inverted, a dynamic we believe reflects expectations for slowing growth and muted inflation, rather than a looming recession. The curve should steepen as the Fed cuts rates and reaffirms its accommodative stance.
A rapid deceleration in inflation and manufacturing activity in the eurozone has pushed yields to historic lows. In Germany, government bond yields are negative across the yield curve. U.K. rates remain modestly higher and positive, but the curve remains relatively flat. Rates in Japan remain negative amid ongoing and aggressive central bank stimulus.
Given the recent downward shift in developed markets rates, we see little room for global rates to rally further. We continue to focus on markets where rates are more likely to fall or remain stable, such as Mexico, Peru and Indonesia.
“War is the realm of uncertainty; three-quarters of the factors on which action in war is based are wrapped in a fog of greater or lesser uncertainty.” —Carl von Clausewitz
The constant and inconsistent messaging on trade—at times bellicose, at times conciliatory— is wearing on corporate decision-makers and leading to caution in corporate capital-spending decisions. It’s not that companies have lowered their outlooks. Rather, it’s the lack of visibility on trade policy and its impact on supply chains in many industries that lead to conservative budgeting, especially as we approach the 2020 budgeting cycle. We can paraphrase this as the fog of trade war.
From an investment perspective, portfolio positioning and analyst forecasts also must incorporate this uncertainty and the possibility of a prolonged trade conflict or its sudden resolution. Longer term, the demise of free trade would be inflationary or detrimental to corporate margins. Near term, however, the impact of the trade war is slower economic growth, which is an offset to higher prices.
Economic statistics clearly point to being in the late stages of the economic cycle where growth-style investments are advantaged. Our U.S. Growth strategies continue to take the longer view and favor companies exposed to secular growth, rather than those deriving their growth from economically cyclical factors. From this perspective we continue to focus on the underlying competitive advantages that drive secular growth over the entire economic cycle.
Our Disciplined Equity team’s bottom-up analysis of corporate earnings reports involves evaluating not only financial metrics, but also the sentiment of executives on earnings calls. To gather this data, we use natural language processing techniques to analyze the language and content of thousands of corporate earnings calls each quarter. Looking first at corporate earnings, after a strong 2018, earnings growth was negative in the first quarter of 2019 but appears to have stabilized in the second quarter. The tone of executives on these earnings calls follows a similar rising, falling, stabilizing pattern.
These measures suggest relative stability in corporate earnings and business outlooks. However, our unbiased view of quarterly earnings transcripts shows rising concerns about tariffs and trade. To see what companies themselves were saying, we searched for key terms relating to the trade dispute in thousands of corporate earnings call transcripts over the last two years. Our work shows “tariff” to be the most cited of all terms we searched in 2018 and to date in 2019. “Trade” and “slowdown” were also prominent. Significantly, however, “recession” was far down the list.
These findings provide insight into the concerns of corporate executives, either in explaining prior business performance or in forecasting revenues and earnings for future quarters. While comparatively few mentioned “recession,” a significant number of companies cited “tariffs” in their calls, which suggests that while earnings may be steady now, anxiety and uncertainty are high.
Utilities and real estate investment trusts (REITs) have outperformed for much of 2019, a year in which the market has generally risen. We would normally expect low-volatility stocks, such as utilities and REITs, to lag during rising markets—as they did during much of the 1990s and early 2000s. Instead, we’ve seen massive flows into low-volatility exchange-traded funds (ETFs), which has driven up valuations in utilities and REITs to levels we deem extreme.
Investors’ continued desire for yield, with little regard to risk, in a lower-for-longer interest rate environment has also led to these lofty valuations. It seems these stocks have become momentum stocks. Notably, historically low-volatility stocks have recently demonstrated more volatility relative to the overall market. Further, it's been odd to us that the most expensive stocks in the value indices have been the ones that continue to perform the best.
We acknowledge the trend could continue if interest rates keep falling and investors maintain a premium on defense. We believe active management has a potential advantage to build higher-quality positions that could fare better if the tide turns against low-volatility stocks.
