Investors worried US market could run out of steam

Currently investors are faced with a dearth of persuasive  sources of investment return. An obvious choice is the US market, which is still attractive on several levels, but has already returned 245 per cent since 2009. Recently investors have found it easier to believe the tide is at last turning in Europe, assisted by ECB president Mario Draghi’s decision to push ahead with a $1.1tn (€970bn) asset-purchase programme, than to believe the US market can extend its six-year bull run.

“The US economy is the one area of the global market where you can see robust growth, but US equities are expensive relative to Europe and that is the problem investors are grappling with,” says Ian Heslop, fund manager at Old Mutual Global Investors. 

“Margins are high at the moment and we are seeing the impact of the strong dollar on exports but exports are a small part, just in the teens, of GDP, and under half of profits are created in international markets. When the dollar is strong it hits both the sales lines, which are therefore lower in dollar terms, and profitability, which is what we are seeing (barring Apple), so most international US companies are talking about softening conditions.”

However, four years of aggressive monetary policy have started to work, producing a virtuous cycle of rising employment, larger incomes, stronger sales and production that in turn creates further employment growth. This is occurring against a backdrop of a manufacturing renaissance based in large part on improved domestic energy production and a banking system that has been healed.

“Most data points over the last few years have looked better, such as corporate investment and personal debt levels, all except the housing market which is not providing a kicker yet but has good potential to be a driver,” says Matthew Benkendorf, lead portfolio manager of the US equity strategy, at Vontobel AM. “And we do still need the ‘E’ in PE to be higher.”

In fact, current valuations levels are still lower than at the top of the last three major bull markets. The market currently trades on a PE of 16.6x, but in Q4 1961, it traded at 22.4x, in Q2 1987, it traded at 21.1x and in Q12001 it traded at 27.8. 

“The US economy is clearly improving, moving from the 1 per cent to 2 per cent average rate of GDP growth that has been the norm since the financial crisis ended, to a growth rate in the 2.5 to 3 per cent area,” says Ed Cowart, portfolio manager at Nordea. 

Corporate profits have moved to all-time highs, surpassing the previous peak by more than 30 per cent, he explains. The rate of profit growth will slow some this year but Mr Cowart expects earnings for the S&P 500 to increase by 7-8 per cent in 2015.

It has been more than three years since the market has had a 10 percent correction, he adds, which is unusual but not unprecedented. “To us, this reflects the strength of the underlying fundamentals and the vast amount of money on the sidelines – underinvested and underperforming – that is partially deployed on any weakness in stock prices. This will not go on forever. At some point, that correction will get to 10 per cent or maybe 15 per cent.” 

But the key thing for long-term investors to keep in mind is that real bear markets are associated with earnings declines; falling earnings are caused by recessions; and recessions are virtually always caused by US Federal Reserve policy getting too tight, usually as a reaction to accelerating inflation, claims Mr Cowart.

Today, the S&P 500 stands about 3 per cent below its all-time high of late December, but the market has travelled hundreds of points up and down over the past six weeks. The crash in oil prices; the strength in the US dollar; and the Federal Reserve’s shifting posture from full-out easing to a slightly tighter position have come together to unsettle the market.

Lower oil prices are seen as a benefit overall, at current levels equivalent to a 2 per cent cut in income tax. They particularly help the middle class whose disposable income has been squeezed between slow-growing wages and rising costs for necessities such as food, gas and rents. In the US, tax makes up a smaller portion of the cost of petrol than in Europe, so there is more show-through. 

While that is good for consumer spending, lower oil prices have a very negative impact on the energy industry, communities that are dependent on oil-field activity and on a large part of the capital-goods sector. Where the impact is benign, it is usually only marginal, but where it is damaging, it can be devastating.

“The benefits from lower oil are spread wide and fairly thinly while the pain is concentrated and acute," says Mr Cowart. “Think of the millions of US motorists saving $25 or so in weekly gasoline costs. It is a nice addition to household budgets and a stimulus to spending, but not a life-changing event for the vast majority of consumers. On the other hand, the oil-field worker who has lost his job because of his company’s constrained cash flow feels the pain of lower oil prices intensely.”

The difference between now and the mid-1980s, when oil prices stayed low for years, is that in 1986, world oil demand was about 59 million barrels per day with OPEC having excess production capacity of 14m barrels per day, or nearly 25 per cent. Current world demand is around 92m barrels per day and excess OPEC capacity is less than 2m barrels per day, or only 2 per cent, so supply should tighten through the year.

The Fed’s delay on interest rates, and the prospect that rate rises are likely to be gradual, has also been welcomed by equity markets. Historically, the stockmarket has not reacted badly to the first increase in interest rates where it reflects a strengthening economy. 

 Wage growth could be key to the Fed’s timing. “Employment rates are continuing to improve, but headline inflation is likely to tick down because of the collapse in energy prices,” says Andrew Acheson, portfolio manager at Pioneer. 

“The 5.7 per cent unemployment rate is decreasing steadily. Typically when it gets to around 5.5 per cent, wage pressure tends to build towards 3 per cent year over year. It is currently at approximately 2.2 per cent, so some way from that danger level. This could occur several months down the line, or more likely several quarters yet, leading to a rate rise in September or early next year.”

There are also implications from the hedging put in place by exploration and production companies that drill for shale oil, he says. Many companies hedged 2015 production at the $85 per barrel level, and these hedges are in the money. But there is always a party on the other side – it could be that one hedged (at that $85 level) airline is disadvantaged versus another unhedged airline. There may be losses for some banks and hedge funds that sold those hedges, adds Mr Acheson.

