Fundamental All Cap Core

INVESTMENT PHILOSOPHY

We believe that quality companies with a sustainable competitive advantage and cash flow generation bought at the “right price” should outperform. Patience and a long-term investment horizon allows for the compounding of companies’ cash flows.

MARKET COMMENTARY

US Equities

Equity | June 27, 2018

Sandy Sanders, Senior Portfolio Manager, US Equities

Global Intelligence Interim Outlook June 2018 - US Equities: The Backdrop Icon

THE BACKDROP

The consumer is fully employed, wages are growing and household debt levels, particularly mortgage expenses, are at a 10-Year low, leaving the consumer balance sheet in fine shape.3

As of May, the current economic cycle is now the second longest in US history, having just matched the 106-month duration of the February 1961 to December 1969 recovery. Most market prognosticators argue we are late in the cycle and debate whether it is time to consider if a bear market is imminent. For our part, we are focused on bottom-up fundamentals and like what we see.

We also believe the US economy remains in excellent health with further room to grow, a view that we feel is supported by three key pillars:

  1. Banks are in a strong position. They have been completely recapitalized in the wake of the Global Financial Crisis and it is our belief that they are the healthiest that they've been for a generation. Furthermore, Congress last month approved a regulatory rollback on onerous Dodd-Frank laws.1 We expect that as US banks exit the latest round of the Fed's stress test (CCAR), they will emerge with a clean bill of health, remaining well-capitalized and positioned to drive the economy.
  2. Housing starts in the US currently stand at just over one million. The long-term average is 1.5 million and we hit three million in 2007. Thus, compared to the previous peak, we believe there is still significant room to growth with considerable pent-up demand remaining in the system. We believe this will be driven primarily by the 'Millennial Generation', particularly now they are fully-employed.2 Recent household formation data shows more consumers opting to purchase, rather than rent homes - in a meaningful way - for the first time since the financial crisis.2
  3. The consumer is fully employed, wages are growing and household debt levels, particularly mortgage expenses, are at a 10-Year low, leaving the consumer balance sheet in fine shape.3 This is understandably having a knock-on effect on business confidence. S&P capex was up 16% in the first quarter, the strongest growth rate in six years.4 We will be monitoring how this investment trajectory unfolds as US companies weigh opportunities to capitalize on strong consumer and business confidence against the risks posed by trade war and macro uncertainty.
Global Intelligence Interim Outlook June 2018 - US Equities: Opportunities For Investors Icon

OPPORTUNITIES FOR INVESTORS

We believe companies will need to invest in productivity and begin to substitute capital for labor. Technology companies will likely be among the biggest beneficiaries of this trend.

At present, our assessments of intrinsic value using five-to-15-year analysis of a range of potential cash flow outcomes is finding many compelling growth and value ideas in today’s markets. Technology companies and industrial stocks, in our view, will be interesting bellwethers in this regard. With the US essentially at full-employment, we believe companies will need to invest in productivity and begin to substitute capital for labor. Technology companies will likely be among the biggest beneficiaries of this trend.

The tech sector has experienced steady investment since the 2009 recovery began, and that trend has accelerated of late. The chart below shows that the sector accounted for 50% of capex spending in Q1, with money going into cloud investment, system improvement, real estate, data centers and subsea cables. The sector has had an incredible run, but at this stage it pays to be selective and we remain focused on competitively advantaged share-gainers in this space. Meanwhile, measures of industrial cycles suggest that we may actually be somewhat early in the recovery for the industrials sector. We believe order growth, repatriated cash and the new tax regime could collectively accelerate investment spending by these companies, which could also translate into rising demand for their products.

Tech Leads the Way on Capex. Industrials Next?

Tech Leads the Way on Capex. Industrials Next? Chart
Source: Federal Reserve, Eurostat, Melius Research, as of May 25, 2018.

Despite the positive outlooks outlined above, the performance of bank shares has been mixed. We view this as symptomatic of the skepticism in the market at present, which is not wholly unsurprising. Midterm election years are generally volatile periods for markets and 2018 is no different: trade risk, rate risk, heightened geopolitical tensions surrounding Iran and North Korea have made for a more volatile environment. We think there is enormous potential in financials, however. The regulatory environment is improving, ROE (return-on-equity) is rising and balance sheets remain strong. In addition, lending is healthy and capital returns should continue to track and perhaps, exceed earnings growth. China is also taking steps to open up its financial markets and this has the potential to create opportunities for a number of larger financial institutions.

We continue to have a favorable view of the consumer discretionary sector, supported by the strong consumer. One company we like, which manufactures a wide array of recreational vehicles, has reported a considerable increase in sales in Q1. Consumer spending is still quite modest but we think it has room to grow, given the pace of growth in the US economy and the associated elevated level of consumer confidence.

Global Intelligence Interim Outlook June 2018 - US Equities: Risks Icon

RISKS

Rate risk is something we monitor very closely.

Although we feel the trade tariff dialog is largely chest-beating, market concerns over a trade war do have the potential to delay capital spending and therefore impact earnings. There will always be geopolitical risks but it does nothing to upset the fundamentals so we tend not to give such noise too much credence. That said, we are monitoring spending plans at the industry and company level. The chart below demonstrates that trade war risk and the associated uncertainty around capital investment returns has constrained some spending plans. However, they remain at elevated levels. Ironically, slower capital deployment might actually serve to elongate the cycle further.

Capital Spending Remains at Elevated Levels Despite Uncertainty

Capital Spending Remains at Elevated Levels Despite Uncertainty Chart
Source: Haver/Federal Reserve/Census Bureau, Guggenheim Securities LLC May 2018.

There is also some concern about the yield curve and the pace of rate increases. Rates risk is something we monitor very closely. We believe the current mix of full employment, productivity growth and steadily growing GDP – along with inflation that is near the Fed's target level – will keep the central bank on its current steady rate hike trajectory. We do not expect the Fed to accelerate the pace of its rate normalization plan.

Global Intelligence Interim Outlook June 2018 - US Equities: On Our Radar Icon

ON OUR RADAR

We have yet to see a 4% GDP growth rate so far in this recovery and signs indicate that we can expect more steady economic expansion ahead.

We have a more upbeat view of the US economy than some of our colleagues. In periods of low inflation, things happen slowly. We’ve been in a low growth environment over the last seven years. We are now moving away from this lower-for-longer environment to more reasonable levels of growth. The combination of a healthy consumer, potentially lower corporate taxes and reduced regulations creates an environment in which equities can do well. We don’t believe the market is over-valued following February’s correction – given that economic growth in the US is still accelerating. We have yet to see a 4% GDP growth rate so far in this recovery and signs indicate that we can expect more steady economic expansion ahead, with limited risks of the US economy overheating.

1 New York Times: Congress Approved First Big Dodd Frank Rollback, May 22, 2018.
2 CNBC: Housing Starts Total 1.319 Million in March, vs 1.262 Million Starts Expected, April 17, 2018.
3 Federal Reserve Bank of St. Louis, March 8, 2018.
4 Federal Reserve, Eurostat, as of May 25, 2018.
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About the Author

2016 Mar Sandy SandersSandy Sanders

Senior Portfolio Manager, US Equities

The opinions expressed are those of Manulife Asset Management™ at the time of publication, and are subject to change based on market and other conditions. The information in this article including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management.