In a Post-Cycle World, Earnings Growth Is King

Investors are increasingly asking whether the macroeconomic growth cycle still exists, and, if so, where are we in it? The answers to these important questions have real implications for the way equity investors should think about their portfolios.

AllianceBernstein’s global economists recently downgraded their growth forecasts for next year. But, while the softer outlook suggests that economies and financial markets will be more vulnerable to the many risks they face, we continue to think a significant recession is unlikely.

For some investors, this is just the problem. It’s been 10 years since the last global recession and the macroeconomic and geopolitical risks are intensifying. Although markets have been more volatile over the past year, stocks have continued to climb. Stormier weather seems inevitable.

Small wonder then that investors would like some sense as to when the storm will break or at least some idea of where they stand in the investment cycle—and assurance that such a cycle still exists!

With today’s complex market realities, there are no simple answers. It is possible, however, to look rationally at what these uncertainties mean for investment and to map out how investors might learn to live with them so that they can continue to invest effectively for the long term.

Developed Markets Are a Challenge

Part of the uncertainty arises from the fact that developed markets—those with open, manufacturing-based economies such as Europe and Japan—are among the most exposed to the various risks (debt, demographics, low-productivity growth and the US-China trade war) affecting the global outlook.

For most investors, developed markets matter. After all, China is no longer the engine of global growth that it once was and India, despite its potential, is unlikely to become a second China anytime soon. While African markets are interesting, their contribution to world growth is likely to be incremental.

Developed markets are mature, however, and tend to grow slower than their emerging counterparts. Consequently, when growth and interest rates are low, as they are now, they are likely to stay lower for longer in developed markets than anywhere else.

This helps make the cycle very muted, but a muted cycle doesn’t necessarily imply an absence of market volatility. In a low-growth environment, for example, it’s not unusual for the economic data to slip into negative territory for one quarter and back into positive territory for the next.

A low-growth, high-risk environment can be a febrile one for investors, so it’s not uncommon for a single quarter of negative growth to be interpreted as a harbinger of recession and for investment markets to react accordingly.

Conversely, a quarter of good economic data might be taken as a sign of recovery—another, albeit different, reason for markets to become volatile. Given that this is the reality investors now face, what sort of stocks should they think about owning?

In a world of relatively low growth, investors should focus on businesses that can continue to grow despite the complex backdrop

Earnings Are the Bedrock of Equity Returns

The key, in our view, is to look for stocks with medium- to long-term growth potential based on idiosyncratic characteristics.

In a world of relatively low growth, investors should focus on businesses that can continue to grow despite the complex backdrop, in our view. That’s not as straightforward as it sounds. First, it isn’t always clear which companies can grow consistently; second, these companies are prized and therefore tend to trade at expensive valuations.

To deal with the first challenge, we believe investors should target companies that can grow consistently by virtue of competitive advantages, pricing power, resilient balance sheets and strong management. Characteristics like these can be identified objectively by in-depth, bottom-up research. The valuation question, however, is a much more subjective exercise that we will explore in a forthcoming blog.

Making earnings growth potential the centerpiece of an investment focus, rather than sectors or themes, can help create a varied portfolio. Examples of stocks that fit the bill, in our view, are diverse, including MasterCard, Microsoft and Temenos in the payments; cloud-computing and banking-software markets, respectively; Alibaba Group in the Asian consumer markets; and Eurofins and Genmab, science-oriented companies based in Europe.

Seeing Through the Uncertainty

We think this is a sound approach, but it’s not for investors who are underprepared. It requires an active management style and a concentrated portfolio with a small number of holdings to allow for the necessarily close and continuous research scrutiny of individual stocks.

Of course, some stocks will occasionally undershoot earnings expectations, even in more benign conditions than those prevailing today, so investment managers must learn from mistakes. But mistakes can be avoided, even in today’s tricky environment, by searching for companies with businesses that can withstand the current market and macroeconomic uncertainty and deliver long-term results.

Mark Phelps is Chief Investment Officer—Concentrated Global Growth at AllianceBernstein

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.