Up until the end of 2018, the US economy appeared to be resilient to the general slowdown affecting the rest of the global economy. But volatility hit hard in December, with a broad market sell-off wiping out many of the gains made during the previous 11 months. Equities have since recovered, helped in part by the Federal Reserve’s change in policy, but will the calm last?
All the asset and wealth managers PWM spoke to for this article expect growth in the US economy to slow this year. Since exiting its last recession in mid-2009, the US economy has become notorious for starting years off slowly, with growth often picking up in the spring, says Caroline Simmons, deputy head of UBS Wealth Management’s UK Chief Investment Office.
“You’d be forgiven for thinking that 2019 is following the same pattern, however we feel that the US economy is now at a late stage in the business cycle” she says. “This is consistent with positive equity returns on average, but also higher uncertainty and volatility.”
Yet she does not expect the economy to slip into recession. “The policy turmoil of the last few months certainly hasn’t helped matters, nor did a month-long federal government shutdown,” admits Mr Simmons. But, while this was negative for the economy, a strong job market and rising wages continue to support consumer spending, she explains, expecting stocks to continue to advance regardless of a soft patch in earnings growth.
Data releases are pointing increasingly towards slower growth in the US economy, warns Cormac Weldon, head of US equities at Artemis, while it is also clear the global economy is slowing too, with particular weakness in Europe and China. This means now is not the time to make significant investments in companies that would require an improving economic backdrop to deliver returns, he explains.
Artemis therefore has little exposure to the US banking sector, and has also sold its holding in railroad company Norfolk Southern. “Any slowing in the domestic economy or increased friction in global trade is likely to have an impact on the volume of freight carried by rail,” he explains.
Instead of these cyclical stocks, the firm is investing in businesses whose growth stems from idiosyncratic factors and whose success is relatively independent from developments in the wider economy.
Mr Weldon gives the example of payment companies such as Visa, PayPal and Worldpay, which will benefit from the move away from cash and is an industry sheltered by relatively high barriers to entry, as well as the healthcare insurance sector.
As the US, and global, economies began to slow last year, the Fed was on “the verge of making a policy mistake” by continuing to tighten policy, says Krishna Memani, CIO at OppenheimerFunds. But its pivot towards ongoing policy easing was a very welcome change, he believes.
“As a result, we believe the Fed singlehandedly has extended this expansion by a few years. We believe the current economic cycle in the US has at least five more years to go.”
Mr Memani expects the slowing but relatively steady growth rate, the absence of inflation and continued policy support from the central bank to extend the current expansion for much longer than most investors expect.
“With that context, we believe the US market cycle is likely to provide positive but modest returns for quite some time,” he says.
Singapore-based DBS Bank’s view of the sector was also buoyed by the Fed’s actions, and “on balance”, it maintains a positive view of US equities. “The valuation of the S&P 500 remains undemanding at 17x forward P/E, a level which is broadly in-line with its long-term average,” says its CIO, Hou Wey Fook.
The bank adopts a “barbell approach” in its portfolio strategy, by positioning its overweight exposures on both growth and resilient sectors. In growth, it favours technology, communication services and consumer discretionary, whereas for resilience, it likes healthcare and consumer staples.
Valuations
Opinions are divided as to whether valuations in US equities are stretched or not, with much depending on what measures are used. A long bull run has certainly seen prices climb, but the correction at the end of last year took some steam out of the market, although it has since recovered.
Valuations are most useful as a starting point for future returns, argues David Bailin, global head of investments at Citi Private Bank. “High valuation starting points have historically been associated with lower future long-term returns, which is one of the reasons we see the greatest long-run upside potential in areas such as emerging market equities and EM Asia in particular.”
Further upside in the equity market can be expected, he says, but after some impressive returns it makes sense to hedge against some of the downside risks. “This allows investors to continue to participate in further upside but also to sleep well at night.”
The market “wobble” and the subsequent recovery was based on sentiment rather than on economic data, claims Kasia Kiladis, investment director in the US equity team at Fidelity International. President Trump’s tax cuts had helped boost earnings earlier in the year, unemployment continued to tick down and the US led global growth.
“But towards the end of the year things started to get a bit more worrisome, because things were so good. Everyone started to get a bit twitchy as to how much better could things get?”
