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Why you should stick with quality, even if it is expensive

15 August 2018

GAM Investments’ Larry Hatheway explains why investors should not abandon quality growth stocks yet.

By Maitane Sardon,

Reporter, FE Trustnet

Investors should stick with quality despite high valuations as the drivers for a style shift won’t be seen before November at the earliest, according to GAM Investments’ Larry Hatheway.

Hatheway, chief economist at GAM Investments, said capital preservation and modest incremental returns remains the appropriate portfolio objective, a reason why investors should continue backing quality stocks over value.

“The preconditions for a rotation from quality to value – in the broadest sense – will not be met, at least not before November and perhaps not for even longer,” Hatheway noted.

“Cheap is cheap for a reason and is not something we see changing soon.”

As such, the GAM chief economist said it continues to invest its equity allocations in companies with proven track records.

Performance of indices over 10yrs

  

Source: FE Analytics

Indeed, the recovery period since the onset of the global financial crisis has been characterised by the outperformance of growth or momentum trades.

Despite a brief period where the growth trend was reversed in 2016, value stocks have lagged behind their quality growth peers over the last decade.

However, many strategists have warned about being too highly concentrated in style-based portfolios given the uncertainty about the future direction of the markets.

As such, many investors continue to pile into growth, with Schroders manager Nick Kirrage noting that only around 10 per cent of equity fund managers are value-focused.

According to Hatheway, to answer the questions about whether quality will continue to outperform value or when it will be safe to rotate back into what is cheap, investors should heed the economic fundamentals and the geo political backdrop.

He noted that cheap stocks are only going to rise in value if certain conditions are met.

“Firstly, if the US and its key trading partners resolve their trade conflicts,” the GAM chief economist explained. “That will require good faith negotiation rather than unrealistic expectations of unilateral capitulation.”


Secondly, for investors to return to value stocks the US dollar must in turn stop appreciating.

He said: “Dollar strength is both a sign of concern – a haven bid for quality – as well as a long-recognised obstacle to performance for emerging markets.”

A third condition for the investment style to return to favour, according to Hatheway, is the return of more convincing European and emerging market growth, which, he said, should halt dollar appreciation and improve corporate profitability.

“Better growth, without inflation, could also facilitate the rotation from expensive government debt to relatively cheaper equity,” GAM’s chief economist explained.

However, Hatheway noted that these outcomes are unlikely to be met in the short term.

“The odds favour some pick-up in non-US growth,” he said. “Globally, financial conditions remain supportive. Feedbacks from rising income, demand and investment are also support. And if rest of world growth picks up, dollar appreciation will probably be capped.”

World GDP (US dollar)

 

Source: The World Bank

The real wild card for markets, according to Hatheway, is the ongoing potential for trade conflict resolution.

He said: “While it is possible to ponder many scenarios, as well as the motives of those involved, the root of the challenge is distressingly familiar to those following Brexit talks.

“Specifically, it is impossible to come to a negotiated agreement if one party does not know what the other wants.”

For Europe or China, Hatheway highlighted negotiations with the US were “equally unproductive” if they cannot discern US priorities.

He explained: “Is it the elimination of barriers to trade, the enforcement of intellectual property rights or the elimination of bilateral trade deficits that the US administration seeks?

“It could be one, all or none of these possibilities based on Washington’s shifting rhetoric.”


Moreover, Hatheway said the US stance over trade seems to be based on a “deeply-flawed assumption that trade is a zero-sum game of winner takes all rather than mutually beneficial”.

“The administration’s stance also has clear political aims of mobilising key constituencies ahead of the November mid-term elections,” he added.

Looking back over the first six months of the year, the economist said much of the fundamental economic backdrop remains well supported.

“Global growth has not been this synchronised since the late 1980s,” he said. “The number of advanced economies operating at trend growth and near full employment is at a level that is unprecedented in a generation.

“Advanced economy inflation is returning to norms associated with price stability, but as yet without signs of overshooting. And corporate profits in the US and Japan are near post-war peaks, as measured by various metrics.”

World employment levels

  

Source: International Labour Organization

Alone, he noted that these factors – which were key drivers for last year’s returns – would power advances in equity, credit and emerging markets but warned.

He said: “The intrusion of geopolitical risk in 2018 – mostly in the form of trade conflicts and recently via sanctions – have led these issues to take their toll on emerging debt, currency and equity markets.

“Compounding matters is a general sense that the politics driving international economic conflict – at least on the part of the US – are unlikely to change until after the mid-term US elections in November, and perhaps not even then.”

Hatheway added: “Similarly, the perception that the US administration appears unwilling to reciprocate to overtures from trading partners for negotiated solutions, which could ratchet down concerns of escalation, is also not helping.”

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