Broad downdrafts, like those we’ve experienced with more frequency in recent months, tend to punish high- and low-quality companies alike in the near term. Longer term, however, we believe higher-quality stocks recover from fear-induced volatility and outperform. Thus, rampant selling may create opportunities to buy good stocks at attractive prices.
For example, trade-related volatility hurt industrial companies but allowed us to purchase a higher-quality electrical product company when its stock price fell to attractive levels. Health care is a sector that regularly comes under pressure due to heated political rhetoric around drug pricing and debates about Medicare for All. This situation presents opportunities to buy higher-quality stocks.
Elsewhere, concerns about falling interest rates have depressed valuations of banks. Though declining net interest margins have hurt their earnings, we believe many banks have strong levels of capital and benefit from a supportive credit environment. In addition, banks are becoming more efficient by closing expendable branches and increasing their digital capabilities. The trick is to know which ones are fundamentally strong and poised to rebound when the environment improves.
"The significant number of companies citing ‘tariffs’ in their calls suggests that while earnings may be steady now, anxiety and uncertainty are high."
Uncertainty around global trade continues to cloud the outlook for economies and equity markets worldwide. The ongoing dispute between the U.S. and China has pressured corporate earnings, exacerbated a slowdown in global growth and helped raise the possibility of a global recession. It has also caused many corporate management teams to reduce or delay capital expenditure and investment plans.
China responded to the announcement of President Donald Trump’s latest round of tariffs by letting its currency depreciate to the lowest level in a decade. This was viewed as a way to lower the cost of its goods and thereby mitigate the effects of the tariffs. This latest round of gamesmanship introduced the possibility of currencies as the next battleground between the two countries. The Fed cut U.S. interest rates twice in the third quarter, and President Trump publicly berated the central bank for not being more aggressive in cutting rates to spur growth. While most investors do not expect a full-blown currency war between the two largest economies, recent events have only added to the ongoing uncertainty about the global economy.
While it’s impossible to know when and how these disputes will play out, we believe such disruptions create opportunities. In our bottom-up analysis, we consider how these risks may affect a company. That has helped us identify select companies with less exposure to global trade. We’re also finding opportunities in the U.S., Europe and Asia in companies focused on their local markets and thereby less exposed to the ongoing trade war. We’re also seeing certain companies thrive despite the added pressure from tariffs.
Global earnings growth has become increasingly scarce, more narrowly focused and at risk of decelerating further. The escalation of trade rhetoric has only increased investor pessimism about the global outlook. Nonetheless, expectations still reflect a strong corporate earnings recovery for the remainder of 2019 and into 2020. In such an environment, we believe stock selection is key because the dispersion of returns increases with heightened volatility.
No one knows what’s going to happen with Brexit, and considerable work remains for the U.K. government to resolve the issue.
Meanwhile, we agree with consensus that the U.K.’s leaving the EU with a “no-deal Brexit” would be detrimental to the U.K. economy and to the ability of U.K. companies to compete. As we went to press with this Outlook, it appeared increasingly unlikely the U.K. would exit the EU on October 31 without a deal.
"The escalation of trade rhetoric has only increased investor pessimism about the global outlook. Nonetheless, expectations still reflect a strong corporate earnings recovery for the remainder of 2019 and into 2020."
The impact of the trade war between the U.S. and China continues to overshadow corporate fundamentals across emerging markets. In the third quarter, headlines alternated almost daily between encouraging progress on talks one day and threats of new tariffs the next. In response, equity markets whipsawed between new highs and memorable declines as investors tried to sort out which way the conflict was headed. We expect to see similar confusion in the final quarter of the year as this uncertainty continues.
The U.S. announced its latest round of tariffs—15% on $300 billion of Chinese goods effective September 1—after negotiations that both nations described as productive. Shortly thereafter, both sides announced plans for additional talks in October and November. These reversals suggest the U.S. is intent on pressuring China into an agreement that President Trump could present as a clear victory to the American people. We think China is unlikely to make the types of concessions the U.S. seeks without first receiving some compromises.
