Exxon versus Apple: Will consumption favor value over growth?
Consumerism hits a wall: Is this bad news for markets? (Part 2 of 12)
Growth prevails in the short run, value in the long run
The below graph illustrates how large-cap growth shares have outperformed large-cap value shares since 2008—with exceptional outperformance early in the recovery. Growth shares were exceptionally strong relative to value shares coming out of the 2008 crisis, and they still maintain their lead. However, as we note in the next article of this series, mid-cap value shares have outperformed mid-cap growth shares. This article takes a quick look at large-cap value versus growth shares in the context of deceleration in long-term consumption and overall economic growth.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Large-cap growth: Global blue chips with attractive dividends in a low rate environment
The Morningstar large-cap growth index’s largest holding remains Apple Inc. (AAPL), at 9.04% of holdings. With a $468 billion market capitalization, a 21.28% profit margin, a $52.91 billion operating cash flow, a 11.36 forward price-earnings ratio for 2015, and a 2.30% trailing dividend yield, Apple continues to attract equity investors. Despite slowing consumption data, Apple products continue to sell and have remained somewhat resistant to weakness in broad consumption data.
The Morningstar large cap value index’s top holding remains Exxon Mobile (XOM), at 8.88% of holdings. With a $405 billion market capitalization, 8.28% profit margin, $44.91 billion operating cash flow, 12.42 forward price-earnings ratio for 2015, and a 2.70% training dividend yield, Exxon Mobile remains a reliable large cap investment, with a dividend yield higher than the ten-year Treasury bond.
Consumption headwinds
Should consumption and overall growth data remain tepid, it’s likely that growth companies less dependent upon overall economic data, such as Apple, could continue to outperform value companies like Exxon Mobile, which could be more sensitive to broad economic growth and consumption data. Over the last year, Apple has risen near 25%, while Exxon Mobile has risen closer to 50%. However, should economic data decline drastically as a result of unexpectedly weak economic data, growth companies could be more vulnerable to short-term selloffs relative to large value shares with lower yet stable earnings, such as Exxon.
To see how consumption as a percentage of U.S. gross domestic product, or GDP, has weakened since 2010, please see the next article in this series.
To see how recent economic trends are impacting fixed income markets, please see Fixed income ETF must-know: Has the bear market in bonds begun?
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).
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