During the third quarter, U.S. equity prices fell 10 percent for the first time in more than three years, leaving the market at lower year-on-year levels for only the second time since 2009. The recent falls came on the back of two major concerns from China: the Shanghai Stock Exchange’s swoon and the devaluation of the yuan.
With so many U.S. companies now heavily involved in international business, it is no surprise that troubles in the world’s second-largest economy caused investors some angst. The obvious losers were the commodity producers, but as market volatility increased and risk aversion spread, investors sold holdings in the once popular health care group as well. Only utilities remain in positive territory for the quarter.
All of this has left investors asking whether the terrific run in U.S. equities since 2011 is over. Is the setback a buying opportunity or the beginning of a more serious downturn?
To answer that question, let’s start by looking at profits. In contrast to the sharp move in stock prices, the profit expectations held by us at J.P. Morgan Asset Management haven’t really changed much in the past three months. We have continued to reduce forecasts for companies most exposed to weaker global growth and lower commodity prices. In particular, our energy forecasts have dropped and now stand at only one third of 2014 levels.
Technology companies are also facing a weaker near-term operating environment as smartphone sales slow and the personal computer market remains in decline. But in many other industry groups, the trend is much better. Most management teams that we meet with are pretty confident about demand in the U.S., and Europe seems to be slowly improving as well. The strong U.S. dollar is having a sharp impact on foreign earnings, although on that front, the severity likely peaked in the quarter that just ended. So we think that with commodity profits already very depressed and the U.S. economy in reasonably good shape, the near-term outlook will start improving again.
Our long-term forecasts haven’t moved much over the past few months. We think that the benefits of globalization that have accrued to so many U.S. multinational companies will persist for the foreseeable future, although we are carefully watching competitive threats from both low-cost developed countries after recent currency moves, as well as emerging winners in the developing world. So far, we haven’t seen too much cause for concern. We still perceive a meaningful opportunity for energy and materials profitability to bounce back along with commodity prices over the next couple of years. In some segments of the technology sector, we see more pressure ahead on profits for companies that are likely to lose out from the growth of the public cloud, while smartphone sales, a huge driver of profits in recent years, are also not likely to grow much more. Overall, however, we think there are enough positives to keep profits increasing at a high-single-digit rate over the next five to seven years.
If that’s correct, the market’s current valuation of about 16 times forward earnings looks reasonable to us, although prices have quickly bounced back from more attractive levels reached briefly in mid-August and again in late September. The clear risk is that we are wrong to think that this economic cycle has years to run, and instead the world economy slips back into recession. Credit markets are beginning to suggest that is an increasing possibility, though we aren’t yet seeing other warning signs. Outside the U.S., the outlook in Europe seems to be a little brighter, although news from Asia and Latin America remains bleak. Meanwhile, lower long-term interest rates favor the equities market over bonds.
So we’d expect reasonable returns, although with an increase in volatility as the economic cycle continues.
Paul Quinsee is chief investment officer of U.S. equities at J.P. Morgan Asset Management in New York.
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