Tightening financial conditions, and the global slowdown helped to fuel the volatility, and while the market has now recovered, Ms Kiladis warns that underlying economic indicators have not significantly improved.
The Fed’s actions helped to calm markets, but she worries if the economy takes a turn for the worse, the central bank will not have the room to manoeuvre it had in previous recessions.
“The Fed has been raising rates for a number of years, despite low inflation, many argue because they wanted to give themselves that firepower. So they will have it to some extent, but not to the level that they had historically. Rates are low and the deficit is high, so if growth slows there won’t be many levers to pull.”
Despite this, Ms Kiladis sees opportunities within all sectors, in companies where there is less debt and they are counter-cyclical, which look attractive if there is a downturn in the economy.
“Even in financials, which is traditionally very cyclical, there are a proportion that are counter cyclical, like insurance, or diversified financial, while US banks are much safer than they were before the crisis,” she says.
There is no systemic deterioration in market fundamentals nor broad-based weakness in corporate fundamentals at this time, claims Grant Bowers, portfolio manager of the Franklin US Opportunities Fund. He believes valuations remain reasonable, and the US equities still present an attractive market.
“Despite elevated geopolitical headlines and trade tensions, growth fundamentals have continued to be positive as the two main pillars of the US economy – consumer spending and corporate earnings – have remained solid. As active managers, we look beyond short-term market volatility and seek to take advantage of market weakness to build on our investment themes.”
There are particular opportunities to be found in technology and healthcare, he claims. Many companies have realised that investing in technological improvements are required for them to remain competitive in the global marketplace. Cybersecurity, software as a service (SaaS), cloud computing, digital payments, mobility and smart devices are some of the technological areas to spark his interest.
Similarly, the long-term outlook for the healthcare sector looks promising, with an ageing global population driving demand for improved treatments and cures. “This demographic tailwind, combined with innovation in drug development and medical technology, is creating numerous potential investment opportunities,” explains Mr Bowers.
While both these sectors have traditionally experienced bouts of short-term volatility, those have often created attractive buying opportunities, he adds.
Structurally declining interest rates and structurally increasing corporate profit margins in corporates have boosted the US equity market in recent times, while up until the last couple of years there has also been a stable political environment and established global trade relationships, says Matt Benkendorf, CIO of Vontobel’s Quality Growth boutique. This, in part, explains the rise in passive investments, he claims, as the rising tide has lifted all boats.
But times are changing. “It is going to be particularly difficult going forward, but that doesn’t mean down. But without these tailwinds, it just isn’t going to be so easy.”
Mr Benkendorf runs several strategies in a bottom-up, benchmark agnostic style, looking for quality growth in inherently predictable businesses. “We believe they will perform regardless of what happens in the market or economy and despite such a long bull run, I do not feel we are exhausted in our opportunity set.”
These high quality companies are also an area of interest for Raphael Pitoun at CQS New City Equity, who is looking to launch a global fund in the high quality growth space.
“We plan to overweight the US, as we find the best companies there,” he says. “Companies need to be innovation-centric and have the right business organisation and corporate governance. And when you look at those two criteria, the best companies you can find in the world are in the US. Not all, but most.”
Others are betting on a resurgence of ‘value’ stocks, an investment style that has been out of fashion for a while.
“After 12 years of growth stock leadership, value stocks are exceptionally cheap,” says John Bailer, lead manager of the BNY Mellon US Equity Income Fund. “This has enabled us to construct a portfolio as inexpensive as it was seven years ago.”
He highlights value sectors such as materials, energy and particularly financials, which is the fund’s largest absolute sector position.
“Financials trade at their cheapest levels relative to the broad equity market in decades and have the best balance sheets they have had in decades with strong capital positions and liquidity,” says Mr Bailer.
As earnings have improved, these companies have increased returns to shareholders and have among the highest dividend growth rates in the US equity market, he adds.
But not all managers are as bullish about the role US stocks should be playing in portfolios. “You are not getting paid to take risk at this point,” says Roger Jones, head of equities at London & Capital. “The market suggests caution.”
He believes that valuations, “are fairly stretched by any measures”, and, while the firm had been overweight the US for a long time, it has now dialled that back. “We are now slightly underweight, and will probably go further underweight, given the risks against the potential rewards,” explains Mr Jones.
