Macroeconomic Outlook — The S&P 500 Index generated a total return of 7.71% for the third quarter, bringing the nine month return to 10.56%. It reached an all-time high of 2,931 on September 20th, before retreating slightly to end the quarter at 2,914. Global desynchronization continued with international markets underperforming the U.S. by a wide margin. The MSCI All Country World Index ex-U.S. generated a meager total return of 0.8% for the third quarter while the global composite index, of which U.S. stocks represent 52%, returned 4.40%.
Two factors contributed to the relative strength of the U.S. market. Two years of fiscal stimulus in the form of tax cuts and government spending have helped corporate earnings. Second, there is a structural difference in the composition of the U.S. Index. Growth and non-cyclical stocks in the technology, consumer discretionary and healthcare sectors represent more than half of the S&P 500 Index. In contrast, most non-U.S. markets have heavier representation in cyclical and value oriented stocks in sectors such as materials and financials.
We have been in a relatively slow growth world which makes companies with strong top line momentum more valuable for their scarcity. More of these successful growth companies are domiciled in the U.S. than elsewhere. Valuation spreads between growth and value stocks began 2018 at near record levels and have only grown wider. Indeed, even beyond the U.S., the most expensive and least cyclical markets at the start of the year have performed best. The NASDAQ, the most expensive global market, is also the best performing. Japan, which we discuss below, is another expensive and positive performing market.
The widening gap between growth and value has some parallels to the late 1990s/early 2000s period. That was the last time earnings expectations were this high and technology this large a percentage of the S&P 500. However, while similar on the surface, there are differences. The betas of the most expensive stocks in the market are much lower today than two decades ago. If a stock has a beta of less than 1, the security is theoretically less volatile than the market as a whole. If a stock has a beta of more than 1, it is more volatile. Interestingly, in the late 1990s/early 2000s, expensive or high P/E stocks, which included technology stocks, had an average beta of 1.2, or 20% more volatile than the market. Today, this same group has a beta of 0.96, slightly less volatile than the overall market. Conversely, the beta of the lowest P/E stocks averaged 0.98 in the early 2000s and today are actually more volatile with a beta of 1.23.
Technology has been the work horse of this bull market. Unlike the late 1990s and 2000s, technology companies are not being measured exclusively by clicks and eyeballs. Today, the technology sector is fundamentally sound in terms of exceptionally strong profit and cash flow generation. The chart below shows the impact of improving technology profit margins on the overall equity market for the better part of a decade. Without technology, the operating margin for the S&P would be significantly lower. Naturally, increasing profits must underpin the parabolic rise in margins. Since 2006, technology’s earnings per share has almost quadrupled, pulling overall S&P profits higher.
In our view, the profit outlook for the technology sector remains bright, driven to a large extent by capital expenditures. Technology continues to make inroads in the overall capex pie, and now has doubled its share since the 2008/2009 financial crisis to roughly 12%. Technology new orders-to-inventories are also picking up and suggest that market analysts are underestimating relative earnings per share growth. Finally, consumer outlays on tech goods are increasing faster than overall consumer spending. Nevertheless, we have moderated our technology sector overweight due to extremely strong relative performance of our core tech holdings, but they remain some of our highest conviction thematic holdings.
What’s Depressing Growth?
While demographics are weighing on global growth, in our opinion high levels of debt are also a major contributor to slower growth. The real rate of GDP growth when debt levels are high has historically been half the rate of that when debt levels are low.
Debt represents consumption today at the expense of consumption in the future. Excessive debt is a burden on growth unless it is used for productive investment. Unfortunately, it appears much of the recent incremental debt has been used for consumption.
Within the U.S., from an aggregate perspective, total nonfinancial debt-to-GDP has remained largely stable since the 2008/2009 financial crisis. But there has been a distinct change in attitudes toward debt – households have deleveraged with the ratio of consumer debt to income down from 130% to 100%. However, public sector debt has more than offset the slowdown in consumer borrowing.
There is a catch-22 aspect in this. If more robust economic growth leads to a normalization of interest rates, debt service could soar which would then likely put the economy back in a very slow growth environment. Since the Fed started raising the federal funds rate at the end of 2015, net interest paid by the U.S. Government rose from $225.5 billion during the 12 months of 2015 to a record high of $320.3 billion for the 12 months ended August 2018. Over this same period, publicly-held U.S. Treasury bonds jumped $2.1 trillion to a record $15.8 trillion. If the Fed succeeds in gradually normalizing monetary policy and the federal funds rate rises to 3.00% by the end of 2019, the current amount of debt outstanding would push the government’s interest expense to over $500 billion annually by 2020.