A rate rise would provide a welcome boost to consumer income as deposit rates rise. Other sectors that could have further to run are the energy sector, industrials and regional banking companies. Many managers also like healthcare companies that are well-positioned under the US Affordable Care Act. Mature information technology companies are awash with cash and are increasingly implementing share buybacks. Of course, a strong period of growth hides weaknesses in businesses, such as if they are overly indebted or have over invested, and this will particularly apparent in the exploration and production sector. 

“The main thing we’re seeing is volatility is rising and so momentum plays are less profitable as volatility rises,” says Mr Heslop at Old Mutual. “Investors are becoming more cautious and the appetite for risk stocks is reducing and that means certain stocks won’t perform well, generally the poorer quality ones which have been carried along by the rising tide. Cheap stocks are less powerful in periods where appetite is low. So we are defensively placed with an underweight energy stocks and an overweight healthcare.”

Another factor is that the banking system is stronger. The US did a better job of recapitalising the banking system than Europe, when the Treasury forced an injection of capital into the banks, even forcing banks such as Wells Fargo to take capital to strengthen their balance sheets, says Vontobel’s Mr Benkendorf. “At the time they were up in arms, but with hindsight it was an important move for confidence. In continental Europe there are a lot of lingering concerns around the capital adequacy of banks and this is not good for morale.” 

Although some areas have appreciated, for example tech and biotech, there will be a divergence about what can deliver earnings growth and what cannot. “We are going to need to see a change in US interest rate policy to really shake the tree and then it will be self-evident what is overvalued,” he adds.

Time to look further down the menu 

In view of the dollar strength, most strategists are recommending domestically-focused companies over multinationals, which almost by definition implies moving down the market capitalisation scale. 

Caroline Simmons, deputy head of UK investment office at UBS Wealth Management, points out that mid caps are also more geared to the business cycle, and particularly likes the tech sector. “US companies have been building up the cash on their balance sheets and it now comprises 12 per cent of their assets on average compared with 7 per cent historically.”

Tech stocks in particular have amassed piles of cash to potentially give away in share buybacks and to reinvest in the business, while other companies are spending much of their Capex on IT, she says. The IT sector normally trades at an 11 per cent premium to the rest of the market and is currently trading at just a 7 per cent discount to the market’s forward 12 month earnings. Historically, whenever the IT sector trades at 15-20x PE in a year, it rises by around 18 percent in the following 12 months.

However, Andrew Acheson, portfolio manager at Pioneer, argues that contrary to established wisdom, US equity market multiples are positively correlated with a strong dollar, and large caps tend to out-perform smaller caps. In the late 90s the market multiple increased leading to the Technology bubble, and during most of the past decade up until about two years ago, a period of dollar weakness, the market multiple declined, he says.

“Over the past year or so, a period of dollar strength has seen the multiple expand, and large companies out-performing small,” explains Mr Acheson. “This is contrary to what happens in most markets, as local currency weakness usually leads to rising multiples as exporters gain competitiveness.” 

When the dollar is strong, it tends to mean the US economy is in better shape than its main trade weighted partners and therefore the currency attracts flows from non US based investors. Also, in this kind of market, investors tend to buy large caps rather than more speculative issues.

Passive funds in the US have ballooned. “The US economy is in a good position to deliver decent sustained growth and that, plus the prospects for the dollar, makes it a more attractive place for investors,” says Peter Westaway, head of the investment strategy group, Europe at Vanguard. 

He adds that passive funds have garnered flows because there is growing awareness of the weaknesses of active management. Even managers who have a good run of performance will revert back to the pack, he says, with research showing that managers who come in the top quintile one year have a worse than random chance of making it into the top fifth five years later.

One reason active funds underperformed the S&P in 2014 is that active managers are tilted to smaller companies but last year – unusually – the mega companies performed better. 

View from Morningstar: European investors hungry for US large cap equities

With most broad US equity benchmarks at their all-time highs, it comes as no surprise that US equity funds have, on average, substantially outperformed their counterparts in all other global regions over the last one, three and five years, including both developed and emerging markets. 

Besides stockmarket performance, currencies have also played a significant role, especially for euro-based investors who have seen their home currency depreciate by more than 15 per cent in the last 12 months. Within US equities, market cap effects have not been a key driver of returns in recent years, since the performance of large, mid and small cap Morningstar categories has been fairly similar.

Not surprisingly, this strong rally has attracted investors’ attention, who across Europe have poured almost €11bn into US equity large cap funds over the last 12 months, according to Morningstar data. In contrast, small and mid cap funds have been out of favour in the wake of their recent underperformance relative to their larger cap counterparts. 

Legg Mason CB US Agrsv Growth has been a big beneficiary of this trend, and has enjoyed inflows of €1.8bn in the last 12 months, making this product the largest active fund in its category. 

It is rated Silver by Morningstar analysts who, amongst other things, appreciate the lengthy experience of Richard Freeman, one of the fund’s co-managers who has been running this strategy since its inception in 1983. 

Another highly rated fund is Heptagon Yacktman US Equity, whose management is outsourced to US-firm Yacktman Asset Management. The lead fund manager is Donald Yacktman, a very seasoned investor who has run this strategy since 1992. 

Despite recent underperformance, mostly caused by its typically conservative positioning, we think this is a solid choice and one rated Silver by Morningstar analysts.

Javier Saenz De Cenzano, CFA, director of manager research Morningstar, Iberia & Italy