U.S. Equities: Volatility – Opportunity or warning sign?

Helen Ford, US-equity specialist at T. Rowe Price would encourage investors to maintain a U.S. equity portfolio with a balanced allocation to the full breadth of the market.

In 2015, U.S. equities were what we would best describe as violently flat. With uncertainty over the outlook for the Chinese economy, concerns over Greece and Europe, tensions in the Middle East, and continued weakness in energy and commodity prices, it was not surprising that anxiety levels rose.

In addition, the intense level of focus in the lead up to the first Federal Reserve (Fed) interest rate hike in December (the first hike in nine years) contributed to nervousness. To a greater or lesser degree, these concerns have persisted so far in 2016, and in the near term investors have put more weight on these issues rather than focusing on the underlying fundamentals of individual companies.

In this challenging global economic environment, U.S. dollar price-sensitive sectors such as energy and metals are experiencing an earnings recession. However, it is important to recognize that we have continued to see relatively strong corporate results from the health care and technology sectors, along with certain areas of the consumer sector. In addition, we continue to see high levels of merger and acquisition activity, as well as ongoing share buybacks supported by cash-rich balance sheets.

Conundrum for the Fed
Given the uncertain backdrop, the pace and timing of further interest rate rises remains a hot topic of debate. While being aware of the global economic environment, the Fed is also aware of the continual improvement in the labor market, moderate increases in wage inflation, and the steady ongoing improvement in the housing market. The U.S. consumer has lower debt levels than at the beginning of the global financial crisis and is benefiting from lower energy prices. Given this, and notwithstanding the slow GDP growth reported for the last quarter of 2015, it is unlikely that a recession is imminent.

While some commentators have argued that the decline in oil prices is symptomatic of flagging demand and possibly even a precursor to more generalized demand shortfalls that may lead to a U.S. recession, we would note that the rapid falls were more to do with excess supply caused by ongoing productivity improvements in U.S. shale oil production.

However, given the Federal Open Market Committees sensitivity to financial market conditions and the rapidly decreasing prospect of inflation reaching its 2% target anytime soon, further rate hikes are likely to be moderate and highly data dependent.

Weakness seen at the outset of 2016 has been excessive in relation to the underlying economic backdrop. As investors have traded broad groups of stocks somewhat indiscriminately, based on macro-related concerns, T. Rowe Price have taken advantage of near-term weakness to add to positions in several of their higher-conviction names. Given the markets pullback, valuations have also become more attractive and the view current levels as reasonable considering where we are in the economic cycle.

Growth versus Value
While growth and value have alternated leadership over much of the past decade, during 2015 we saw dramatic outperformance from growth. The market narrowed, and a relatively small number of growth stocks drove performance. When combined with the weakness experienced within traditional value sectors (namely energy, materials, and financials), the result was a notable outperformance of growth over value benchmarks. Looking forward, there are reasonable arguments to support both sides of the growth versus value debate, and T. Rowe Price would encourage investors to maintain a U.S. equity portfolio with a balanced allocation to the full breadth of the market.

The current dividend yield of roughly 2.3% is superior to the yield of U.S. 10-year Treasuries, and the S&P 500 is trading at a higher earnings yield than investment-grade corporate bonds. On balance, the health of corporate America also remains strong, with balance sheets in aggregate having been meaningfully strengthened over the past several years. While it may be reasonable to expect recent wage growth to negatively impact overall levels of corporate profitability, T. Rowe Price does not anticipate a meaningful decline.

Further strenght of the U.S. Dolllar?
The U.S. dollar has risen strongly on a trade-weighted basis over the past several years. Divergent monetary policies and different economic trends help to explain the dollars ascent.

While further appreciation would likely present challenges to a number of U.S. multinational companies, the majority of the dollar strength is likely behind us at this point. Accordingly, T. Rowe Price expects to see a moderation of the headwinds caused from currency strength over the second half of 2016.

Health care, technology, and select consumer-related segments of the market are providing many attractive options at the moment. Longer term, T. Rowe Price is optimistic about the potential for future innovation in health care and expect to see significant breakthrough developments over the next decade in the areas of cancer, gene therapy, and Alzheimers disease.

The research is focused on identifying companies with strong pipelines, compelling technology, and a high likelihood of long-term commercial viability. Within information technology, over the past several years T. Rowe Price have been heavily invested in companies benefiting from the ongoing convergence of communications and computing. They continue to find interesting opportunities related to the continuing shift to public cloud computing and in companies well positioned to capitalize on trends in social media, Internet search and advertising, and global electronic payments. They also anticipate that select consumerrelated segments of the market will continue to offer attractive investment opportunities. With positive trends in employment, wage growth, and inflation, they look for continued strength from companies offering compelling goods and services to a strong and improving consumer-end market.

Where do we go from here?
In this more challenging market environment, it is important to be aware of both the positive and negative factors influencing the market. The bears are focused on the fact that profit margins have plateaued and that a strong dollar and accelerating wage growth are negatively impacting profitability. The bulls would note, however, that you have the opportunity to invest in select industry-leading companies that are well positioned to drive earnings growth. While the timing is uncertain, at some point the environment for commodity price and dollar-sensitive companies will improve. While rising wages have the potential to negatively impact profit margins, at the same time, they are a positive for consumers. Further rate increases are likely to be moderate, and monetary policy around the world remains accommodative. Bull markets usually end with recession or due to valuation bubblesT. Rowe Price sees no signs of either.

Given these factors, T. Rowe Price remains reasonably constructive, but returns are likely to be more modest. As they have witnessed for the last few years, sentiment is likely to ebb and flow. This will again likely provide opportunities to invest on bouts of stock-specific volatility. T. Rowe Price look to take advantage of these and to build positions in companies that are attractive on a risk/reward basis. The outlook is inherently more stock-specific than it has been for some time, but patient investors should be rewarded over the long term.