Back to July 2019

Safe haven

By Goh Thean Eu  
  • Asia
  • Global
  • USA

Amid trade tensions and slowing growth, large-cap stocks may outperform

Large-cap stocks have always been popular among investors because they are well-researched, relatively defensive in nature and, in many cases, pay dividends to shareholders on a regular basis.

Even so, these stocks have had a choppy ride in the first half of the year. Investors started off 2019 on a cautious note after a disappointing end to 2018 when major stock markets tumbled.

But within a few days, investor sentiment improved amid hopes of a successful conclusion to negotiations to end the US-China trade war. However, sentiment turned when those hopes were dashed and the two largest economies in the world resumed threats of tit-for-tat tariff hikes.

Nevertheless, major stock markets are still in positive territory, an indication that large-cap stocks which are typically constituents of stock benchmarks are still performing well.

The Dow Jones Industrial Average gained 14.54% between January 1 and June 23, Hong Kong’s Hang Seng Index rose 10.42%, Japan’s Nikkei 225 was up 6.21%, and South Korea’s Kospi was up 4.33%.

Large-caps versus small-caps

Large-cap stocks underperformed small-caps modestly in the first five months of the year.

The MSCI ACWI Large Cap, which gauges the performance of large-cap stocks across 23 developed markets and 26 emerging markets, rose 9.2% between January 1 and May 31. The MSCI ACWI SMID Cap Growth index, a yardstick for mid and small-cap stocks in those markets, rose 11.93% over the same period.

David Ng, chief investment officer and deputy chief executive officer of Affin Hwang Asset Management, says small and mid-cap stocks outperformed mainly because they tend to have greater sensitivity to market movements.

“This means, small-cap stocks tend to do worse [than large-caps] when the overall market is weak, and also tend to do better when the overall market is strong,” he says.

Smaller stocks also tend to be more volatile because they are less liquid, and are also more vulnerable to economic weakness, he adds.

Under-owned large-caps

The data also suggest that large-caps in Asia underperformed counterparts in developed markets. The MSCI World Large Cap index rose 9.86% between January and May while the MSCI Asia Pacific ex-Japan Large Cap Growth Index was up 6.13%.

The US-China trade war had a “big impact” on Asian large-caps because Asian nations are more dependent on export-driven growth compared to the US, according to Felix Lam, senior portfolio manager for Asia Pacific equities at BNP Paribas Asset Management.

“As a result of the trade war, a lot of goods and services from Asia, and China especially, will be much less competitive than before, therefore trade impact will be large in China than those in the developed markets,” he says.

He also points out that Asian large-cap stocks are relatively under-owned by institutional investors compared to large-caps in the West for a number of reasons, including accessibility and limited information flow.

“However, we believe over time this will improve and expect more institutional investors to invest in Asian large-caps, as Asia has become fertile ground for companies looking for long-term growth opportunities amidst the boom of its middle class,” Mr. Lam says.

He is of the view that the performance of Asian currencies against the US dollar is the main factor that could drive the expansion of institutional ownership in the region’s large-cap stocks.

“We believe that the key is lower volatility of the currency market against the US dollar. This allows investors to have more chance to stay invested in the medium term, and more inclined to stay through any market cycle,” he says.

Looking ahead

The outlook for large-caps largely depends on the economy and how the trade tensions play out. The global economy is slowing and there are fears of a looming recession in the US. In such an environment, large-cap stocks are expected to do better than the small-caps, at least over the next 12 months.

“Large-cap corporates tend to be more resilient than small-cap companies. As such, we believe risk-reward dynamic is better in the large-cap space,” Mr. Ng says.

The US-China trade war will likely continue to keep markets on edge. Indeed, there are some, including Julian Cook, a portfolio specialist at T. Rowe Price, who are surprised that markets have held up well thus far amid the trade conflict between the world’s largest and second largest economies.

“It is certainly a factor that is worth considering, though the ability to reliably predict the outcome is far more nuanced, and the effects and compliance of any deal play out over a far longer time frame than most are willing to consider,” Mr. Cook says.

He also says investors should probably accept that the risk of a US recession has increased, although he isn’t forecasting a slump in the next 12 months.

He argues there are as yet no consistent data supporting the three things which he says normally “kill” an economic cycle – accelerating inflation, collapsing profit margins, and rising interest rates.

He points out that US corporate earnings are currently expected to grow at a high-single-digit to low-double-digit rate, and that the US stock market is within 1.5% of reaching a record high.

“We do not see the next 12 months as a ‘risk off’ environment though we are spending more time being cognisant of the potential effects a recession could have on companies that we hold and would like to buy,” he says.

Mr. Cook is also keeping close tabs on yield curve inversion as yields on short-term debt exceed those for long-term bonds. “It is something we are paying a lot of attention to as it may impair companies’ abilities to fund and finance their businesses,” he says.

The challenges

When it comes to investing in large-cap stocks or managing a large-cap fund, one key challenge is to find good companies at low valuations because typically, the stocks are already widely invested and tend to be fairly priced or expensive.

“Despite the difficulty, it is still possible to find and invest in great companies at reasonable valuations. This is also an area where active managers try to add value,” Mr. Ng says.

For Mr. Lam, the key is to focus on supply factors. He believes the emphasis has too long been on demand-side factors, and not enough on the supply-side. For example, in the case of Chinese manufacturers, he argues that the market has been focusing on factors such as export sales and projects, whereas the strength of manufacturing facilities, manpower, and entry barrier for products are also very important.

“When you think about it, if the supply is in good shape, it means the market structure is good, and the players can easily increase the price during the good times,” he says.

He acknowledges that analysing supply-side factors isn’t easy. “The fact that it is more difficult to analyse means a lot to us, it allows us to be more competitive in this area,” he says.

Uncertain times can also yield good investment opportunities.

“It may sound unusual, but we tend to like periods of uncertainty as that presents opportunity through market inefficiency,” Mr. Cook says.

What’s important is to maintain investment discipline, and to build portfolios from the bottom up. “We let valuation dictate the entry or exit rather than the price,” he says.

Risk management is key for Mr. Ng, who says it’s important to be diversified across different countries. He says his firm has reduced its exposure to export-oriented companies that could be hurt by US tariffs, and technology companies which are affected by US sanctions on China’s Huawei Technologies.

He has also pared holdings in consumer discretionary stocks such as automotive companies in light of the fact that people tend cut back on discretionary spending when the economy slows.

Mr. Ng say dividend stocks benefit in the current environment. These include real estate investment trusts, utilities and telecommunication companies.

“These businesses tend to be less vulnerable to slowing economy. Trade war or no trade war, most of us will still pay our monthly rent, electricity bill and phone bill,” he says.

According to Kathryn Koch, co-head of fundamental equity at Goldman Sachs Asset Management “intriguing investment opportunities” may be found in companies that are “benefiting from secular growth opportunities that could persist, irrespective of the market cycle”.

She says demand from millennials may become the main driver of growth in these companies. Numbering around 2.3 billion, millennials are the largest population cohort in the history of the world, and they are either entering or already in their prime earning years. Millennials, she says, have become the world’s “most powerful consumer”.

“Because millennials are spending their money differently to previous generations, they are causing huge disruption to established businesses across the world. They are also creating many opportunities for companies whose products millennials use and desire,” Ms. Koch says.