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Eric Papesh, US equity investment specialist at T. Rowe Price, talks us through the US market at the mid-point of 2022. With the US stock market going into bear market territory in June, we discuss why markets have performed so badly, if worse is yet to come and whether investors expect a recession in the US. Eric also gives his views on large vs small cap investments and if we’ve seen the last of US equity markets led the world stock markets.
In this interview, Staci West talks with Eric Papesh, US equity investment specialist at T. Rowe Price, about the performance of US equities so far this year. T. Rowe Price has two Elite Rated US equity products, the T. Rowe Price US Large Cap Growth Equity and T. Rowe Price US Smaller Companies Equity funds.
Please Note: Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.
US equities have had a bit of a rough start. They’ve actually had their worst start of the year period since 1939, and the US stock market went into bear territory in June. So, maybe just give us a little bit of a background overview. Why have markets performed so badly?
[00:36] It has been a very, very difficult start to the year for US equity markets and really equities globally. In many respects, you can think of the recent environment as somewhat of a hangover from some of the stimulus that we saw. Both in terms of monetary support and fiscal stimulus. And that is effectively fading right now. So, the stimulus led to pretty rapid increases in inflationary pressures.
And, in response to inflation, central banks – that’s the US Fed specifically – is trying to reduce aggregate demand to deal with inflationary pressures. So, raising rates. That is leading to concerns over slowing growth. So, between inflation rates and questions or concerns around slowing growth, those are all related topics. They’re very, kind of, influential on the next leg of equity markets. And I think those three things are really at the heart of some of the weaker results we’ve seen so far this year from US equities.
And, as you said, inflation is not a US issue, we’re seeing it globally, but in the US in particular, do you think that this kind of performance or this market has bottomed now, or do you actually think there’s worse yet to come?
You can think about it in terms of time, and the duration of the correction that we’ve seen, or price in the magnitude of the recent sell-off. In terms of price, we’re getting close to a level that has been in line with historical corrections or recessions. 20-25% has been kind of the median correction that we’ve seen in economic recessions in the US since the World War II period. I think markets year to date are down in the range of 20ish%. So, from a price standpoint, we’re in line with what the median returns have been.
From a time standpoint, it seems like we’re still a little early in this, in terms of where we’re at on some of those issues I mentioned a moment ago; rates, inflation and growth. So, from a timing or a duration standpoint, it seems like we’ve probably got a little ways to go.
Having said that though, I do think that a lot of concerns or questions are reflected in current valuations. So, the markets are down meaningfully year to date. From the beginning of the year, the estimates – earnings estimates – have actually increased, the next 12 month estimates have actually increased by about 7-8%.
So, earnings have not been the thing that has been driving the weakness in the equity markets, it’s been the price investors are willing to pay for that stream of earnings. So, the price to earnings multiple on the market has come down meaningfully, from 22 times forward earnings at the beginning of the year to about 16 times for earnings today. So, I’d argue that a lot of the questions or concerns are more reflected in the price of the market today.
You touched on it a bit there, but we are getting these mixed messages about the US economy. Either being: Is it strong? [Or] are we about to go into a recession? So, what is, what is your view on that? Do you see the US economy going into a recession or rebounding quite strongly?
[04:52] Yeah, here at T. Rowe, we don’t have one view. We don’t have a house view on the direction of the market or the economy. And to be honest, there are a number of investors with differing views on this question specifically. So, I’ll offer my own perspective.
I think we are fairly early in terms of addressing inflationary pressures. The real rates in the US are still deeply negative, inflation is still meaningfully higher than the Fed wants to see it. So, I think they will continue to tighten financial conditions just in aggregate to deal with inflation. And I think that is going to continue to put pressure on the economy.
That is ultimately – their goal is to slow the economy down. The challenge that they’ve got is to arrive at this soft landing that everybody talks about. IT’s a difficult goal. It’s a difficult task to execute on or deliver on. There is certainly a reasonably high probability that we will see a contracting economy. So, a recessionary environment.
I think it’s not a binary ‘will we see a recession or not?’, but I also think you need to factor in the depth of any recession. So again, I think it’s a reasonably high probability that we will experience declining economic growth. But I think the duration of any decline is likely to be pretty modest.
And then that’s in part due to the fact that the average corporate entity in the States is in a really pretty healthy position in terms of their underlying balance sheets. Similarly, I think the broad kind of consumer in the US is in a pretty healthy position as well. So, strong balance sheets on the corporate side and on the consumer side, would probably minimise the depth of any impending recession. – if in fact we see one.
And again, I appreciate this might not necessarily be a house view, but for you, do you think that the large cap space or maybe even smaller companies in the US, potentially even mid-caps maybe to an extent, are offering better value for investors given everything that we’ve just talked about being so up in the air and unpredictable? Do you have any thoughts on where you think the better opportunity might be at the minute?
[07:51] Absolutely. So, I think within the US equity market today, the small and mid-cap segment is very attractive currently. And there’s a few points I’ll offer there. So, I think having a dedicated exposure to the smaller end of the US equity market is a very prudent strategy. Very exciting companies down cap, smaller cap companies, a lot of growth and innovation takes place just generally in the smaller end of the market. The ability of active managers to add value – add alpha – there, I think is very exciting and interesting as well. Currently, the valuations of smaller companies compared to large cap companies in the US are very, very attractive.
If you look back historically from kind of similar starting points, in terms of valuations, you’ve tended to see meaningful outperformance from small caps over kind of 6-12 months following the level where we’re at today. So, there’s a strong valuation argument in favour of small caps today.
I think the recent kind of reports that we’ve seen from small cap companies have tended to be better than for their large cap competitors as well – and the revisions. So, the most recent updates in terms of analysts publishing updates to their estimates have actually been better – strong results recently. Things have generally been improving for the average small cap company at a faster rate than they have for large cap companies.
The other thing I’ll highlight too, is if you look back historically from market lows or from recessions, small cap companies, on average, have really done well coming out of the downturn effectively. So, going back to my initial comment, I think it’s a very good place to have dedicated exposure to. And I think the tactical setup currently is more attractive than normal. So, I would certainly encourage investors to have some allocation to the smaller end of the market today.
That’s very interesting. And lastly, so the US equity market has led world stock markets over the past decade. Do you think that time has come to an end and other markets will do better going forward?
[10:37] That’s a good question. I wish I had a crystal ball and that I could tell you with a lot of confidence. The US equity market has really delivered exceptional results over the last decade. I think that the three-year number is plus 25% annually, so exceptionally strong results recently. We’ve seen a little bit of a give back in terms of leadership so far this year. I think markets outside the United States have delivered a little bit better performance compared to the US equity mark – 3-4% year to date. So, not heroic, but on the right side of the ledger effectively.
I think the profitability, within the US equity market, is a big reason that the market has delivered the returns that it has. The profitability metrics are at a much higher level in the US versus markets outside the US. And at the same time, the growth that has been delivered has been meaningfully better as well. So, with the right higher levels of profitability and rapid growth, you would expect to see better performance from those types of companies on average. But the more recent period has been a little bit in favour of markets outside the US.