Capital Markets: Observations & Insights

First page I Next page Last page

Degrees of Debt - Summer 2018

SUMMER 2018

Capital Markets: Observations and Insights Capital Markets: Observations and Insights Degrees of Debt

Degrees of Debt

“Rather go to bed supperless, than rise in debt.” – Benjamin Franklin

We have written often about our belief that the largest driver of the economy and real wealth creation is productivity growth. However, economic growth can fluctuate around its long-term trajectory as consumers and businesses spend more than they produce by increasing debt or spend less than they produce as they repay debt. So where are we in this cycle of debt expansion and contraction? In the U.S. and worldwide, debt has grown significantly as a percentage of economic output over the past decade. But there is no magic limit to debt balances. Rather, debt service, or the share of income used for interest payments and amortizations, typically plays an important roll in governing how much debt consumers or businesses can sustain. While debt levels around the world are quite high, debt service is generally manageable. With the vast majority of that debt being fixed, it would take a long and sustained increase in interest rates to push debt service into the danger zone. For example, U.S. debt service for the consumer and business sectors is considerably lower than it has been in the peaks prior to the past two recessions. Therefore, we do not believe that investors need to worry about having to skip a meal…

Daniel C. Chung, CFA Chief Executive Officer Chief Investment Officer

Brad Neuman, CFA Senior Vice President Director of Market Strategy

Page 1

Key Observations

• Global debt levels are high but servicing costs are manageable and delinquencies remain subdued • Monetary conditions are tightening but stocks and the economy should be able to absorb moderate increases in interest rates • Business spending has begun to accelerate and outpace the broader economy, driven by strong earnings growth, tax reform, solid business confidence, and accommodative lending conditions

Table of Contents

Degrees of Debt

Pages 3-8

Performance

Pages 9-15

Fundamentals

Pages 16-23

Valuation

Pages 24-28

Page 2

Degrees of Debt

The Sea of Debt Rises

• Over the past decade, global debt has grown 5% annually and now exceeds $175 trillion

• The fast pace of credit growth has driven global debt as a percentage of GDP to nearly 245%

Global Debt

200

270%

180

250%

160

140

Debt has been rising in absolute terms and as a % of global GDP

230%

120

% of GDP

100

210%

80 $ Trillions

190%

170%

150%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: Bank for International Settlements, June 2018. Debt is credit to non-financial sectors.

Page 3

Some Countries Have Been More Reliant on Debt Degrees of Debt

• In aggregate, global debt as a percentage of economic output is close to its highest level in the past decade • For a major economy, Japan has by far the most debt relative to GDP while the U.S. is relatively in-line with the rest of the world

• China has had the largest buildup of debt, which could indicate misallocation of capital

= current

Debt as % of GDP

= 10-yr range

400%

300%

Debt levels vary but are high relative to history

200%

100%

Source: Bank for International Settlements, June 2018. Debt is credit to non-financial sectors.

Page 4

But Low Interest Rates Keep Debt Service Down Degrees of Debt

• Falling interest rates have allowed many countries to reduce debt service ratios

‒ China’s debt service ratio is an outlier—up significantly and close to its highs

= current

Debt Service Ratio

25%

= 10-yr range

20%

In contrast to high debt levels, debt service ratios are relatively low

15%

10%

Source: Bank for International Settlements, June 2018. Debt Service Ratio is the share of income used for interest payments and amortizations in the non-financial private sector.

Page 5

Degrees of Debt

U.S. Debt Service Is Historically Low

Despite higher levels of debt as a % of GDP, the U.S. non-financial private sector debt service ratio is much lower than in the past two recessions

‒ Both household and corporate debt service ratios have declined

‒ Since more than 80% of U.S. consumer and business debt is fixed, higher interest rates should not have a dramatic impact on service costs

U.S. Debt Service Ratio

20%

18%

Debt service ratio indicates households and corporations are not burdened by debt payments

16%

14%

12%

10%

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

Source: Bank for International Settlements, June 2018. Debt Service Ratio is the share of income used for interest payments and amortizations in the non-financial private sector. Shaded regions indicate recessions.

