Roundtable: Will the US economic recovery grind to a halt?

From Financial Centres / Americas & Caribbean / USA 26 October 2012

By Elisa Trovato

The US economy has been performing better than most developed markets, but with a “fiscal cliff” on the horizon and a stuttering global economy, can this continue?

Elisa Trovato: Our aim today is to discuss the economic outlook and investment opportunities in the US, asset allocation strategies and manager selection criteria. The US has been outperforming most developed market equities over the past three years. But, with the presidential elections looming, the threat of the US ‘fiscal cliff’ and uncertainty over the sovereign debt crisis, there are questions about whether this relative outperformance can persist. What is the impact of all this on the US economy and corporations?

Mouhammed Choukeir: Economic uncertainty is there and it is heightened by the fact that now central banks are essentially delaying the inevitable, which is where some of these indebted nations, households and corporations have to either refinance or restructure their debt. Even though there may be growth, CEOs actually retrench and hold back some of their investment decisions. That will inevitably lead to corporations delaying their investment programmes. Corporations are also highly indebted.

They came into this crisis five years ago with huge amounts of debt. In the US, they have been much more aggressive than the rest of the world in deleveraging, which is a positive thing.

Bill McQuaker: Alan Greenspan talked about a ‘capital strike’, which sums up a lot of what has been problematic over the last year or two: decision-makers have been unwilling to make decisions. We need to find ways of ending the strike that is taking place on the capital side of the equation. To my mind, maybe open-ended quantitative easing helps.

Also, changes in terms of regulation and simplification of regulation would help. Other areas that offer scope in the same way are: greater certainty about taxation, and, in the US, greater certainty about healthcare costs, because healthcare is such an important variable there. In each instance, it is not about necessarily changing things in a political sense, it is just about clarity. It is about a greater level of certainty about what the future holds, so that people can make judgments and find it easier to take risks.

Elisa Trovato: Has the third round of quantitative easing been effective in boosting investor sentiment?

Oliver Gregson: Inertia, both from investors and corporate CEOs, is currently a big problem. I do not see this type of ongoing stimulus as being a longer-term solution to that dynamic. Much of this liquidity is simply being tied up in unintended places, which is being exacerbated by some of the regulations, like Basel III, that are going to come in. Not much of it is actually getting out into the end economy, into people’s pockets and into lending. We have to get corporate CEOs, CFOs and the US consumer back and engaged in spending and investing. An interesting indicator will be when we start to see some of the flows out of the fixed income sector.

Claudia Panseri: If the Fed did not inject so much money, deflation would become a real problem. It probably does not help in the short term, but over the long-term, it may be a completely different scenario from what we were expecting in 2008 and 2009. It is probably a way to balance the fiscal cliff. We have $500bn (€385bn) on the table at the end of the year, which means 4 per cent of the GDP in the US, so QE3 helps to avoid a second recession in the US, also considering Bernanke will be replaced in a few months.

Grant Bughman: The market largely anticipated further quantitative easing, and that is why you saw the rally from July onwards. From our perspective, quantitative easing does have a meaningful impact, in particular on mortgages. One of the benefits of lower mortgage rates is to incentivise purchases of homes, which should go a long way towards underpinning the recovery in the US. The difficulty is whether banks are going to lend. We have seen no change in the standards of mortgages in the US.

Oliver Gregson: The crux for the US economy’s potential going forward is the US consumer – 70 per cent of US GDP. In our view, the US consumer is in a qualitatively better place than many commentators allude to. The asset side of their balance sheet is in relatively good health. The recovery in housing will continue to act as a tailwind. Equally the consumption trend, as evidenced by reduction in the savings rate from high single digits has been supported by the decrease in debt as a percentage of disposable income and aided by the very low level of interest rates.

With the deleveraging to a large degree done, interest rates are going nowhere fast. US consumers, the engine room of global growth, could potentially take the lead into okay-ish GDP growth in the US of 2 to 2.5 per cent going forward.

Bill McQuaker: I think there are also some other dynamics going on. US labour costs have been flat lining for a long time now. That was not that significant in terms of relativities until three or four years ago, when Chinese labour costs started to rise and continue to rise quite sharply year on year. The pendulum is swinging in favour of the US.

On top of that, the dollar has been weakening for 10 years, and the US has discovered considerable quantities of exploitable onshore energy. One of the long-term drags on US confidence has been reliance on Middle Eastern oil. In the not too distant future that reliance could disappear. That could be quite energising for the US in terms of underlying national confidence.

Those three things in combination make me think that certain industries are going to make a comeback in the US.

Claudia Panseri: Export is becoming one of the main contributions to GDP, after internal consumption. This is really important as a very long-term theme in the US.

Elisa Trovato: Lars, do you see any other investment themes emerging in the US?

