The Australian and global economies have performed strongly over the last decade, supported by historically low-interest rates. During this time growth companies have powered ahead, strongly outperforming income and value-orientated stocks on the share markets.
However, some commentators are now questioning whether this golden scenario for growth stocks will continue – or if its days are numbered.
We outline five questions that investors should be asking to decide if we are now nearing the end of the cycle for growth stocks or if there is still plenty of fuel left in the tank.
1) What will be the impact on growth companies of rising interest rates?
While Australian domestic interest rates have remained firmly anchored at the historic low of 1.50% since August 2016, companies are already feeling the impact of rising rates across the globe.
The structural change in borrowing costs is starting to impact consumer confidence as house prices fall, especially in Sydney and Melbourne which saw the steepest valuation increases. Heavily indebted homeowners, some of whom are being shifted from interest-only to repayment mortgage products by their lenders appear to be especially vulnerable to higher rates.
Increasing borrowing costs will also impact company earnings directly and raise the rate of return threshold for new investments. Those borrowing offshore in US dollars are facing the double whammy of both higher interest rates and a volatile exchange rate.
Investors should be alert to the impact of such trends, which can be expected to foreshadow a turning point in the growth cycle.
2) What is happening to company earnings?
A feature of rational markets is the relationship between earnings growth and share price appreciation. Whereas valuations normally follow profit trends, we are seeing signs that this relationship is starting to diverge. This is seen in company price to earnings ratios which for some growth companies are reaching multiples that can only be justified if current growth trajectories accelerate, before continuing in perpetuity.
Some growth stock valuations will come to be validated, such as when overseas expansion plans currently in their early stages, are successfully executed, transforming the scale of their companies.
However, investors should watch carefully to ensure that earnings on markets and individual companies are on track to justify the currently lofty valuations of growth stocks.
3) What is happening to credit quality?
It is a feature of the business cycle that sustained economic growth and equity returns over a period almost inevitably give rise to strengthening investor confidence across asset classes. This can be especially reflected in credit markets.
Corporate leverage is high across global markets, but especially in the US. Markets tend to be relaxed about this in times of low interest rates when borrowing costs are manageable, however this will clearly not always be the case.
Bonds rated BBB, the lowest tier of investment grade debt, now account for 49% of the overall global investment grade corporate market, compared to 25% at the time of the GFC. Furthermore, total bank lending to US corporates has risen and lenders are now less cushioned by unsecured bonds, suggesting bank recoveries will be lower in any future credit event.
Credit spreads, the additional yield above risk-free government bonds, at which corporate bonds trade, have not yet blown out significantly. However, investors should monitor the situation closely for signs that the debt markets are recognising a turning point in the cycle.
4) Will there be a recession in the US?
The US is the only major market where the path of rising interest rates is well established, and thus can be assumed to be in the later stages of the economic cycle. US rate hikes are expected to continue throughout this year and 2019 with a possible cut in 2020. Fixed income markets are pricing in a slim chance of a recession in that year.
Full employment levels suggest the US economy has limited capacity to accelerate further in the absence of a productivity boom. Further trade barriers may well act as an impediment to excess US demand being absorbed without creating inflationary pressures. Hence any future increase in demand at a time of constrained supply growth may potentially lead to higher inflation. This would likely lead to tighter monetary policy than expected by investors, potentially giving rise to a recession. A US recession would almost certainly bring global earnings growth to a juddering halt.
Investors should be alert to signs of growing excess in the US economy that would require higher interest rates than currently expected by markets.
5) Are those in the know buying or selling?
Company directors are obliged to report their share dealings in their own companies. Whereas modest net sales are not uncommon – often for non-investment reasons – a widespread pattern of insider selling may well indicate that earnings and valuation levels have reached levels that are unlikely to be sustained. Such sales have risen over the last six-month period.
Investors should watch these trades closely as we enter the later stages of the business cycle as they can provide clues that the growth of companies or wider economies is reaching a turning point.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.