A weak first quarter rattled investors, but we welcome the opportunity to find quality companies at attractive valuations
Early this year, concerns over higher inflation and interest rates led to a rise in volatility, and global equity indices ended the quarter down in most markets. However, despite the weak start to 2018, the Invesco International and Global Growth team sees positive signs among a number of important Earnings, Quality and Valuation (EQV) measures. The recent spike in volatility is a welcome development for investors like ourselves who emphasize valuation as a critical input to risk and return potential.
The quarter in review
In U.S. dollar terms, the MSCI All Country World Index fell by about 1.0% in the first quarter. U.S. stocks (represented by the S&P 500 Index) declined by about 0.9% in U.S. dollar terms. On either end of the spectrum was Europe, with the MSCI Europe Index down 2.0% (USD), and emerging markets, with the MSCI Emerging Markets Index up 1.4% (USD) – boosted by Latin American equities and Brazil, in particular.1
Cyclical areas of the market, including many blue chip technology shares, felt the brunt of the share price declines. Growth continued its outperformance over value, but by much smaller margins than seen in the fourth quarter. In general, small caps outperformed large caps in most regions.2
What we see through our EQV lens:
Consensus estimates for growth are healthy, with the MSCI All Country World Index expected to deliver approximately 5% growth in revenue and 11% to 12% growth in earnings over the coming 12 months.3 By region, the U.S. is expected to deliver 16% earnings growth, emerging markets about 13%, Europe and Canada 8% to 9% each, and Japan about 2%.4
However, the strength of global growth and estimate revision data clearly moderated in the first quarter compared with the fourth quarter of 2017. In the U.S., consensus estimates have been bolstered by tax cuts and a weaker U.S. dollar, but in Europe and Japan, the strength of the euro and yen have acted as drag on exports and foreign earnings translation. More recently, the uncertainty around U.S. trade policy has tempered the outlook for growth expectations globally.
In short, investors are less certain about 2018 growth today than they were three months ago and eagerly await first-quarter results to adjust expectations accordingly.
There has been no change in the overall picture of quality around the world: In general, non-U.S. companies boast better relative balance sheet strength versus U.S. companies, which are more leveraged.
If interest rates continue to rise from still low levels, we believe it will be only a matter of time before equity market investors begin to pay more attention to balance sheets and interest coverage ratios – critical components of our quality assessment. Even if rates do not rise, balance sheet strength will increasingly be in focus as changes to International Financial Reporting Standards disclosure (beginning Jan. 1, 2019) will require companies to include operating leases as part of their debt reporting, increasing leverage ratios and reducing return on assets in many instances.
There has also been no change to the stretched nature of absolute valuations, particularly in the U.S., where the Shiller price-to-earnings ratio and the price-to-book ratio have only been higher during the tech bubble of the late 1990s.5 On a relative basis, price-to-earnings and price-to-cash-flow ratios favour companies outside of the U.S. where the relative earnings leverage story remains compelling, in our view.
While markets change, our EQV philosophy and process remain the same. All of the strategies managed by the team focus on identifying high-quality companies that have sustainable growth and are trading at attractive valuation levels. We believe recent volatility has brought renewed focus to the importance of these traits among investors.