Thus, both sides are increasingly painting themselves into a corner, with little room for compromise. Many investors believed President Trump would deliver a somewhat softer trade deal to expand economic growth and boost U.S. stocks before the 2020 election season. His administration’s recent stance, however, makes it more difficult to accept any deal that could be perceived as backing down. On the other side, China may simply try to wait out the Trump presidency, refusing to bend and revisiting the situation after the 2020 U.S. election. In the meantime, we expect China to continue to focus on supporting its domestic economy through infrastructure investment, tax reform and targeted easing.
While the trade situation plays out, we’re finding opportunities in companies less exposed to global trade and some that may benefit from resilient consumer activity. For example, Chinese consumers are turning increasingly to domestic brands. Beneficiaries include homegrown makers of athletic equipment and apparel and luxury auto makers. Consumers have been spurred on by loyalty to local companies and government admonitions to buy local.
The recent strength of the U.S. dollar has been another factor weighing on EM equities. However, we believe the dollar rally may have plateaued, and dollar strength may represent less of a headwind than it did last year.
Until the Fed signals a change in policy to aggressively support growth and target inflation above 2%, we expect the dollar to remain range-bound and near recent highs. Such a situation would continue to pressure EM exporters and those countries paying off dollar-denominated debt. Consequently, we continue to focus on EM companies with greater exposure to domestically focused sectors (e.g., consumers and infrastructure) and EM consumers’ demand for a higher standard of living rather than companies exposed to global trade. We’re also finding opportunities in countries whose economies are benefiting from positive domestic political and economic reforms, such as Brazil and Indonesia.
"Until the Fed signals a change in policy to aggressively support growth and target inflation above 2%, we expect the dollar to remain range-bound and near recent highs."
Heightened trade tensions, slowing global growth, weak inflation and dovish central banks continue to drive our positive view of Treasuries. Global demand for Treasuries, which offer higher relative yields than government securities elsewhere, is helping push yields lower. We expect the 10-year Treasury note to trade in a range of approximately 1.40% to 2.15% over the next few months. We believe the slope of the Treasury yield curve reflects slower global growth, lower inflation expectations and prospects for Fed easing. We don’t believe the curve is signaling an imminent recession.
We expect year-over-year headline and core inflation to stabilize near 2%. Tariffs likely will nudge inflation higher but slowing growth and decelerating home prices could push inflation lower. Longerterm inflation expectations (break-even rates) continue to decline and present challenges for the Fed. As break-even rates decline, we believe TIPS are becoming more attractive.
We continue to underweight fixed-coupon agency mortgage-backed securities (MBS) and overweight mortgage credit. Given the potential for spread widening, we have reduced exposure to non-agency commercial MBS (CMBS) and collateralized loan obligations (CLOs). From a long-term and strategic perspective, we plan to continue reducing risk while focusing on high-quality securitized securities. Overall, we believe the securitized sector continues to offer attractive valuations and downside protection.
Given the strong year-to-date rally, we believe most investment-grade corporate bonds appear expensive. We also believe the credit market is in its late stages, and we expect recent spread widening to persist as the cycle matures. As such, we continue to believe macro developments, including slowing global growth, trade conflicts and central bank policies, will drive the direction of spreads.
Despite pockets of weakness, including in the energy and retail sectors, U.S. high-yield fundamentals generally remain stable. Companies continue to adjust their earnings outlooks downward to reflect a more challenging macroeconomic backdrop. Valuations remain tight, particularly in the higher-quality tiers of the high-yield market, as investors position more defensively. Against this backdrop, we’ve been reducing our exposure to high-yield bonds.
Municipal finances across the country generally remain stable. Muni supply is up slightly versus 2018, and demand remains robust, particularly from high-tax states. Given our outlook for moderating growth, low interest rates and solid credit fundamentals, we have a modest bias toward lower-quality securities (investment-grade securities with BBB credit ratings). Among investment-grade munis, we continue to favor securities in the higher education, transportation and hospital sectors. Within the high-yield segment of the muni market, we favor charter schools and retirement communities.
