Invesco: 'End of cycle' mentality alive and kicking

The trends we described last quarter - rising interest rates, tightening liquidity conditions and trade protectionism remained evident in Q3. On top of this we observed runs on a number of emerging market currencies (Argentina and Turkey in particular) which caused a degree of contagion to all other emerging market currency and stock markets.

Invesco Global Opportunities Fund (UK) Q3 2018

The intensity of trade protectionism activity continued to ratchet up; it has now begun to have a direct impact on corporate profitability. It is also manifesting itself in an ‘end of cycle’ mentality amongst investors which is driving significant underperformance in cyclical stocks.

A number of corporations in the automotive and industrial spheres have reported sharply rising raw materials costs driven by both tariffs and commodity price increases. In the US there is added pressure from tightening labour market conditions and rapidly rising freight costs. It will be important for markets to determine how sustaining this inflationary pressure is. Our judgement would be that global interest rates are materially mispriced if it turns out to be more entrenched.

Companies haven’t yet had time to pass these cost increases on to customers and so there is a (temporary) margin squeeze being encountered. The automotive industry has also suffered the added headache of having to comply with new ‘WLTP’ (Worldwide harmonised Light-duty vehicle Test Cycles) emissions regulation which has caused serious production bottlenecks.

The trade war is only one element of a very challenging geopolitical backdrop. In general, politics remains very unpredictable. In Brazil we are approaching the conclusion of a very hostile general election. In Europe there is much uncertainty around Brexit negotiations and Italian fiscal concerns have once again boiled to the surface.

In short there is an awful lot of uncertainty around. While we have been very challenged by some of these issues we are enthused by the number of attractively priced equities currently on offer in the market. As ever, uncertainty tends to create opportunity for the patient investor.

The geo-political uncertainty has manifested itself in even ‘narrower’ stock market leadership. Those companies which have been able to demonstrate a degree of resilience to these macroeconomic and political challenges have continued to re-rate on account of their scarcity value. To provide some context on this phenomenon we have analysed the year to date returns of the MSCI AC World index (see Figure 1) where 66.8% of the index return has come from FAANMG stocks.

The US technology heavyweights listed above have contributed 2.05% to the overall (3.07%) return of the global equity market this year. The seven stocks (above) have contributed two thirds of this year’s market return despite accounting for only 8% of its market capitalisation.

To be clear, we are not using this as a justification for the relative underperformance of the Invesco Global Opportunities Strategy versus the MSCI AC World index in Q3 but more to explain the nature of the market backdrop we are operating in. The market is (understandably) rewarding stocks that deliver very consistent growth in a world that has become more uncertain. Figure 2 shows that the top quintile of companies, by revenue growth, in the US equity market has delivered almost unprecedented relative returns in 2017 and 2018.

The empirical evidence going back to 1952 suggests that the current environment is quite rare. It also has a concerning symmetry with the lead up to the tech bubble of 1999. We see worrying evidence that stocks are being driven to elevated valuation multiples by virtue of their current growth trends. The crowding of investors into this narrow group of stocks opens up the potential for permanent capital loss should the market re-appraise the sustainability of that growth or perhaps in the case of ‘Big Tech’, consider the spectre of increased regulatory interference.

Alternatively the market may reappraise the risk premium it is placing upon more traditional companies which exhibit lower (more cyclical) growth patterns. We can find many fine companies trading on multiples which, in our eyes, price in a significant deterioration in earnings power but where we are likely to benefit from sound balance sheets, astute management and strong industry positioning.

While the trends in market leadership described above are quite evident globally there has been one notable exception. In China the ‘big growers’ have strongly detached from their US counterparts on account of trade war concerns and some signs of regulatory interference (see Figure 3).

We find this divergence quite intriguing. Firstly it should act as a reminder that stocks with lofty valuation multiples can be quite sensitive to a reassessment of their earnings growth trend. Perhaps it should also remind investors that these companies have gotten to such a size and level of societal influence that regulatory risk is becoming a more credible threat.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

The strategy may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of a portfolio. The Manager, however, will ensure that the use of derivatives does not materially alter the overall risk profile of the strategy.

Although the strategy does not actively pursue a concentrated portfolio, a portfolio may have a concentrated number of holdings on occasions. Accordingly, a portfolio may carry a higher degree of risk than one which invests in a broader range of companies or takes smaller positions in a relatively large number of holdings.

Important information

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

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Stephen Anness - Fund Manager

Andrew Hall - Fund Manager