US economy edging back towards normal

Last year, 2013, was a great year for US equities, with the Standard & Poor’s 500 rising 32 per cent. But disappointing manufacturing and payroll data have panicked the market this year, and emerging market currencies have been hit by the reality of the Federal Reserve’s decision to commence monetary tightening, prompting a series of sell-offs that have reverberated around the globe.

This sell-off in emerging markets can be seen as a resumption of the nervousness in May 2013, when the MSCI EM index fell from 1050 to 883 by the end of June. This time the US was caught up in the melee, with the S&P 500 suffering its worst one-day drop since June on February 3, and down 5 per cent since the start of the year.

Fund managers are relatively unperturbed, however, and believe the US recovery is entrenched. The consensus view – among US equity fund specialists at least – is that markets are overreacting to US economic data and the Fed’s tapering of its government debt purchases should primarily be taken as a sign that the world’s largest economy is improving.

“Our view on interest rates and tapering is that a stronger economy will lead the Federal Reserve to continue to taper and for interest rates to steadily grind higher over the next 12 to 18 months,” says Kurt Feuerman, chief investment officer of Select Equity Portfolios at AllianceBernstein.

“This would look like a normal economic cycle, as opposed to the extraordinary economic environment of the last five years,” he adds. “This is still an environment we think is conducive to rising equity markets: corporate balance sheets are in great shape, earnings should push to record highs, and we still think stocks are better value relative to bonds.”

Confidence in US corporate earnings remains strong in the belief that the drivers behind last year’s high margins will be long-lasting. In 2013, earnings growth was around 7 per cent, boosted by some major share buybacks, and this year it is expected to come in around 10 per cent. By the end of January, 250 US companies had reported and most surprised on the upside, with some big share buybacks, such as Time Warner’s $5m (€3.6m) buyback, already announced.

Average sales per share were a modest 3-4 per cent last year, subdued by substantially higher personal tax rates and government restraint in spending, points out Paul Cloonan, portfolio manager, Pioneer Funds – US Fundamental Growth. In the face of this, consumer spending remained fairly resilient, he says, and this year the drag from fiscal and tax rates should be reduced while the job market has improved.

However, companies that earn a large part of their revenues from emerging markets will be hit by currency drag if the dollar stays strong. Consumer staples have been hit hard by their exposures to emerging markets, as demonstrated by Estée Lauder and Philip Morris, which both fell 10 per cent in January, for example.

The consensus is that consumer strength will underpin the recovery as the wealth effect created by rising home prices and equity markets over the last two years begins to empower families to spend more.

“Too few houses have been built in the US since 2006,” says Grant Bughman, client portfolio manager of the UBS US Growth fund.

“There were one million fewer homes than the population needed at the lowest point, the number is probably back up to 500,000 now as the supply of new homes has been ramped up, and the housing market is strengthening.” This is significant because it is a huge factor for the economy – every 500,000 of new homes is worth 150 basis points on GDP and around 2m jobs, he says.

House prices are also rising – until recently one quarter of homeowners had negative equity but the rebound is allowing homeowners to unlock the value in their homes by moving and it is also encouraging refurbishment, states Mr Bughman. The UBS fund therefore has positions in flooring and household appliances.

There is however a sense that not all sectors of the US economy are yet sharing in its resurgence and that as the recovery permeates through SMEs and other sectors of commerce it will spur a greater feelgood factor and loosen disposable wealth.

“While Wall Street had a full recovery, the broader economy using indicators such as employment growth and small business growth has not recovered to 2007 levels,” says Duilio Ramallo, fund manager at Robeco.

“The recovery has been underwhelming for smaller and mid-sized businesses and we hope to see that change this year. Corporations have been lean and reluctant to hire, but if there is any pick up in demand then they will be forced to increase hiring, possibly leading to a virtuous cycle.”

In the immediate future, however, the start of the Fed’s taper has caused nervousness across emerging markets and there is fear that contagion will impact the real economy.

“The emerging market contagion can run through several channels,” says Patrick Moonen, senior strategist within the multi-asset boutique of ING Investment Management. “Its impact on direct trade I think is limited.”

The second channel is via commodities and should be a minor positive for US equities and corporates as the prices of commodities, energy and metals will be kept in check, helping corporate profit margins, he says. For example, the chemical sector would be a beneficiary. “It also impacts disposable income as lower prices will help the US consumer,” he says.

Thirdly, and most difficult to assess, explains Mr Moonen, is the financial channel, if the turbulence leads to global risk aversion. “It could be seen to have quite an impact as there would be more volatility and lower equity prices and a broad-based sell-off. But as we see it now, emerging markets are a risk but have not entered into a negative feedback loop. We see it as a temporary correction for developed markets.”

Many are calling the cyclical sectors to outperform. “Given our positive view of the economy, we think the cyclical areas of the market are most attractive,” says AllianceBernstein’s Mr Feuerman.

“We are overweight consumer discretionary, industrials and financials. We think many companies in these groups, particularly the latter two, are still relatively cheap and will certainly benefit from accelerating economic growth. On the other side, we do not see the same opportunity in more defensive areas of the market, namely consumer staples and utilities. We are also underweight energy and materials as we see slowing growth in emerging markets as a negative for commodity prices.”

