At the macroeconomic level, we are watching trends in inflation, interest rates, employment and credit-default levels for signs of change. As bottom-up investors, we are also constantly talking to individual company management teams to get an assessment of end-market demand, global competition and the health of their customers.
We still think the U.S. economy is strong and equities have the potential to do well in the coming years. That said, preparing for an economic downturn or market pullback is something that is done over time, as we build our portfolios stock-by-stock. Our rigorous, fundamental research focuses on companies that are not just growth businesses, but also those which meet our quality criteria. We seek to invest in companies with strong competitive positions, solid financials and innovative management teams. We believe these types of high-quality companies can outperform the market over the economic cycle and are more likely to prove structural winners over time.
The Big Three Risks: Trade, Inflation, Interest Rates
Tariffs and trade restrictions continue to be in the news and probably are the biggest uncertainty for the markets right now—with potentially significant impact on economic growth. We are watching these developments cautiously and constantly working to understand the potential exposure of the companies we invest in.
Not to diminish the risk, but we think trade tensions should be viewed through the lens of American politics: A trade dispute or tariff threat may be more of a means to an end of scoring political points with a targeted set of voters. We see a low risk of an all-out trade war, or a serious erosion of the trade regime that has underpinned the rise in global prosperity since the end of World War II.
The second challenge is inflation. As U.S. economic growth has accelerated this year, we are seeing a modest pickup in inflation, and the Federal Reserve (Fed) seems to have grown more hawkish as a result. The market appears comfortable with the current pace of interest-rate increases given the country’s economic strength, but there are concerns the Fed could overshoot its targets, especially if growth moderates in 2019.
The last challenge is more political—the U.S. midterm elections. Elections always bring some uncertainty and volatility as the market reacts to a potential change in the political and regulatory landscape. The mid-term elections in the United States get a lot of press, but, in our view, a change to a more divided Congress wouldn’t likely have a huge fundamental impact on the economy or broad investment landscape. The pro-business, less-restrictive regulatory backdrop that started in late 2016 would likely continue. We would just have more gridlock in Washington, which, ironically, could actually be good for the markets, as markets don’t like uncertainty.
Pocket Of Rich Valuations, but Tech Bubble Comparisons Irrational
The S&P 500 Index currently trades at about 16.5x next year’s earnings, which is right about at the five-year average and modestly above the 10-year average, which covers the depths of the financial crisis (Source: FactSet, as of August 17, 2018.).
Valuations have moderated in 2018, and the U.S. market is cheaper on a price-to-earnings (P/E) basis than it was at the end of 2017 (Source: Ibid.). The rapid earnings growth we have seen in 2018 partly explains why that’s the case, but the moderation in valuations is also a reflection of the increase in risks being priced into the market.