Government bond yields in Germany and France remain well into negative territory, and the European Central Bank (ECB) is committed to leaving rates lower for longer. U.K. rates are modestly higher despite Brexit uncertainty. We prefer markets where rates are likely to fall or remain stable, including select local emerging markets.
We are now underweighting European credit, largely due to valuations, which have become further distorted by negative government bond yields in Europe. Credit fundamentals remain reasonably benign but subject to ongoing economic stability. Our underweight is focused on industrial sectors, which are more exposed to an economic downturn if global trade slows or the ECB’s quantitative easing efforts disappoint. We believe subordinated financial sector bonds still offer the most value. These securities have strongly outperformed year to date, and we have reduced our exposure to a more-neutral position.
EM corporate and sovereign spreads appear fair overall. We’re finding some pockets of value, mostly in the high-yield segment. Our external sovereign positioning includes some frontier markets where we believe investors are undervaluing strong fundamentals. Select high-yield corporates are attractive in historical terms and versus U.S. credit. However, it’s important to remain selective due to heightened idiosyncratic country risks. We also see opportunities among currencies in countries benefiting from improving external balances and attractive valuations. A more-dovish Fed provides support for EM assets, while slowing global growth and ongoing trade tensions pose heightened risks. Following the sharp decline in developed markets rates, we see little room for global rates to rally further.
The list of worries weighing on investors is growing. For much of the year, stocks have advanced despite anxiety about deteriorating global growth, trade disputes, monetary policy errors, geopolitics and Brexit. More recently, we added the brief inversion of two- and 10-year Treasury yields to our list of concerns.
We respect the yield curve’s track record of forecasting recessions, but it’s only one of many economic indicators. For instance, it makes sense to take consumer confidence into consideration because household spending accounts for roughly two-thirds of the U.S. economy. Currently, consumer sentiment is sanguine, but it’s possible the next recession would be self-fulfilling. We’re seeing a lot of recession headlines and if consumer confidence worsens as a result, we could see further equity downside and a rising probability of recession.
We believe the dearth of liquidity exacerbated late-summer market volatility around trade and the yield curve inversion. We also suspect that trading in certain quantitative strategies was a factor. Looking ahead, however, we believe the longer the curve stays flat or inverted, it becomes more likely that longer-term fundamental investors will reduce their risk exposure.
News could have a significant impact on the market in the coming months. What’s more, the market’s reaction may seem counterintuitive. For example, recent equity price and yield curve movements indicate the markets are pressuring the central bank into an aggressive cut or a promise for such a cut. As a result, good news about the economy could be interpreted as bad news for the market. Why? Because a positive or better-than-expected economic report could cause the Fed to be more patient in its rate-cutting regime.
Watching the news on the trade front is more straightforward. Meaningful progress in U.S.-China trade negotiations could boost sentiment, encourage investors to take on more risk and trigger a steeper yield curve. Nevertheless, our base case on trade remains the same: a protracted dispute as the two countries argue structural issues to score political points.
Given the macro environment and the steady rise in stocks through much of 2019, we gradually reduced risk in anticipation of more volatility. We have increased our short exposure by implementing equity, interest rate and credit hedges to reduce market risk. We’ve also added shorts on individual stocks and bonds where we believe we can profit as volatility heightens.
The credit environment has been relatively benign. Nonetheless, we remain concerned about a potential global slowdown. Corporate credit has generated strong returns year-to-date and therefore could be vulnerable in the next downturn. But if the credit cycle doesn’t turn in the immediate future, we believe yield-seeking investors could prove to be natural buyers in a world of depressed rates. Our corporate bond holdings are skewed toward higher-quality positions, and we’re closely watching rising corporate leverage, declining interest coverage, potential downgrades and deteriorating loan covenants and quality. We also remain overweight securitized instruments, which we believe have a higher potential to outperform given they benefit from healthy U.S. consumers while having less exposure to trade.