Higher US interest rates may improve profits initially, with low returns on cash and low interest margins in the banking sector depressing returns during the era of zero rate policy. Financial shares have not recovered to 2007 levels, and their low valuations and return of capital to shareholders is attractive. Many funds are overweight financials such as the JP Morgan US Value Fund which holds regional banks such as Wells Fargo and insurance names such as Prudential. Auto sales have also picked up, as cars had reached a high in terms of average age, and credit expansion goes along with that.

Multinational US corporations will also be major beneficiaries of the globalisation and technological change over the next decade. Mr Bughman at UBS for example likes consumer-related tech names of which the posterchild is Apple, and Visa and Mastercard which are pure plays on rising commerce and also reflect the secular shift to plastic payments, a multi-year growth story that also enjoys high barriers to entry.

Another favoured sector is digital advertising as advertisers spend less on print, radio and television, and expect their efforts to be better targeted. Facebook’s results in January blew away market expectations and were down to advertisers being prepared to pay for highly specific targeted consumer advertising.

In terms of friendless sectors, the energy sector may be overvalued. “We believe the unlocking of shale is having hugely positive reverberations for the economy but a lot of that is already priced into shares, so while we were overweight energy 12 months ago, we are now benchmark neutral and have avoided defensive high yielding stocks such as utilities which have already benefited disproportionately from investors’ thirst for yield,” says Mr Bughman. 

Wealth Managers View – Fundamentals still favour equities

“If you had your contrarian hat on you would say that now is the time to get out and leave the party,” says Fiona Harris, client portfolio manager, US equities at JP Morgan Asset Management, bearing in mind that investors in US equities did so well last year. “But we think leaving now is too early.”

For absolute and relative reasons the market was cheap last year but it was in a better economic position than anyone else, she explains. In 2014 it is no longer cheap and it is easy to make the case that it is now fairly valued, compared with last year when there was optimism about economic and earnings growth and the chance of surprises on the upside. But companies are sitting on record levels of cash and putting it to work in buybacks and dividends, and this year there is also nothing to hold them back on capex, says Ms Harris.

 “We would still describe the fundamental backdrop as equity-friendly,” agrees Leo Grohowksi, chief investment officer at BNY Mellon Wealth Management. He believes the important asset allocation decision in 2013 was to be overweight equities and underweight bonds.

“We will not see the same performance dispersion this year  between equities and bonds, but equities still make the most sense. Once that decision has been made, we are overweight the US, neutral emerging market equity and underweight developed nation equities outside the US,” adds Mr Grohowski.

JP Morgan prefers large cap stocks in the US space. “There is a view that large caps are overvalued but we believe this is not the case,” he explains. “The S&P is trading at a multiple of about 15x on this year’s earnings. Bull markets don’t typically end when multiples are in the mid-teens. Treasury note yields are under 3 per cent and inflation is less than 2 per cent. We still have an S&P target year end of 1900-1950 which implies a return of 10 per cent including dividends.”

Last year, dividend stocks were left behind as investors were concerned about the impact of higher rates, and preferred high beta names. “Companies that paid no dividend last year in the S&P 500 actually outperformed those that did pay a dividend,” adds Ms Harris at JP Morgan. 

“While that may appear to be counterintuitive, we think it is due to investors’ concerns about the impact that rising interest rates could have on dividend paying stocks.”

Investors also displayed a preference for higher beta names and a willingness to take additional risk because of the attractive valuations on these higher growth names, she says. “However, when you look at investment opportunities, you have to balance risk and reward. Take the tech sector for example. Investors might be surprised to realise that more established value propositions such as Hewlett Packard actually did better than more exciting segments of the market.”

In this climate, active management is preferred. “I believe we are in an environment where  valuations and fundamentals matter, so it is generally better to choose active management,” says BNY Mellon’s Mr Grohowksi. “In contrast, in 2011 for example, the macro backdrop drove correlations higher across equity sectors and stocks, which rendered security selection a lot less important.”

View from Morningstar – A record year

The S&P 500 hit several record highs in 2013, finishing with a calendar year gain of 26.67 per cent. Funds in the Morningstar Large Cap US categories (blend, value and growth) on average kept up pretty well with the index, with growth stocks (27.28 per cent) outperforming value stocks (26.65 per cent).

Within the value area, Robeco US Premium Equities, rated Silver, was among the best performers, returning 31.15 per cent over the year. The fund is managed by Duilio Ramallo, who runs the portfolio in a pure bottom up way: only buying companies that are believed to be undervalued and which score well on the three pillars of the process: valuation, fundamental factors, and catalyst for change.

Although within the growth space, Brown Advisory US Equity Growth, rated Bronze, lagged its category average by 4.2 per cent, fund manager Ken Stuzin has built up a tremendous track record since the launch of the Europe-listed funds from 2009 onward. Mr Stuzin likes companies with the ability to maintain capex spending during downturns, so stable businesses are preferred.

Fidelity America (29.77 per cent), managed to outperform its category by 4.25 per cent. Fidelity replaced the firm’s US-based analyst resource with a London-based team. There is already evidence that the new team structure is paying off in terms of portfolio construction. For example, building bigger positions in his highest-conviction stocks. This is a direct consequence of having access to more timely and tailor-made research from analysts. The number of holdings has consequently decreased from more than 100 in 2011 to 65 by the end of 2013.

San Lie, head of fund research for Benelux, Morningstar