The prospects for most stockmarkets look uninspiring, says Luca Paolini, chief strategist at Pictet Asset Management, prompting the firm to underweight equities in favour of cash. “The US stockmarket looks the most vulnerable to a correction,” he says.
“Not only is it the most expensive in our scorecard, but profit margins among US companies look set to contract from record highs of 11 per cent, with many already reporting higher wage costs.”
China worries
One risk on managers’ minds is the relationship between the US and China. The two global superpowers have been at loggerheads in recent months, with spats over trade and intellectual property.
“We are all familiar with the phrase ‘if the US sneezes the world catches a cold’,” says Ms Kiladis at Fidelity. “Well that is now also true for China, and can you imagine if both sneezed at the same time? The global economy would tank.” Getting some kind of agreement is important for both sides, she says, with Mr Trump entering election mode and the Chinese looking to protect their economy.
Assuming the president wants to be re-elected, the rhetoric over trade tariffs should soften before it has a detrimental effect on the US economy, says Mr Weldon at Artemis, though he warns concerns over the “theft” of US intellectual property may take longer to resolve.
Trade tensions have been a major preoccupation for investors, says UBS’s Ms Simmons, and relations between the two countries remain fragile, even as high-level talks continue.
In addition to the feud with China, the US continues to threaten higher tariffs on auto imports, which, if implemented, could hit Germany and Japan especially hard. These frictions look set to persist over the coming years, she says. But while they negatively impacted markets in 2018, there are now encouraging signs the damage to markets can be contained if we see no further escalation.
“Investors should therefore stay invested but protect their portfolios against downside risks,” advises Ms Simmons.
VIEW FROM MORNINGSTAR: New year breathes new life into stockmarket
The US stockmarket bounced back strongly in first quarter of 2019 from December’s sharpe decline, with the S&P 500 posting a gain of more than 13 per cent in dollar terms, making the US the best-performing equity region globally.
Most of these gains were generated in the first month of the year, as the S&P 500 posted its best January performance since 1987, rising by nearly 8 per cent. The US Federal Reserve’s decision to put further interest rate hike on hold, improved sentiment on geopolitical risks including trade frictions with China and fading fears of a global recession, all served to lift the market.
All major US indexes rose strongly for the quarter, with growth and smaller-cap stocks leading the way. Small-cap equities which fell by more than 20 per cent in the fourth of 2018 (and by 11.9 per cent for December alone), snapped back as the Russell 2000 Index returned 14.5 per cent in the first quarter 2019.
Keeping-up with last year’s big theme, large-cap growth equities fared better than their value counterparts, with the Russell 1000 Growth Index returning 16 per cent, led by technology names. It should be noted that the largest and most popular index constituents – Apple, Microsoft, Amazon, Facebook and Alphabet – posted double digit gains during the quarter, but only Facebook and Microsoft made up all the ground they lost in the last quarter of 2018.
Looking at the S&P 500, all sectors were in positive territory. Technology and real estate sectors led the pack, delivering 19.7 per cent and 17.3 per cent, respectively. The strong performance in REITs and high-yielding sectors was boosted by interest rate movements and change in the US Fed’s monetary policy. Weaker sectors included financials and healthcare companies, especially pharmaceuticals.
The MS INVF US Advantage fund is managed by an experienced team led by Dennis Lynch, who executes a long-term, high-conviction approach. Mr Lynch and his team look for companies with defensible business models that dominate their markets or benefit from a strong network effect. The fund owns fewer industry disrupters that invite greater volatility, instead focusing on more established companies with enduring competitive advantages.
It performed well in growth-fuelled markets like 2017, but its focus on established companies led to a smoother ride for investors as the fund was in the middle of the pack in rockier periods, including the mid- 2015/early 2016 technology pullback.
The Franklin US Opportunities fund has been managed by Grant Bowers since March 2007. The manager targets firms that will generate sustainable long-term earnings growth – emphasising those with solid balance sheets, barriers to entry, and strong management.
Portfolio positioning has backed the consumer discretionary, healthcare and technology segments in recent years. The strategy has tended to perform well when growth stocks are favoured.
Fatima Khizou, Analyst, Manager Research, Morningstar
