A look at key risks and opportunities as we enter the final quarter of 2018.
Simon [Sam] Davis
Co-Head of Equities
Portfolio Manager of Putnam International
Equity Fund and Putnam Europe Equity Fund
Shep Perkins, CFA
Co-Head of Equities
Portfolio Manager of Putnam Global Equity Fund
and Putnam Sustainable Leaders Fund
Risk: Inflation shockSHEP: While many market observers expect inflation to remain muted, the potential for it to rise faster than expected is a key risk for today's equity markets. We are seeing much tighter labor market conditions as unemployment has declined globally, especially in the United States. In mid-September, the number of Americans filing for unemployment benefits dropped to a 49-year low. And while we have not seen meaningful wage growth yet, it has picked up in recent months. This labor market backdrop — combined with a solid U.S. economy, corporate tax cuts, strong consumer confidence, and government stimulus — could trigger a significant uptick in inflation.
"An escalating tariff conflict could put 'sand in the gears' of
SAM: The job market is tightening across developed markets, driving up labor costs, particularly in the areas of transportation and logistics. At the same time, oil prices have risen meaningfully. Although energy is not factored into the core inflation rate, higher oil prices do have a secondary impact on prices of goods and services. In combination with a tight labor market, it could cause inflation to surprise on the upside.
As a result, the Federal Reserve could tighten faster than anticipated, which would likely have a negative impact on equity markets even outside the United States. Rising rates can be beneficial for stocks early on, but there is an inflection point after which it becomes problematic. Another issue to consider is that we remain in uncharted territory with the reversal of quantitative easing. As central banks take on the unprecedented challenge of shrinking their bloated balance sheets, it is difficult to determine how that will play out in the markets.
SHEP: Bond proxy stocks, many of which we believe are overvalued, could come under pressure should we see an unexpectedly sharp spike in interest rates. Growth stocks could also struggle, and in general, price/earnings multiples tend to contract in a higher rate environment. From a corporate earnings standpoint, inflation could lead to higher costs and a squeeze on profit margins, elevating the potential for an earnings recession.
Opportunity: Equity recovery in EuropeSAM: Europe is an area of potential opportunity for equity investors. In recent months, we have seen growing confidence in the durability and sustainability of the region's macroeconomic recovery. Economic indicators have stabilized and corporate profitability has improved, while weakened currencies provide a further growth tailwind. If economic data begins to strengthen and interest rates rise in a measured way, European equities should outperform. European value assets represent the greatest opportunity, in our view. The European equity market has a strong value bias, represented by businesses in traditional sectors such as financials, energy, and materials — all of which tend to outperform in an improving macro environment that includes rising rates. European bank stocks have sold off fairly aggressively in 2018, and investors have largely ignored the potential boost they would receive from higher rates. Also, European bank valuations appear even more attractive when considering improvements in the banks' financial condition as they have cut costs, built up capital, and maintained solid asset quality.
Risk: Global trade conflictSAM: Any discussion of today's equity market risks must include the escalating tariff conflict between the U.S. and China. There is potential for this issue to put “sand in the gears” of global trade and have a more chilling effect than is currently priced into global equity markets. Investors initially had a fairly benign view of the friction. However, it has moved from being viewed as a short-term negotiating tactic by the Trump administration to a more serious ideological dispute. In September, Trump announced tariffs on $200 billion worth of goods imported from China, and is prepared to place tariffs on the remaining $267 billion worth of imports. The tariffs will start at 10% and climb to 25% by January 2019.
Opportunity: Trade friction mispricingsSAM: While a trade war is a significant risk, it is also quite possible that the damaging effects of the U.S.–China trade friction have been overestimated. In our research team's work, we are seeing evidence in the case of specific assets, such as domestically focused Chinese companies that have been sold off irrationally and are completely immune to trade issues. There are stocks elsewhere that have been overly punished by trade conflict fears. Japanese industrial companies, for example, have declined sharply due to their perceived exposure to global supply chains, and these mispricings represent an opportunity for long-term investors.
While we do not expect trade headwinds to be positive for the Chinese economy, the negative impact may not be as massive as some fear. By loosening credit, allowing the currency to weaken, and taking other measures to stabilize the economy, the Chinese government is working to soften the blow of a trade-related slowdown. While it could take some time before we see the results of these stimulus measures, we are monitoring the situation for ongoing risks and opportunities.
Opportunity: Non-U.S. marketsSHEP: We have seen a considerable bifurcation this year in terms of performance between U.S. and international equities. U.S. equities, especially growth stocks, had outperformed all other regions, and the underperforming international markets represent a potential opportunity. Some of the issues that have weighed on the international markets could emerge in the United States, giving non-U.S. equities an opportunity to take the lead. If the dollar starts to weaken, emerging markets could find their footing, and we could see improved performance from Europe and Japan as well.
SAM: In a number of regions, improving corporate governance should be a significant driver of equity performance. This is most notable in Japan, where valuations remain attractive, in my view, and many companies are still working to implement change. Examples include improving the efficiency of their balance sheets, returning cash to shareholders in the form of share buybacks or dividends, and focusing on profit generation and cost cutting. Since Prime Minister Shinzo Abe took office in 2012, the Japanese government has made great progress in encouraging businesses to improve their profitability and capital efficiency, but we are likely to see more advances in the months and years ahead.
"Innovation from companies across the global equity universe continues to boost return potential for investors."
Opportunity: InnovationSHEP: The outperformance of growth stocks over value stocks, which has been most prominent in the United States, is due in large part to innovation. Growth companies are taking market share from more traditional value-oriented businesses thanks to impressive advances in technology, especially software solutions. Innovative products and services typically have global appeal, giving growth companies a huge addressable market and a meaningful advantage over companies with legacy products that are more expensive and have less appealing long-term growth prospects. Even in the face of market fluctuations and macroeconomic headwinds, innovation from companies across the global equity universe continues to boost the return potential for investors.
Next: Italy's policy standoff
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Despite risks of inflation and trade conflicts, opportunities exist for equity investors worldwide.