Concerns over excitable market in US election year

The US has been the best performing major market index over the last year, out-performing not only other developed markets but also Asia ex-Japan and emerging markets. And it has done so by some margin. S&P 500 companies have strong corporate balance sheets, record amounts of cash and are generating good profits, which has propelled a rise in the index of 10.6 per cent year to date compared with 2.5 per cent for the MSCI EAFE Index of developed markets outside of the US and Canada.

More recently, however, concern has escalated that markets have outpaced prospects for the real economy. After 32 straight months of expansion, manufacturing stagnated in July. Nor will the estimated 100,000 new jobs created in July help much, as US unemployment figures have remained above 8 per cent for more than three years, and the figure is only slightly better than the 75,000 a month from April through June.

With only modest growth in sight, Federal Reserve policymakers are discussing whether additional stimulus is required to combat a slowing economy and the lingering European debt crisis, and are expected to act in September if job growth and consumer spending fail to pick up.

Arguably, however, the US is still better value and more sustainable than other countries, and the bulls believe this relative outperformance can persist. US research firm Leuthold Group studied 49 major stockmarkets since October 2009 , when the European debt crisis began to bite, and found that US markets outperformed 40 of the other countries. Of the eight nations which beat it, only South Korea could be described as a developed economy.

Disappointment with recent data can easily be viewed as a reflection of the excessive confidence in the US at the start of the year and overly-high earnings estimates, particularly in the technology sector. Although earnings have slowed from their annualised rate of 10 per cent through the 2000s, to 8-9 per cent in the last two quarters, this is still attractive on a relative basis.

NARROW FOCUS

Another widely-held view is that analysts are particularly bearish on the US because they are overly swayed by political factors such as the debt crisis and they tend to focus on just one story such as the next Mario Draghi pronouncement.

“The fundamental corporate backdrop is good and there is a clear distinction between that and the US economy, which is quite soft,” says James Butterfill, equity strategist, at Coutts.

“Quarterly results are strong. We’ve had 12 quarters of corporates beating their profits expectation, corporate deleveraging has been going well in recent years and average corporate funding costs are low,” he explains.

“Unemployment stands at 8.2 per cent which is disappointing on one hand, but good for business as it creates an employer’s market. Low wage costs will have a massive impact which is why I am fairly bullish and believe in EPS (for the S&P 500) of $104.5 a share against a consensus of $102. Raw materials costs have also fallen in Q2 and natural gas, a key cost in manufacturing, is plentiful and cheap in the US,” adds Mr Butterfill.

The Peak Margin Theory (that margins are too high) is a misconception, Mr Butterfill believes, because labour costs will stay low. Other commentators have also noted that the gap between emerging markets and US factory wages is narrowing, and recently the Wall Street Journal reported that US factory workers are three times more efficient than Chinese.

The US market may even be capable of decoupling from other global economies, and the slowdown in China and Europe could prove beneficial because falling crude oil prices puts more cash in the pockets of US consumers, lifting their income by 0.5 per cent in June.

Critically, the housing market shows strong signs of bottoming, which is encouraging since housing drives so many parts of the economy. House prices and mortgage rates are both at historically low levels. The average rate on a 30-year fixed-rate mortgage has fallen below 3.5 per cent for the first time in 60 years, and the average US house price is only 2.7 times the average family income, compared with five times in the UK.

John Carey, portfolio manager at Pioneer Investment Management, sees pent up demand in the automobile industry where sales have lagged the scrappage rate and improvement in spending on infrastructure, bridges and roads. US banks have also done a much better job of recapitalising than their European counterparts since the credit crisis, and while some of the largest banks are still burdened by the debt problem, regional banks are for the most part in excellent shape.

Consumer discretionary, technology and healthcare are other favoured sectors even in the context of a difficult foreign exchange environment. “Tech revenues grew by over 7.5 per cent year on year,” says Mark Stoeckle, CIO US equities at BNP Paribas Investment Partners. “Against a background of difficult foreign exchange that is impressive.”

NARROW FOCUS

Historically, presidential election years tend to be positive too, with markets rising more than 80 per cent of the time, but the next milestone is the so-called US fiscal cliff when automatic tax increases and deep government spending cuts will hit hard. Even Ben Bernanke, chairman of the Federal Reserve, has warned a recession could follow, and various major companies such as Lockheed Martin predict they will be forced to cut headcount.