Page 6

Degrees of Debt

Default Risk Subdued

• After the Global Financial Crisis, delinquency rates across the U.S. declined significantly

‒ Real estate and commercial loan delinquencies have continued to decline, while consumer delinquency rates appear to have bottomed and are modestly rising

U.S. Delinquency Rates

Consumer

Commercial

Real Estate

12%

10%

Delinquency rates do not indicate a significant rise in defaults

Source: Federal Reserve. Data is for all U.S. commercial banks. Real estate loans represent both consumer and commercial loans.

Page 7

Degrees of Debt

Solid Ability to Pay

• Corporations are generally in a good position to be able to service their debts

‒ Interest coverage (EBIT/interest expense) is higher than it has been on average over the past 20 years

Interest Coverage

MSCI AC World Ex-U.S.

S&P 500

10x

Global interest coverage is relatively strong

Source: FactSet. Interest coverage is earnings before interest and taxes (EBIT) divided by interest expense.

Page 8

Technology-Related Companies Lead Performance

• Technology-related equities led this year, with U.S. consumer discretionary performance driven by the market-leading returns of the internet retail industry

2Q18 Returns (%)

YTD Returns (%)

U.S.

World

U.S.

World

-4

-8

-12

Energy

Utilities

Energy

Utilities

Telecom

Materials

Telecom

Financials

Industrials

Materials

Financials

Industrials

Technology

Real Estate

Health Care

Technology

Real Estate

Health Care

Consumer Staples

Consumer Discretionary

Source: FactSet as of 6/30/18. U.S. represented by S&P 500 and World represented by MSCI AC World Index in USD.

Page 9

Value Has Lagged Performance

• Year-to-date, value factors have been the worst performers

2Q18 Excess Return (%)

YTD Excess Return (%)

3.1 3.0

3.1

2.4

1.4

0.3

0.2

-0.2

-0.7 -0.7 -0.7

-0.7

-1.3 -1.5

-1.3 -1.3

-1.4

-1.8 -1.9

-1.7

-2.2

Market Cap

Book / Price

EPS Growth

Market Cap

Debt / Equity

Book / Price

EPS Growth

Debt / Equity

Price Volatility

Dividend Yield

Price Volatility

Dividend Yield

Trading Activity

Earnings / Price

Revenue / Price

Trading Activity

Earnings / Price

Revenue / Price

Relative Strength

Earnings Variability

Source: FactSet as of 6/30/18 using Northfield defined quantitative factors for the Northfield broad U.S. market database.

Page 10

Performance

Structural Issues Driving Growth vs. Value

• Growth stocks have dramatically outperformed (+35%) Value stocks over the past decade

• The culprit for value investors has been the very weak performance of buying low P/B stocks, while P/E strategies have fared much better • Book value, used heavily in index classification of Growth vs. Value, may no longer be as relevant given changing business models, e.g., R&D is not capitalized in book value

120

110

P/B, not P/E, has driven Value underperformance

P/E

100

P/B

Russell 1000 Value / Growth

Total Return Index

2008

2010

2012

2014

2016

2018

Source: FactSet as of 3/31/18. Price-to-earnings and price-to-book returns are based on the E/P and B/P Northfield factors for the Northfield broad U.S. market database.

Page 11

Performance

Innovative Companies Often Outperform

• Studies have shown, and our research demonstrates, that the most innovative companies grow their sales, earnings, and stock prices faster*

Innovation Drives Outperformance

600

Most Innovative +16.9% / year

500

400

300

Least Innovative +8.3% / year

200

100

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: FactSet. Most/least innovative stock performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one month returns for 10 years ending 4/30/18. * Baruch Lev and Suresh Radhakrishnan, “The Stock Market Valuation of R&D Leaders.”

