Q3 equity manager report: The froth has left market
Does the stock market still have more to give?
Geopolitical concerns are undeniable. Many equity market valuations appear to be expensive. Despite those truths, our manager research team has found that equity managers are generally bullish.1 We've also seen some managers use the market pullback over the first half of October as a buying opportunity, as they believe that some of the froth has left equity markets. Generally is a key term. There remains a lack of consensus within and across the various geographies in terms of sector and country leadership. In our view, this is likely to lead to bumpy equity markets for the remainder of the year.
At Russell Investments, our distinct relationship with underlying managers allows us to have unique access to insights from specialists across the manager universe. Based on this, we've compiled our chief tactical observations from key geographic and equity regions, in alphabetical order, for the third quarter of 2018.
Value stocks provide a compelling opportunity
- Manager commentary is consistent with our tactical view that value stocks are the right place to be invested. Value-biased managers are becoming increasingly more optimistic, pointing to value stocks being cheaper than growth stocks by two times historical averages.
- However, the market continues to penalize these stocks. The most commonly cited theme from the reporting season was that high price-to-earnings (P/E) stocks became more expensive, with the market being less forgiving of stumbles by lower P/E stocks.
Lots of news, less turnover
- Despite reporting season, a change in prime minister and the final hearing of the Banking Royal Commission, portfolio turnover for the average manager during the quarter appeared to be lower than normal. The preferred themes of overweight energy and industrials and underweight banks did not change.
Cannabis stocks lead the way
- Strong outperformance of cannabis-related stocks made healthcare the top performing equities sector in the quarter. However, managers are still largely staying away, given very high valuations and concerns regarding management quality and the moat surrounding individual companies.
- Energy and materials were the two worst performing equities sectors during the quarter, which generally fell in line with the market dynamic in the quarter, which favored more defensive stocks and penalized more cyclical stocks.
- However, many managers saw this as a buying opportunity based on improving underlying resource prices and generally positive economic growth results.
Emerging market equitiesRisk and opportunity hand in hand
- Oil prices and the U.S. dollar (USD) have been unusually strong together, hurting weak deficit currencies. Managers' macro views have led them to look for domestic ideas and at stocks with USD revenues less impacted by trade concerns.
- The pullback in growth stocks has seen a mixed reaction, as overweight managers trimmed on stock-specific risks, while underweight managers saw potential entry points in high growth tech stocks.
Clouds on the geopolitical horizon
- Managers remain on alert despite being positive on the long-term emerging markets cycle. During Q3, they reassessed company exposures due to the increase in volatility and market dispersion that that was driven by political noise and the U.S. Federal Reserve tightening. Currency and oil price changes across several countries have forced rate hikes to address current account deficits and rising inflation costs.
Italian budget issues take center stage
- Italy Finance Minister Giovanni Tria admitted that the 2019 budget, the centerpiece of his party's election campaign, was not in line with EU rules after his European counterparts pushed Italy to adhere to EU fiscal laws. This continues to be a source of market tension and has yet to be resolved. Amidst these issues, value-oriented managers have been performing better.
Trade war impacts on Europe
- Trade war rhetoric continues, negatively impacting financials (mostly banks) and areas of the market exposed to emerging markets (Turkey and Russia).
Brexit... the relative that never seems to go away
- Due to ongoing uncertainty surrounding Brexit, most managers continue to be underweight the UK, though there is less concern for the market's large, globally-exposed stocks.
Growth managers see few opportunities
- Growth managers continue to prefer secular growth names over cyclicals. Common themes among growth managers include gaming, payment systems, exchanges, medical technology, and internet software.
Value managers are more optimistic
- The increase in volatility this year has created opportunities, particularly in areas affected most by tariff concerns (autos, semiconductors). Most value managers are looking through these issues and expect positive resolutions. Some value managers are starting to buy previously high growth technology names, which have pulled back in recent quarters.
- Managers at the leading edge of quant investing continue to allocate resources to researching unstructured data (e.g., natural language processing applications).
Declining concern over the political risks
- Although U.S.-China trade friction increased, China-related stocks in industries such as steel and shipping rebounded as many managers perceived the risks were already priced in and valuations were attractive.
Bank of Japan's policy modification
- In July, the Bank of Japan announced the introduction of forward guidance on policy rates and additional wording that greater volatility will be accepted to the 10-year interest rate.
- Managers' reactions to the news were mixed. Some increased their weight to banks, while others maintained their underweight positions based on the expectation that rate rises are still far away. Managers pay close attention to interest rate trends, as they can have an impact on the performance of stable companies, which have been trading as bond proxies.
Brexit continues to be a major question mark
- It remains impossible to predict the Brexit outcome. The fears of a no deal Brexit weighed on UK domestic companies, driving poor relative returns from mid-caps.
- UK equities are now very out of favor in a global context, but not all in equal measure. There is a bifurcated market between high and low P/E stocks, with the latter being more domestically-oriented.
Fears for the UK economy started becoming realized
- Weaker business investment started manifesting itself in UK economic data. CFOs increasingly expect business spending and hiring to slow.
- UK retailers struggled as consumers face these uncertainties and weak Sterling impacted margins.
- UK car sales plummeted as job cuts and closures spread across the UK car industry.
U.S. large cap equities
Managers becoming more defensive
- Over the past year, the median active U.S. large-cap manager has reduced its beta exposure to slightly below beta neutral, which may indicate risk moderation due to heightened uncertainty in the market and stretched valuations.2
- Managers reduced several factor tilts that suggest a more risk averse posture, including declines in momentum, growth, and volatility exposures. Relative valuations of momentum and growth factor exposures are more expensive than their historical averages.
Value sectors becoming favored
- Sector rotations also indicate caution among the active management community. Managers have added to several more value-oriented sectors: energy, materials and utilities. However, these changes are more to reduce underweights to these sectors and not yet leading to overweights.
U.S. small cap equities
Growth stocks continue YTD dominance
- In a reversal from Q2, growth outperformed value by roughly 4% for the quarter, as health care and technology stocks led the way, while key value sectors (e.g., energy) were laggards. Growth stocks are now ahead of value stocks by over 8% year-to-date.3
Active managers leaning further into value?
- As value-oriented sectors underperformed, many market-oriented and value managers rotated into areas with better valuation opportunities, adding exposure to energy, staples, materials, and REITs over the course of the quarter.
- While still overweight the fastest growing stocks, many growth managers also trimmed positions in the top deciles of forecasted earnings growth, and trimmed exposure in stocks with the most expensive valuations, signaling incrementally more valuation sensitivity among managers.
Even within this report, the lack of manager consensus is conspicuous. At the same time, identifying opportunities for outperformance is vital. Keeping a close watch on the views of specialist managers has never mattered more.
1Source: Russell Investments equity manager research, Q3 2018. From hundreds of conversations with managers.
2Source: Russell Investments manager universe analytics.
3Source: Russell 2000® Growth Index, Russell 2000® Value Index. Data as of Sept. 30, 2018.