Lars Kalbreier: The US “regeneration” is a theme we are looking at right now. It is based on resources and labour costs which are really big game changers. Some CEOs I spoke to who have outsourced to India are looking at the net present value of the costs, over the next five years, and given the salary increases and the turnover they are getting, they believe on balance there are some regions in the US that are starting to look more attractive.

STefano Spurio: One important theme we are looking at is finding a mix of companies trading at attractive or acceptable valuations that are leaders in their sector and able to pass on commodity-price increases to end-users. The luxury sector is a good example, because it is able to keep its high margins and at the same time is extremely attuned to the needs and wants of important clients like wealthy individuals in Asia and other emerging markets. These are brands that are sought after by these consumers, and we take this into consideration in our valuation mechanism.

The discussion about a potential reindustrialisation of the US is valid for Europe too. All these companies could benefit in the future from innovation and maintain their leading role in certain fields – be it automation or data-management, such as Visa and MasterCard. Another theme is what we call the quaternary sector. This is linked to countries that are good at spending a lot of money in education to feed companies a highly skilled labour force, which will probably enable firms based in developed countries to counterbalance the growth areas of China, Brazil, etc that are much more labour intensive.

Recently, we have seen wage inflation combined to currency devaluation which makes these markets less attractive. There are opportunities in developed countries, especially in the US, in companies where we can identify some products or services that will be really important in the future for people in developed and emerging market economies.

Elisa Trovato: Are there any sectors that would do well out of a particular presidential election result in the US?

Stefano Spurio: It is not really about the party that wins. If the incumbent is elected, usually the equity market moves up 10 per cent; if the challenger is elected, it goes down, on average, by 4 per cent. However, the question here is all about confidence. If the winning party provides enough confidence to the marketplace, then it will help to finally get out of this prolonged crisis.

Elisa Trovato: What exposure to US equities do you recommend to clients?

Lance Peltz: We have been overweight equities. We did not time or trade the market to dip earlier this year, which – luck or judgment – was right, but we have actually been selling the US to close the underweight in Europe. That is as much a short-term trade valuation opportunity reduction in risk premium as a longer-term fundamental view.

Stefano Spurio: Investors have used the US dollar and US equity market as a natural hedge this year in their allocation to get out of Europe. We did the same and we continue to do so. We thought that, to get out of Europe, a natural hedge was the US dollar for the currency, for the sustainability, for the homogenous government policy and the quick impact from the decision makers into the economy from QE1, QE2 and QE3 (unlike in the eurozone). The US is a better and safer place to be in. That was what was probably driving a big chunk of the performance of the US market this year.

Oliver Gregson: If clients have exposure to US equities we recommend they obtain protection, either in buying some out of the money puts, or looking to get some exposure to volatility increasing in the portfolio. The cost (or premium) to buy this hedge is relatively cheap now. Given that it has been a bumpy journey, and we have seen some pretty decent gains on equity markets in that country, we think this is a sensible strategy, especially as I think the future political drivers of volatility remain elevated.

Elisa Trovato: Grant, how do you manage volatility in your equity funds?

Grant Bughman: We are traditional long-only managers, we are fully invested. We do not have more than 5 per cent cash in our portfolio. We try to manage volatility for our clients by having a disciplined valuation approach, in which we buy different types of complementary business models – what we call classic, elite and cyclical growth.

Cyclical businesses are very closely tied to the economic cycles, so, today, we do not have a lot of exposure to those. We are underweight industrials and financials; we do not own any banks; we are underweight materials. That helps us to mitigate volatility due to macro swings.

In terms of classic growth, companies that have 4-5 per cent revenue growth and slightly higher earnings per share are good businesses that generate a lot of free cash flow, pay dividends and act as a stabiliser. It is a way for us to buy companies when there is noise and when we think the downside is limited, and then, essentially, a barbell with what we think are higher-growth-rate types of companies in a secular industry – for instance, ecommerce – that we think can take share for years.

Elisa Trovato: In a market which is traditionally very efficient, like the US market, do you prefer actively or passive funds, and what kind of active managers do you select in this area?

Lance Peltz: We all know the US is very efficient. It is a market where we are more willing to use exchange traded funds (ETFs) to a much greater extent than any other space. There are times when active managers really struggle. We have worked hard to try to create a model that would be predictive of that; unfortunately, so far we have not had much success. Last year, active managers struggled. I think the S&P 500 would have ranked top of the second decile among funds. In the US, we have a portfolio-construction philosophy where we try to minimise the risk of underperformance by anchoring in ETFs and, if we have a strong view about style, we will allocate to styles where we are more willing to use active managers, as we believe an active manager has more chance of outperforming.

Mouhammed Choukeir: If we have a client who wants US equities, the debate about passive versus active is quite relevant, because the question is, ‘Do we want US equities cheaply using a passive fund or do we want a high-tracking-error active fund?’ For a client who is multi-asset-class in nature – and a lot of clients are –that decision plays a lesser role relative to the asset mix.

