Uncertainty continues to reign over international equity markets, with attacks on Middle Eastern energy infrastructure, brinksmanship around Brexit and increasing ferocity of protests in Hong Kong. These have added to risks from U.S.-China trade tensions, which expanded to other regions and provided little relief to a slowing global economy, particularly within manufacturing.
The sense of gloom worsened over the summer, yet consumers held up relatively well. Many observers ponder whether global economies will go into recession, but central bankers are doing their best to avoid it—monetary stimulus has picked up worldwide and interest rates remain low. In his last month as European Central Bank president, Mario Draghi opened the money tap again with a measured program of quantitative easing. China continues to flood its economy with stimulus, and even the U.S. Federal Reserve cut rates. Markets are optimistic at these moves.
After money supplies start picking up, asset values normally move up, and a few months later the manufacturing sector starts turning. If the trade war does not harden, this could be the case again. As the global economy struggles to find its footing, higher-quality companies with strong balance sheets and free cash flow should be able to successfully weather the inevitable volatility ahead and provide solid investment opportunities.
Is Growth Shifting to Value?
The divergence in performance between value and growth has reached elevated levels. Many strategists are calling for mean reversions and a shift to value, but macroeconomic challenges will render this difficult. For non-U.S. value stocks to sustainably deliver outperformance, they will require long-term confidence that earnings will grow enough to expand currently low multiples.
Growth multiples are indeed higher than value multiples, but public equity market valuations for growth stocks are not particularly elevated, relative to private equity market valuations where cash has been plentiful and valuations extended. Even for growth investors, valuation discipline is integral to the investment process. Volatility can provide opportunities to buy growth stocks at better prices, so investors should prepare for any potential downturns with that mindset.
One potential growth stock is Constellation Software, a high-performance Canadian conglomerate that acquires and manages software makers targeting vertical industries. Its business model is asset light and attractive for its wide moat around the underlying businesses and its core M&A strategy. An earnings compounder with high recurring revenue and stable cash flows, the company is expanding globally and increasing the volume of larger deals. This should enable it to sustain double-digit cash flow growth for years to come.
Another high-quality growth company is Thomson Reuters, the market leader in providing information services for the legal and tax industries. Undermanaged for years, the firm did not invest in new products and had a less optimal margin structure. It sold off a majority stake in its finance and risk business Refinitiv to LSE, which should enable it to focus on expanding core products and cutting costs. The company’s earnings power over the next five years is being underestimated and now is a good time to invest.
More broadly, valuations in the U.K. and Europe are attractive, particularly compared with U.S. equities. Near-term risks in Italy are contained—for now—with a new moderate government in place. Fiscal stimulus is being discussed within the European Union, but no sizable commitment has been made. Such policy would be a clear positive. Brexit is likely to remain a wild card.
Japan, China and emerging markets are dependent on progress in trade talks. How Beijing deals with violence in Hong Kong and the off-again, on-again trade standoff with the U.S. will provide important signs of where the global economy and equity markets are headed. Major mainland intervention in Hong Kong would likely postpone trade discussions. The Trump administration appears willing to do whatever it takes to protect U.S. technology and military supremacy.
As ever, geopolitical risks are a constant and can provide beneficial opportunities to trim, add and remain invested. They are not to be feared but rather to be prudently managed.
Elisa Mazen is a portfolio manager at ClearBridge Investments, a subsidiary of Legg Mason. Her opinions are not meant to be viewed as investment advice or a solicitation for investment. All investments involve risk, including loss of principal.