Page 12

The Earnings Growth Explosion Is Driving Performance Performance

Total Return = Dividend Yield + EPS Growth +/- P/E Change

MSCI All Country World Index ex-USA

S&P 500

Dividend

EPS Growth*

P/E Change

Dividend

EPS Growth*

P/E Change

30%

25%

20%

15%

10%

EPS Growth Explosion

-5%

EPS Growth Explosion

-5%

-10%

-15%

-20%

Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18

12- Month Total Return:

21%

25%

18%

14%

-8%

19%

18%

10%

-9%

22%

Source: FactSet as of 6/30/18. *Based on consensus estimates of next 12-month EPS. Actual earnings per share might be materially different than shown. MSCI ACWI ex-US performance based on local currency.

Page 13

Performance

Has Active Relative Performance Troughed?

• As some of those factors reverse, active management has been doing better ‒ Interest rates not declining/bond-like equities not outperforming ‒ Non-U.S. stocks have fared better ‒ Small caps beginning to outperform ‒ Market performance more subdued

• Powerful cyclical factors impact U.S. active relative performance: ‒ Interest rates/bond-like equities ‒ Non-U.S. stock performance ‒ Small cap performance ‒ Overall market performance

% of U.S. Large Cap Active Managers Outperforming YTD

Active Relative Performance Is Cyclical

100%

68%

80%

54%

60%

40%

23%

20% % of Fund Assets Outperforming

Growth

Core

Value

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

2018

Source: Left chart: Nomura/Instinet, Joseph Mezrich and FactSet through 6/30/18. Fund performance is trailing five-year data of U.S. active equity mutual funds in existence for five years or more and part of the growth, growth & income, and income categories based on CRSP codes. Right chart: Bank of America Merrill Lynch U.S. Equity and U.S. Quant Strategy using Lipper data relative to Russell benchmarks through 6/30/18.

Page 14

Performance

Where to Hide from Tariffs?

• Small cap growth stocks began outperforming this year after steel and aluminum tariffs were announced, producing solid relative returns throughout the trade war rhetoric ‒ Small cap growth may be less affected than the broader market given less international exposure and more secular, as opposed to cyclical, growth drivers

Small Cap Growth Outperforms Amid Trade Tensions

Canada announces retaliatory tariffs

U.S. targeting tariffs on additional $100b of Chinese imports

110

U.S. preparing tariffs on China

EU warns of retaliatory tariffs on $300b of goods

105

Total Return

China refuses U.S. demand on trade

100

U.S announces steel & aluminum tariffs

Mexico announces retaliatory tariffs

Russell 2000 Growth / S&P 500

Dec-17

Jan-18

Feb-18

Mar-18

Apr-18

May-18

Jun-18

Source: FactSet, StreetAccount, and Alger.

Page 15

The Upside of Being Slow Fundamentals

• Why has the current economic expansion lasted so long and when will it end?

‒ A big part of the answer is the depth of the recession that preceded it and the rate of the recovery thus far ‒ Economic recoveries of comparable length have had far more growth than the present one, suggesting a long runway of economic expansion now

60%

1960

50%

1990

40%

1981

30%

Long runway to catch up?

1973

20%

1969

2001

Current

10%

Real Cumulative GDP Growth

-10%

Number of Quarters from Peak

Source: U.S. Bureau of Economic Analysis and Fred Alger, Inc.

Page 16

Fundamentals

Leading Indicators Suggest Continued Expansion

• The LEI historically leads S&P 500 EPS by 6-18 months

• Typically, changes in the Leading Economic Index (LEI) have preceded changes in economic growth • The rate of change of the LEI implies solid economic growth

• The record LEI reading in 2Q18 suggests EPS have room to run

15%

110

$170

10%

$150

100 GDP Growth YoY

18 Month Lead

S&P 500 EPS

$130

-5%

$110

-10%

-2%

$90

-15%

-4%

$70

Leading Economic Index

-20%

-6%

Leading Economic Index YoY

-25%

-8%

$50

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: FactSet, Conference Board. EPS estimates based on next 12-months consensus.