It is difficult to predict when debt and deficit levels will weigh on markets. However, if interest rates start to rise above a neutral rate as a result of excessive debt levels, equity and fixed income markets will likely suffer.
In a year marked by ex-U.S. global equity weakness, Japan is one market that continues to stand out with the Nikkei breaking out to seven-month highs in September.
The Bank of Japan recently reaffirmed its intention to keep interest rates low indefinitely. Shinzo Abe was re-elected in late September and will become the country’s longest-serving prime minister with a term running to 2021. Corporate profitability is at a record high, yet foreign investors have pulled more than $40 billion out of Japanese equities, masking some of the market’s strength.
The Japanese economy is showing the strongest signs yet of breaking out of its deflationary funk. Unfavorable demographics is often blamed for all that ails Asia’s second largest economy. But recent tightness in the labor market has led to a rise in the participation rate. Even with a larger labor force, demand for workers remains unmet and wage gains are now becoming more broad-based. If sustained, this rise in workers’ pay should lead to stronger consumer spending.
Japanese companies appear able to absorb the increased cost of labor. Across a swathe of sectors, profit margins have risen to record highs as an undervalued yen boosts competitiveness. As long as labor productivity improvements keep pace with the rise in wages, profit margins are unlikely to come under undue pressure. And while changes in productivity are notoriously hard to measure, the renewed willingness of Japanese companies to invest in the domestic economy suggests productivity growth will likely continue.
After the U.S., Japan is our largest portfolio weighting. As the gap between economic momentum in the U.S. and the rest of the world narrows, we may increase our weighting in Japanese companies, as many are also leading participants in our themes.
Genomics and the advent of molecular medicine is one of our high conviction investment themes. This year the one millionth whole genome sequence was completed. The cost of sequencing the genome dropped below $1,000. Applications were filed with the FDA to begin trials of treatments using a gene editing technique called CRISPR. Scientists have identified more than five million genetic mutations with links to cancer. All of these developments give us confidence in the investment thesis.
From an investment perspective, not only is the market for genomic sequencers growing at an accelerating rate, but the machines in service are also being more fully utilized. We estimate that the market for genome sequencing equipment is growing about 10% per year. The market for consumables, which are the materials used with each run of a sequencer, is growing about three times faster. This is important because the genomic equipment sector follows the “razor/razor blade” model. Once a lab or a hospital buys a machine, they have to purchase consumables to run the machine. Similar to the shaving paradigm, over a lifetime of use, the recurring revenue from the consumables is likely to exceed the cost of the initial equipment. According to Illumina’s most recent reports, during 2018 customers will purchase an average of approximately $900,000 of consumables for each of its new NovaSeq sequencers. This exceeds initial company estimates of $730,000. Current forecasts are for the amount to rise to $1.5 million by 2021.
As more diagnostics, and ultimately treatments, rely on understanding specific genetic sequences, we expect the market for sequencing equipment, and more important, the recurring revenue from higher margin consumable sales to grow rapidly. Beyond the equipment and supply manufacturers, we are researching and investing in companies that are developing never-before possible therapies for previously hard to treat or untreatable diseases.
The 10-year U.S. bond yield continued to fluctuate in a relatively narrow range during the third quarter. It reached a low of 2.81% on August 24 and a high of 3.10% on September 25. Yields ended the quarter at 3.06%.
As expected, the Federal Reserve again raised the fed funds rate during the quarter by 25 basis points (0.25%). Since the long end of the yield curve did not rise by a commensurate amount, the slope of the curve flattened. In fact, on August 27, the difference between the yields on 10-year Treasury bonds and 2-year Treasury bonds hit an intraday cycle low of 18 basis points. Unlike an inverted yield curve, a flat curve is not necessarily a sign of impending recession, but it is a signal that the Federal Reserve may not be able to raise rates much more before tightening slows economic growth.
Long-term bond yields are still far short of the 3.50% to 3.75% levels many were forecasting at the beginning of the year. We think yields will advance slowly in the near to intermediate term before falling back below 3.00% when the cycle inevitably turns.