Efficiency is one argument, but the other is that what we have seen since the crisis broke out is the increase in correlation. Stockpickers have a really tough time, as they increasingly have the challenge of either being risk-on or risk-off. Also, in the US, there is a herd mentality whereby many managers do not take big deviations around some of their benchmarks. In other markets, some actively take it; some have no choice, because it happens naturally, due to the high volatility and the correlations, so the opportunity set is much bigger outside of the US.

Bill McQuaker: I think this notion that the US market is superefficient is questionable. The view is based on the fact that the average manager does not beat the S&P. The average manager these days turns his portfolio over to an extraordinary degree in the US. The holding period is down to about a year for the average manager. There is a lot of trading cost being borne by these funds, and then there are fees and the like on top, so it is no big surprise that the average manager trails the S&P.

When we talk about active management, ‘active’ is not a short word meaning ‘activity’, but is about having a portfolio structure that is significantly different from the market average or the index, where turnover is low, and where the drivers are fundamental rather than short-return or more technical in nature. Those things in combination have often been consistent with better performance.

The second point is that the US money-management market has taken on a structure which is very ‘structured’. An investment may be attractive but does not get into the portfolio because if the fund does not keep its characterisation, clients and consultants will desert it, so the investment opportunity is ignored. This is particularly extreme in the US.

Lance Peltz: The biggest challenge is that, in the universe of non-style-driven, flexible, go anywhere US equity managers, we have found very low persistence in performance relative to a benchmark. We can talk about the drawbacks of benchmarks and so on, but it helps us model portfolio construction whereas we have found greater persistence and visibility. We went about visibility, expected performance patterns and persistence with more style-driven managers, like a large-cap growth manager, when you know what you are going to get.

Lars Kalbreier: Regarding asset managers who can outperform in the long run, the key is to find managers who take active bets with conviction. We look at the tracking error that managers take and, if the tracking-error budget has been just too low over time, we believe the manager does not have the confidence to take active bets; hence, we would prefer ETFs. We learn that active managers tend to underperform the benchmark after costs, but the benchmark is theoretical, so what you need to compare it to is an ETF that is investible. That changes the situation depending on the asset class. An ETF will never be able to replicate the benchmark totally.

Also, if you take the whole universe of fund managers and look at how many passive managers in disguise you have, if you start stripping these out, the comparisons start to look more favourable for active managers.

Elisa Trovato: Do you favour value or growth at the moment for US equity funds?

Lars Kalbreier: For US equity funds, the analysis that we do for the investment committee just tells us that, right now, there is more value in value than in growth. It is something which is very tactical in nature and can change quickly. It is very much valuation-based.

Perhaps just one way around this kind of dilemma between value and growth – and we do not like these religious boxes – is a management style called Growth at a Reasonable Price.

Claudia Panseri: We use sector allocation rather than style. However, in terms of value and growth, we are right now more into banks and building materials in the US, so I would probably say value relative to growth.

Grant Bughman: One of the things to point to regarding value and growth is the difference in the benchmarks. Financials is a much larger percentage of the value benchmark – it is over 25 per cent; it is 4 per cent of the growth benchmarks. Technology is a much larger percentage of the growth benchmark than it is of the value benchmark. You have to think about questions regarding whether value is cheap or whether growth is cheap in the context of what types of companies you are paying for.

We are growth managers, so we obviously have a growth bias. Our clients have hired us to be a growth manager, but they have done so with the expectation that we can beat the S&P 500, and we have been able to demonstrate that over time because of the flexibility that we have to buy growth companies that some may think are expensive, as well as very cheap companies that we think are still good businesses.

Elisa Trovato: US equity managers are often criticised for being very oriented towards stock-picking and for not sufficiently integrating macroeconomic factors in their investment philosophy, which leads to problems in generating consistent alpha. Do you agree?

Bill McQuaker: There is some truth in it. I think there is, to an unusual degree, a focus on stock-picking per se among US managers. They talk about building the portfolio from the bottom up more than you would find in the UK or Europe. There are, nevertheless, some managers who do build in some kind of macro influence, even if they are bottom-up in nature. An example would be people who are alert to broad changes in the macro environment and use that to drive the extent to which they are demanding of underlying company characteristics.

Mouhammed Choukeir: If you are thinking about the macro considerations, the tool that you really need to have to navigate a crisis is cash. Go into cash when the macro outlook is not so great and the macro factors are quite bleak. A lot of equity managers limit their cash budget for two reasons: one is the tracking-error issues that we discussed. Second, the reason why asset allocators allocate to an equity manager is not to make that asset-allocation call. They say, ‘You have to be fully invested most of the time, so you go and pick the best stocks, even if the stockmarket is going down’. That limits the ability to navigate using macro factors.