Page 17

Monetary Policy Is Not Restrictive Fundamentals

• Over the past half century, every U.S. recession has been preceded by a significantly positive real Federal Funds rate of 2% or higher

• In contrast, today we have a real Fed Funds rate of about 0%

Real Federal Funds Rate Prior to U.S. Recessions

10%

Today real short-term interest rates are far

lower than what induced previous recessions

Source: FactSet as of June 2018. Inflation represented by PCE Price Index ex-food and energy (year over year). Nominal Federal Funds rate is average of three months prior to recession. Horizontal axis labels denote recession periods.

Page 18

Business Spending to Accelerate Further Fundamentals

• Drivers of faster corporate expenditures include:

‒ Strong profit growth

‒ Tax reform—lower statutory rates, foreign profit repatriation, accelerated depreciation

‒ Higher business confidence—driven in part by lower regulation and certainty about taxes

‒ Accommodative financial conditions—banks’ willingness to lend and low credit spreads

Business Spending

15%

Robust earnings growth should help drive an acceleration in business spending

10%

Y-ear-Over-Year Growth

-5%

1Q16

2Q16

3Q16

4Q16

1Q17

2Q17

3Q17

4Q17

1Q18

2Q18

3Q18

4Q18

1Q19

Source:FactSet. Business spending is U.S. private fixed nonresidential investment with estimates (dotted line) based on a regression with S&P 500 EPS.

Page 19

Fundamentals

Economic Outlook

Tailwinds

• Robust corporate profits

• Strong business and consumer confidence

• Strengthening corporate spending

• Solid U.S. consumer balance sheet

Headwinds

• Tightening monetary policy

• Rising U.S. labor costs

• Potential trade wars

• China growth slowdown

• Geopolitical risk

Page 20

A Powerful Trend Fundamentals

• There have been various periods in history marked by fears of “trade wars”

• Over time, countries have acted rationally and reduced trade barriers

• While there may be more pain to come, ultimately we believe the powerful trend toward lower tariffs will prevail

‒ Active management may be able to take advantage of opportunities that arise

U.S. Tariff Rates

Time magazine cover on “Trade Wars”

Bush steel tariffs

Chicken Tax / European trade dispute

Japanese auto quotas imposed

Source: U.S. International Trade Commission and Alger. Tariffs are calculated as duties collected divided by total imports.

Page 21

Smaller Capitalization Stocks Poised to Outperform Fundamentals

• Stronger fundamentals : Estimated small cap EPS growth for ‘18 & ‘19 is double that of large cap

• More levered to domestic economy : Small caps are more U.S.-oriented and have less exposure to international trade friction • Rising interest rates : Small caps have historically outperformed large caps in rising rate environments • Reasonable valuation : Small cap P/E multiple premium is reasonable relative to history while a large sales multiple discount implies opportunity

Price-to-Earnings Russell 2000 / Russell 1000

Earnings Per Share

0% 10% 20% 30% 40% 50% 60% 70% 80%

R2000 R1000

200

180

Small Caps Growing Faster

160

140

Median

120

EPS Indexed to 100

100

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2017

2018

2019

Source: FactSet as of June 2018. EPS for 2018-2019 are consensus estimates and actual earnings per share might be materially different than shown.

Page 22

Fundamentals

The Growth Advantage

• Three variables drive P/E multiples: growth, returns, and risk

• As compared to the Russell 1000 Value Index, the Russell 1000 Growth Index has higher expected EPS growth, higher return on equity, and lower risk in the form of better balance sheets

Stronger Growth

Higher Returns

Lower Risk

R1000G R1000V

2.6x

25.5%

16.5%

10.4%

11.7%

1.0x

Long-Term EPS Growth

Return on Equity

Net Debt / EBITDA

Source: FactSet as of 6/30/18. Growth represents consensus long-term analyst estimates, and actual future EPS growth rates might be materially different than the forecasts shown.

Page 23

Addressing Rising Rate Concerns – Valuation Valuation

• Concern: Will rising interest rates weigh on P/E multiples?