"We respect the yield curve’s track record of forecasting recessions, but it’s only one of many economic indicators."
Market fundamentals ultimately reflect economic fundamentals, and economic growth is slowing worldwide. Europe’s economy is barely growing and must contend with the possibility of a hard Brexit. Whatever the outcome of Brexit negotiations, the blow to business confidence and barriers to trade will weigh on economies on both sides of the English Channel. Similarly, the Chinese economy is feeling the effect of the trade war, with manufacturing activity slowing sharply. This explains why China has thrown the kitchen sink at its economy in the form of stimulus measures.
If we’re generous, we can see U.S. economic growth in the range of 1.5% to 2.0%. Of course, while the job market remains strong, housing has been weak, manufacturing activity is bearing the brunt of the trade war, and consumer confidence is falling. What’s more, corporate earnings growth was essentially flat last quarter, and that’s an upgrade from the prior quarter. Earnings guidance going forward is also generally not optimistic. In recognition of these trends, the Fed has returned to cutting rates, and the bond market, too, is pointing toward slow and low growth going forward.
In that environment, we remain cautiously positioned and broadly diversified. But with bond yields close to record lows and the Fed cutting rates, it’s hard to argue for an overweight to bonds and underweight to equities. As a result, we’re staying neutral on stocks versus bonds, and along most dimensions of our allocation framework. However, while we remain well-diversified geographically, we’re removing our U.S. overweight. One area where we maintain a long-held position is growth over value stocks. We’re sympathetic to arguments about value being neglected and due for a rebound, but value stocks historically do best coming out of economic slowdowns, not heading into them.
Earnings yields continue to be the biggest argument in favor of stocks versus bonds, particularly given the big recent Treasury rally. Nevertheless, the economic inputs to our model remain cautious and point toward bonds. Add it all up, and we remain neutral across the broad asset classes.
Here we’ve returned to neutral after a stretch of U.S. outperformance relative to other developed market equities. Relative valuations favor stocks outside the U.S., while momentum factors continue to show a U.S. bias, but not by a wide enough margin to justify maintaining our overweight.
Once again, earnings yields favor the U.S. over EM equities. Most underlying economic and market indicators point toward EM equities. As a result, we land firmly in neutral territory.
The earnings and valuation component of our size model favors small- over large-cap stocks. However, our economic indicators balance those considerations, and we opt to remain at a neutral weight.
Once again, this quarter we overweight growth stocks at the expense of value. We fully recognize that valuations favor value stocks and that the growth rally is historically long in the tooth. Having said that, both the momentum and fundamental aspects of our model point to growth. This is because growth stocks tend to outperform value when economic growth is scarce, as investors are willing to pay a premium for companies that can generate dependable earnings growth despite challenging economic conditions.
We’re cautious on non-U.S. developed market bonds because government securities have negative yields and credit-sensitive bonds have to contend with slowing growth. Within the U.S., we want to be thoughtful about where we’re taking credit risk at this stage of the economic cycle. This fundamental argument is also supported by technical factors—credit spreads (the yield above Treasuries) have narrowed in many areas of the market, so we’re looking to take profits on our tactical sector trades.
Our models show a slight preference for real estate investment trusts (REITs) because of the tailwind of low mortgage rates and attractive yields relative to bonds. But we don’t see strong enough indications to move to an outright overweight position. As a result, we maintain our neutral strategic allocation to global REITs, which offer portfolio diversification benefits.
Q4 | 2019
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
International investing involves special risks, such as political instability and currency fluctuations.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
American Century Investments uses a multifactor stock-ranking model incorporating a variety of stock attributes, which fall into four categories or factor families: valuation, growth, quality, and sentiment.
Diversification does not assure a profit nor does it protect against loss of principal.
Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.
As with all investments, there are risks of fluctuating prices, uncertainty of dividends, rates of return and yields. Current and future holdings are subject to market risk and will fluctuate in value.