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Peter Hardy, senior client portfolio manager, global value equities, for American Century Investments.
It’s funny how things change so quickly these days: less than a month after hitting all-time highs, the market fell by the 6% amount on concerns about the health of the global economy. While this type of volatility can be startling when it occurs, it’s been the norm historically. So we have seen a period of abnormally low volatility and then over the last year we’ve just returned to a period of more normal volatility—not even high, but normal.
Since that sell-off in early August, the market has since bounced back, with riskier growth stocks as the market leaders. And most U.S. benchmarks are up high teens year to date through late August in 2019, and the growth benchmarks are up over 20%. So, when looking at the entire year period, though, there is a very different picture: the volatility in the fourth quarter, the sell-off in April and early May, and now the sell-off in July. The one-year returns for most U.S. benchmarks are flat. And we have done well in that environment by protecting on the downside and keeping up in the up market. So we’re up 7% over that one-year period. Basically volatility can be our friend and we’re very good at managing through volatile periods.
So with that backdrop, let’s discuss trade war fears. Are our trade war fears overstated? Well, the simple answer is: yes and no. That’s because there are two components to the trade war issue. First is a valuation component—how we value individual businesses—and the second is a global economic growth or global asset valuation standpoint, where the markets are valued very differently than than our underlying approach.
So when valuing a business, our approach has always been conservative in that we tend to use conservative assumptions and take a long-term view towards valuation. The specific inputs to our valuation approach are normal returns—and by normal we look at the prospective average return level for a company over the, say, next five to 10 years, and and apply a normal valuation. One way we are conservative additionally is that we don’t use best-case returns in our assumptions because that’s when companies can be overvalued. We also look at the downside potential of a company from a return standpoint, apply a downside valuation, and then based on where the stock is trading of a company, we can see the discount to its normal valuation and the premium to its downside valuation. That’s how things look attractive to us.
For the most part, when looking at the impacts of tariff or trade wars on our individual businesses, the market reaction has been greater than what we would anticipate the valuation impacts being. Basically our belief is that increased costs resulting from tariffs, while impacting short-term earnings, does not impact the long-term return on capital assumption that we make. Cost can be passed on to customers and then any issues resulting from a geographic location of a facility can be mitigated by moving facilities over time.
So Intel is a company we own at a lower weight. It’s attractive but not as attractive as some other names in our quality universe. But it’s a good example. Intel’s clients, customers, are large computer brands or contract manufacturers in China. So from a a direct tariff standpoint, they would be impacted. However, Intel has largely built their supply chain in a “China for China” fashion, and they have manufacturing facilities in the U.S., Ireland and Israel. By virtue of that, it mitigates some of the tariff issues associated with Chinese exposure under our valuation approach. And that would be where we see the impacts to Intel in the stock reactions based on trade war fears being overstated. We’re going to be very vigilant and continuing to evaluate this situation. But that would be the basic point why we say trade war fears are overstated.
On the other hand, trade war as a potential risk to asset prices is a very real one. We’ve previously discussed how we see valuations of really all assets as full or overvalued. There are several reasons for this. One, a super accommodated monetary environment where interest rates are low, yields are negative and central banks have been purchasing assets. This easy monetary environment has led to more worldwide debt and made that higher level of debt more serviceable. Alongside of this, global growth has been stable and companies have been financially productive. The volatility that we’ve seen over the last year has largely been caused by concerns about global economic growth, which bring into question the sustainability of high worldwide debt levels.
China has been a backbone of global growth and the growth in China has been fueled in part by large increases in debt. So issues in China could exacerbate a slowdown there. Any Chinese slowdown could result in further global economic slowing, and tariffs and trade war are potential accelerants to Chinese slowing. Point being that there are risks present in the current environment. We’ve seen volatility come back in the market as the risks have become more evident, and this volatility is likely to persist in the future, in 2019 and 2020. Our approach has been one that has provided protection in periods of market volatility and reasonable returns as the market is going up, and that is why we’ve been doing well.