During the first quarter of 2018, U.S Equity markets have posted both record highs and sudden troughs, including a headline-capturing bout of volatility in February, which saw major global indices post their largest monthly declines in more than 2 years.
The Chicago Board of Exchange Volatility Index (VIX), often referred to as the Wall Street ‘fear gauge’ recorded its largest one day rally ever as investor complacency and the unprecedented build-up in low volatility Exchange Traded Fund positions, were suddenly interrupted in a timely reminder that Equities have a unique capacity to surprise, both to the upside, and in this instance, to the downside.
The catalyst for this dramatic sell-off? A report reflecting U.S non-farm payrolls and average hourly earnings rose by more than expected in January, raising the prospect of rising inflation in the world’s largest economy and the potential for more aggressive U.S Federal Reserve monetary policy tightening in the form of higher interest rates.
After an unprecedented period of ultra-accommodative monetary policy, as global banks sought to stimulate economic growth and restore financial market order post the Global Financial Crisis of 2008, equity markets had seemingly become immune to the prospect that at some stage the ‘normalisation’ of interest rates would begin. There was a perception that this would therefore have a negative impact on equity valuations in the form of lower excess returns over risk-free rates.
In the midst of this sudden, broad market downturn however, U.S companies on the whole, continued to announce record quarterly revenue and earnings results. Indeed, for the 4th quarter of 2017, S&P 500 companies reported their highest quarterly Sales and Earnings Per Share growth in over six years, assisted by the implementation of the Tax Cuts and Jobs Act which reduced the U.S corporate tax rate from 35% to 21%, and reduced the tax on repatriation of accumulated overseas income.
In addition, despite U.S indices closing at record highs in January, valuations based on forward earnings expectations have been trading broadly in line with historical averages.
S&P 500 Index Forward Price/Earnings Estimates – March 1990 to March 2018
Earnings growth, therefore, continues to drive equity price appreciation, despite the likely prospect of future U.S interest rate hikes. The U.S Federal Reserve, under the stewardship of new Chairman Jerome Powell, has stated that a gradual rise in interest rates is appropriate given current U.S economic growth. A measured, incremental approach to interest rate hikes in our view, should not cause undue earnings deterioration and consequent outsized equity price declines.
The Mutual Trust International Equities Portfolio philosophy is to invest in high-conviction companies reflecting a three to five year investment time frame. With a rigorous, disciplined in-house investment approach, we believe companies with strong recurring earnings and growth prospects, quality management, and a focus on shareholder returns and balance sheet discipline, will deliver sound returns over the medium to longer term, while successfully negotiating periods of enhanced market volatility.
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