• Our take: P/Es never priced in how low interest rates had become (see gap below) so we believe earnings multiples may not suffer when rates rise

S&P 500 EPS Yield

Treasury Bond Yield

16%

14%

Interest rates can rise without impact on stock valuations

12%

10%

>300 bps

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

Source: FactSet, Federal Reserve, and S&P, as of 6/30/18.

Page 24

Sector Valuations Vary Valuation

• Energy appears expensive given relatively depressed levels of earnings while health care looks inexpensive due in part to the perceived threat of pricing pressure

P/E Relative to 20-Year Median

27%

19%

14%

13%

-1%

-2%

-8%

Energy

Utilities

S&P 500

Materials

Financials

Industrials

Health Care

Real Estate

Consumer Staples

Information Technology

Consumer Discretionary

Source: FactSet, based on S&P 500 Index, 6/30/18. Note: telecommunications is excluded given its small number of constituents and pending reclassification. Real estate is a new sector classification, so for the historical data shown above, the industry group category that has nearly 17 years of data was utilized.

Page 25

Growth and Value Near Equilibrium Valuation

• Despite their recent outperformance, Growth stocks are not expensive compared to their Value equity counterparts relative to expected growth rates or history

Russell 1000 Growth vs. Russell 1000 Value PEG Ratio (P/E Divided by Long-Term Growth Rate)

Russell 1000 Growth Relative to Russell 1000 Value P/E

Current premium not egregious and far below tech bubble

220%

1.3x

Growth stocks are cheaper relative to long-term growth

1.2x

48%

Median

Russell 1000 Value

Russell 1000 Growth

Source: FactSet, Bank of America as of 6/30/18.

Page 26

Global Equity Multiples Reasonable Valuation

• Price-to-earnings multiples around the world are modestly higher than their historical average, which is reasonable relative to very low global interest rates

= current

Price-to-Earnings Multiple +/- 2 Standard Deviations from 15-Year Average

= +2 std dev

20x

= average

= -2 std dev

15x

EM is least expensive in

10x

absolute terms and relative to history

S&P 500 MSCI AC World MSCI EAFE MSCI EM

Z-Score (Standard Deviations Above/Below Mean)

0.9

0.5

0.2

0.1

Source: FactSet. Monthly estimates over past 15 years, ending 6/30/18.

Page 27

Valuation The Single Greatest Predictor of Future Stock Market Returns

• There is a strong relationship between starting valuations and ensuing 10-year returns

• Current valuations suggest equities should materially outperform bonds over the coming decade

S&P 500 P/E vs. 10-Year Returns

Russell 1000 Growth P/E vs. 10-Year Returns

= month

= current

peak of tech bubble

25%

R² = 0.79 (0.85 ex-tech bubble)

R² = 0.85

20%

15%

10%

-5%

-10%

S&P 500 10-Year Annualized Return

Russell 1000G 10-Year Annualized Return

Russell 1000 Growth Price/Earnings

S&P 500 Price/Earnings

Source: FactSet. Monthly data through June 2018 and beginning in January 1986 (S&P 500) and December 1978 (Russell 1000 Growth). The tech bubble, represented by the 10-year returns beginning in April 1987-March 1990 and ending in April 1997-March 2000, skewed the regression by resulting in higher returns for given valuations than the historical relationship would imply.

Page 28

Disclosure The views expressed are the views of Fred Alger Management, Inc. as of July 2018. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only.

Risk Disclosures : Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments.

The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small- capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The MSCI ACWI Index (gross) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The MSCI ACWI ex USA Index (gross) captures large and mid cap representation across 23 of 24 Developed Markets (DM) countries excluding the US) and 23 Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the US. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. ALCAPPRESSPR-0718 Fred Alger Management, Inc. • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com Page 29

Page 1 Page 2 Page 3 Page 4 Page 5 Page 6 Page 7 Page 8 Page 9 Page 10 Page 11 Page 12 Page 13 Page 14 Page 15 Page 16 Page 17 Page 18 Page 19 Page 20 Page 21 Page 22 Page 23 Page 24 Page 25 Page 26 Page 27 Page 28 Page 29

Made with FlippingBook - professional solution for displaying marketing and sales documents online