Assessing Equities in a Volatile Environment


February 09, 2016

U.S. stocks (S&P 500 Index) have declined approximately 10% year-to-date, marking one of the weakest starts to a year on record. While concerns have been well articulated over the past year about headwinds facing U.S. equities, including the impact of a slowdown in China on the global growth outlook, the plunge in oil prices, and the Fed’s intent to normalize interest rates, the latest bout of market volatility has revolved around incremental worries that these concerns might be telegraphing a pronounced risk of a U.S. economic recession in the near term.

The U.S. economy grew only 0.7% in the fourth quarter of 2015 on an annualized basis and industrial production turned negative in December, down 0.4% month-over-month, which is often associated with a recessionary growth environment. The strength of the U.S. labor market has been a bright spot in the macro picture over the past several years, but Friday’s mixed January employment report, in which nonfarm payrolls grew by 151,000 jobs, came in well below the market’s 190,000 job expectation. Although average hourly earnings were up an encouraging 2.5% year-over-year, the fact that job growth has faltered is a source of concern. At the same time, the renewed plunge in crude oil prices has heightened anxieties about potential losses associated with lending to the energy sector and exacerbated concerns about the global growth picture. In addition, China’s erratic policy response with respect to monetary policy and management of the Yuan exchange rate have stoked fears of an acceleration of capital flight from that country and the prospect of a currency devaluation or the re-imposition of capital controls. Against this backdrop, investors have struggled to reconcile the Fed’s hawkish December guidance of roughly four additional rate hikes in 2016 with mixed macroeconomic data that is pointing to a still-fragile U.S. economic growth environment.

Despite the deterioration in the global growth outlook and the prospects for the U.S. economy itself, our base case remains a slow-growth environment for the U.S. economy rather than outright recession. To be sure, worries about earnings have spread from isolated concerns about the energy, materials, and industrials sectors to the broader market, but we believe that corporate earnings can remain resilient in a 2-2.5% GDP growth environment. Given the generally high correlation over the long run between earnings growth and stock returns, the equity market sell-off reflects investors’ worries that the weak macro backdrop will translate into an “earnings recession.” We are presently about two-thirds of the way through the fourth quarter 2015 earnings season, and S&P 500 earnings are down approximately 5% year-over-year. Stripping out the negative impact of energy earnings, overall earnings growth is roughly flat. At the same time, forward guidance has been decidedly poor, and profit margins have receded from their record high levels. The stock market has responded with a strong rotation out of growth names and into lagging cyclical stocks and more defensive utilities, staples, and telecom names.

U.S. stocks appear fairly valued, with the S&P 500 Index trading at approximately 15 times forward earnings, which is in line with the long-term average of the past several decades. Consensus earnings growth expectations for this year have been revised downward to around 8%, but further downgrades are likely given the preponderance of negative guidance during the present earnings season, particularly in the energy sector. That said, it does not appear unreasonable to expect mid-single digit earnings growth to the extent that the U.S. economy continues to grow on at least a 2% trajectory. There is certainly the possibility that a further deterioration in macroeconomic data could tip the economy into a slump, but U.S. companies have demonstrated their ability to manage their business operations effectively in the slow growth macro environment given their generally manageable debt burdens and continued drive toward margin sustainability. In the near-term, however, investors should be prepared for continued heightened volatility given the uncertain global growth outlook and the data dependent nature of the Fed’s strategy for hiking interest rates.

Portfolio Strategy

Although we expect economic growth prospects for the U.S. to remain within a subpar trajectory, we continue to identify outstanding companies whose businesses either enjoy superior secular growth prospects or whose stock valuations appear attractive in relation to their earnings growth. When the stock market experiences bouts of volatility and equity prices diverge from companies’ underlying fundamentals, we utilize these opportunities to adjust portfolio weightings as we strive to generate strong long-term returns for our investors.

Given our intensive bottom-up, fundamental research effort, we believe we are well-positioned to exploit market turbulence while staying resolutely focused on quality, balance, large addressable markets, sustainable business model advantages, and compelling long-term valuations for many secular growth-oriented companies. We also continue to identify niche value-oriented opportunities in diverse areas ranging from healthcare and financial services to the housing and energy industries.

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2019 TCW