Ceasefires and Trade Deals Lift Sentiment
Investors appeared unusually calm last week amid skirmishing between nuclear powers, several interest-rate announcements, and the outline of the first trade deal negotiated by the current administration. The Morningstar US Market Index fell slightly while 10-year government bonds and the US dollar remained stable. Following news of a ceasefire between India and Pakistan and a trade deal with China, sentiment is likely to be positive as we enter the new week.
While investors naturally welcome progress on these issues, it is important to avoid complacency in positive market environments in the same way that we seek to avoid panic when the outlook appears negative. This is best done by comparing the current price of assets to a reasonable estimate of their fair value. You can access Morningstar’s fair value assessments through the Markets page, which includes a style box assessment of value. This shows that while there are fewer opportunities for investors among large companies, attractive valuations persist at the smaller end of the market.
Investing Globally
Several markets outside the US also remain attractively priced while benefiting from more positive investor sentiment over the last few months. This is illustrated by returns for the Morningstar Developed Markets ex US Index, up nearly 13% and the Morningstar Emerging Markets Index, 5% higher over the year to date. To review the case for international diversification, check out Daniel Noonan’s latest column.
The most noticeable movement last week was in crude oil prices, which rose 9%, supporting US energy companies. This sector remains undervalued in the view of Morningstar’s analysts, with four of the top five companies, accounting for 51% of the index, rated 3 or 4 stars and an average unweighted discount of 17.5% across the sector.
Energy Stocks Are Volatile but Can Hedge Inflation
The negative sentiment toward energy companies follows a period of weak energy prices that reflect concerns about the oversupply of oil into an environment of weakening demand that has seen earnings fall by 12.7% over the last 12 months. This outcome contrasts sharply with a 13.4% rise in earnings across the market, according to FactSet. Energy companies can be difficult to own as an investor due to the price volatility of their product. However, they can be a useful portfolio component in the event of high and rising inflation. You can find Morningstar’s list of undervalued energy stocks here.
Alphabet Under Pressure
In contrast, the US communication services sector was the weakest, driven primarily by Alphabet GOOG, which declined 6.9% following testimony by Apple AAPL executive Eddy Cue about the future of the company’s relationship with Alphabet in a Department of Justice lawsuit. Morningstar’s Alphabet analyst Malik Ahmed Khan believes the investor reaction is “overblown” and is maintaining Alphabet’s fair value estimate unchanged. Consequently, the stock now appears very undervalued. For more details on Khan’s view, see this article.
Inflation Back in Focus
The attention of market commentators this week is likely to return to inflation and the impact on interest rates. Consumer Price Index data is due on Tuesday: the annual rate is expected to have held steady at 2.4% in April. You can follow the release of this data on this calendar. The week is also peppered with speeches by Federal Reserve officials that will be watched closely for signs of changing monetary policy. For Morningstar’s take, check out this article by our senior US economist, Preston Caldwell.
Economics and Stock Markets
While markets are likely to be driven by the dynamic geopolitical and economic backdrop this week, economically driven changes in asset prices can be swiftly reversed and are not a reliable forecaster of returns. Successful investors typically take a longer-term perspective and focus on the fundamental earning power of companies and the valuation of assets rather than the shifting sands of current events. This is well summarized in Mike Coop’s latest chief investment officer letter.
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