Finding Value in Unloved Industrials, Cyclical Sectors in 2018Dec 1, 2017

2018 Outlook: “A synchronized improvement in global economic and financial market conditions means fundamentals are likely to play a larger role in driving individual stock prices, while geopolitical risks and investor complacency leave markets vulnerable to bouts of volatility that may present us with attractive investment entry points.”

Although equity indexes for the United States and other major developed markets reached loftier levels in 2017, conditions have remained fairly supportive for global stocks. Heading into 2018, the global economy appears to be converging into a synchronized pace of modest and steady growth, while corporate earnings in the United States, Europe and Japan have been on an upswing. The US Federal Reserve and European Central Bank have also done well in their first steps toward unwinding their quantitative easing programs. Some risks, such as far-right parties gaining political power in national elections across Europe, have receded. As a result, we see signs of a number of shifts in the investment landscape that, on balance, could prove to be positive in 2018 for bottom-up, fundamentals-driven value investors such as ourselves.

A More Encouraging Investment Landscape

Investors tend to focus more on individual company news and fundamentals when economic, financial and geopolitical conditions are positive, or at least become less worrisome. We believe such a turn in focus is taking hold, barring any negative surprises, as we have observed generally stronger market responses within the United States to earnings that beat or miss consensus estimates. In addition, correlations between stocks within the S&P 500 and the MSCI World Index had fallen below their long-run average as of October 2017. From our perspective, picking the “right” stocks has the potential to contribute more to investment performance in environments of low stock correlations than high correlation periods.

We believe more attractive opportunities are likely to be found in cyclical sectors of the US and global equity markets, such as industrials, consumer discretionary and financials. A stronger global economy has already boosted consumer spending and is likely to underpin further spending gains in 2018. However, our bottom-up analysis is in line with consensus expectations among economists and investors that capital spending should also improve. The resurgence in corporate profits, a broad-based improvement in global economic growth, the stabilization of commodity prices and strong purchasing managers’ indexes all support an upswing in capital spending. Such a backdrop could provide a considerable tailwind for companies in the industrials sector, as well as some areas of the materials, information technology and energy sectors. Further catalysts for capital spending could come from the push in Washington DC to reduce regulations and the proposed US corporate tax changes laid out in the Tax Cuts and Jobs Act bill, particularly a permanent reduction in the corporate tax rate and a one-time tax break for repatriated overseas corporate earnings.

Geographically, we have become more optimistic about European equities, with the notable exception of those in the United Kingdom due to Brexit uncertainty, but selectivity remains crucial. Our investment theme within Europe is consistent with our broader view that cyclical industries are likely to be more attractive areas for investing. Furthermore, as of October 2017, European stocks remained generally less expensive than US peers on metrics such as price-to-book and price-to-cash-flow.

Beyond equities, we believe the slight deceleration in merger-and-acquisition (M&A) activity during 2017—driven in part by tighter government regulation in China as well as Brexit uncertainty that kept some UK companies on the sidelines—is likely temporary. Potential passage of a tax reform bill in the United States and elevated stock prices could drive a solid year of M&A activity in 2018. In the past, companies have viewed instances of strong equity markets as an opportunity to take advantage of their highly valued stock to make acquisitions or as an opportune time to fetch a good premium for shareholders by being acquired.

Where We See Risks and Limited Opportunities

At the same time, we view the improvement in global conditions as contributing to investor complacency, which has been reflected in subdued volatility index readings in Europe and the United States during 2017. Complacency may leave financial markets more vulnerable to a pronounced drawdown if a macroeconomic, geopolitical or financial event shakes investor confidence. In such moments of uncertainty, we typically seek to take advantage of market dislocations or overreactions.

Many defensive areas of the market have been trading at elevated multiples of earnings in recent years but will likely have less earnings upside potential than cyclicals. We also expect technology disruption to continue (e.g., the rapid market share shift to online retailing from traditional brick and mortar-dominated retailers that are often labeled as value stocks). Within the financials sector, we believe US companies by late 2017 had moved toward being fully valued, particularly regional banks. We think more opportunity may exist abroad as banks in some regions attempt to clarify their business models, a process that took place in the United States more than five years ago. This will take some time but may present opportunities for us.

Given the relatively low-rate environment and narrow credit spreads, we continue to expect few opportunities for mispriced risk in credit markets. In our view, opportunities are more likely to present themselves in generally unloved industries, such as pharmaceuticals, media/broadcasting and telecommunications. Among these industries there is a common theme of increasing political or secular challenges.

Lower Stock Correlations: More Focus on Fundamentals

One-Year Rolling Correlations of Daily Returns of S&P 500 and MSCI World Indexes
January 2000–October 2017
Correlation

S&P 500 Index

MSCI World Index

Source: Ned Davis Research. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com. Correlation uses a 252 trading day moving average. Indexes are unmanaged and one cannot invest directly in them. They do not include fees, expenses or sales charges. Past performance does not guarantee future results.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.