Lars Kalbreier: If you have a strategic asset allocation that tells you to have 10 per cent in European equities, you want this 10 per cent to be fully invested. You do not want to have a European equity manager running 20 per cent cash within that allocation.

Bill McQuaker: Personally I am just less hung-up on the notion that only I or only people who I work with should influence the overall allocation of the fund. I will subcontract some of the responsibility in that space, if I believe that the person I am subcontracting it to has skill.

In some ways, it is a win-win: if they have skill and I have skill, and their skill comes in at different times, you get the same return and lower volatility.

Elisa Trovato: How easy is it to get yield out of the US equity market?

Mouhammed Choukeir: It is much harder to get yield out of the US equity market than other regions. The US equity market in aggregate yields around 2 per cent to 2.5 per cent whereas the UK is at 4 per cent. Investors want yield, central banks are going to keep rates low for a very long time, and the inflation headwinds are not going to go away any time soon. We see more and more investors going into dividend paying or income paying strategies. But the US historically has not been a market that gives back in terms of income. A lot of the time companies used to use the additional money for share repurchases and so on, which on a total return basis is not too bad.

Oliver Gregson: One area of interest for investors is the income from high yield bonds. That market was established in the US and is deeper, more mature and more liquid. While we are still constructive on that asset class, it is primarily for the coupon that you can clip, in a relatively low interest rate environment, in addition to the fact that our expectations for total returns going forward are going to be much lower than they have been historically. The importance of income in driving the return that investors receive is a big area we are seeing flows into.

Lars Kalbreier: What is clearly worrisome is that high yield bonds have become so acceptable now. Default rates are much lower than they used to be. You could argue that companies are being better managed and have more cash on their balance sheets, etc. Unfortunately, we all do the same analysis and we all know how these things usually end. It is lack of alternatives that is the problem.

Bill McQuaker: The upcoming presidential elections might have implications for either the dividend paying capacity of US companies or their ability to buy back stock. There is a massive amount of cash held offshore by US companies, which are very international and have mature overseas businesses that generate cash. At the moment the tax code is such that it is disadvantageous to US companies to bring that money onshore.

If the Republicans win and are trying to find business friendly policies to pursue, then there might be a willingness to grant an amnesty, so that that cash can come back onshore into the US without generating a tax liability. It could be done as a one-off amnesty or could be part of a restructure in the US tax code. Cash balances at the moment in the US are extremely high. This would be the icing on the cake if they were allowed to repatriate overseas cash as well.

Grant Bughman: The other thing about dividends is that corporations recognise the interest in shareholders receiving dividends. Over the last few quarters more and more CFOs and CEOs talk about increasing dividend payout ratios. While looking backwards the yields on stock in the US have been low, corporate America is realising this is how they are going to be judged in terms of their share prices and so they need to figure out ways to increase payouts to shareholders.

Claudia Panseri: This is also because now it is a new style. People have been speaking about growth, value and now income. We are probably more sensitive to see which stocks are able to pay growing dividend over time, rather than high yield payers in absolute terms.

Elisa Trovato: What does the future hold for the US market?

Lance Peltz: I think there is probably a big underestimation in how much the US economy can move to a strong position relative to the rest of the world and emerging markets. Technology, labour substitution, cheap energy and cheap feed stocks are really significant for the US.

Mouhammed Choukeir: If we think about the upside and downside potential, the upside has already been factored into the price – whether it is QE3, which has already been delivered, whether it is what the ECB has already done. There are some quite high expectations in terms of the economic prospects for the US. They could be delivered and even exceeded. We would argue that the upside is actually much smaller than the downside.

Participants

1. Grant Bughman

Client portfolio manager, Director, UBS Global Asset Management

2. Mouhammed Choukeir

Chief Investment Officer, Kleinwort Benson

3. Oliver Gregson

Director of Investment Management, Barclays

4. Lars Kalbreier

Global head of investment funds & ETFs, Credit Suisse Private Banking

5. Bill McQuaker,

Head of Multi-Asset, Henderson Global Investors

6. Claudia Panseri,

Strategist, Société Générale Private Banking

7. Lance Peltz,

Senior Analyst, Investment Management and Guidance, Bank of America Merrill Lynch

8. Stefano Spurio,

Head Investment Advisory Geneva/Monaco, Bank Julius Baer

Moderator: Elisa Trovato,

Deputy Editor, PWM Magazine

Claudia Panseri

• QE 3 helped avoid a second recession in the US while deflation would have been a problem without that injection

• Exports are increasingly becoming an important contributor to the US economy and look set to be a long-term theme

Lance Peltz

• As the US is a very efficient market it is one where investors are happy to use ETFs

• There is probably a big underestimation of how well-placed the US is when considering its high levels of technology, cheap energy and labour markets