“The market tends to get excited without much detail,” adds Mr Stoeckle. “The management teams we speak to are disappointed by the lack of detail from the ECB and the Fed. There are too many unknowns to hire people or make more capital expenditure and no road map on the direction of taxes, which makes it difficult to make decisions.”

If lack of a clear strategy in Europe has made corporates cautious, sooner or later that lack of investment will impact corporate earnings. However, M&A activity has recently tipped up, as companies try to grow top line revenues by entering new business areas.

In the early stages of bull markets, small-cap stocks usually lead the recovery giving way to large stocks later in the cycle. That pattern seems to be emerging in the US as large caps started beating small caps fairly regularly early in 2012 and have become more expensive, on PEs of 22-23 while cyclicals are on 12-13X.

The market has been fixated on dividend stocks, but for UK investors the 2.5 per cent dividend yield on the S&P 500 compares unfavourably with UK equity yields of 4.5 per cent, and indeed US High Yield Bonds which can yield 6-7 per cent and shares the same drivers as US equities.

Jeffrey Mortimer, director of investment strategy at BNY Mellon Wealth Management, argues there is too much emphasis on yield and pure dividend stocks may be a bit pricey, and his attention is switching to focus on total return. “As people move out of their bunkers, they’ll begin to pay up for companies that have the potential to grow their dividends over time,” he predicts.

VIEW FROM MORNINGSTAR

US markets lead the way

The S&P 500 TR gained 22.8 per cent (in € terms) between July 2011 and July 2012, outpacing both the MSCI World NR and a stumbling MSCI Europe NR. The S&P 500 struggled during the second half of 2011 but then experienced a strong first quarter in 2012 thanks to solid corporate balance sheets with improving profits. The strengthening of the dollar also helped US equities.

While the US economy is somewhat insulated and not overly reliant on exports, the news out of the eurozone has impacted mostly major US companies generating a meaningful amount of revenue and profits from Europe. US domestic sectors registered positive performance in the 30-40 per cent territory, whereas economic sensitive sectors such as energy, materials and financials were up 7-15 per cent.

In this context, the Morningstar US Large-Cap Blend Equity category posted a 17.3 per cent increase while both Large-Cap Growth and Large-Cap Value categories were slightly behind (+15.5 per cent and +15.2 per cent). Unsurprisingly, PowerShares EQQQ (+29.1 per cent) is topping the chart. This ETF provides exposure to the largest non-financial equities listed on the Nasdaq 100 and its high concentration of technology companies explains its strong performance.

Among more traditional US Large-Cap Blend funds, Pioneer Fds US Research stood out with an 18.6 per cent gain. Another winner is Robeco US Premium Equities in the US Large-Cap Value category. Manager Duilio Ramallo and his bottom-up approach that focuses on valuation and momentum delivered a 16.9 per cent return, a 1.7 per cent outperformance against the peer average.

Mathieu Caquineau, Senior Funds Analyst, Morningstar France

Searching for safety

Flows into EPFR Global-tracked equity and bond funds were dominated by US fund groups in July against a backdrop that included an escalation in Syria’s civil war, data showing China’s economy growing at its slowest pace in three years and Spanish bond yields again testing 7 per cent.

UBS Wealth Management has been overweight US equities by up to 2 per cent since the start of the year, largely at the expense of Europe, because the US offers better quality earnings with superior momentum and benefits from the strong dollar.

“Given the uncertainty surrounding Europe, we’d rather not be heroes and try to call the bottom of the market and increase exposure to the region until we see some improvement in the situation,” says James Mulford, executive director responsible for multi asset class bespoke portfolios.

“We have recently looked at the relative valuation of Europe versus the US to determine whether or not to increase European exposure. Using a cyclically adjusted price-earnings ratio, Europe appears to be 35 per cent cheaper than the US. However, when you remove the financials, utilities and telecoms, which are most closely linked to the fate of their sovereigns, Europe trades close to the historic average discount to the US of 16 per cent.”

Regarding active management, UBS Wealth Management has compared the returns from the IMA North America equity sector with the S&P 500 and found that over five years the average active manager underperformed by an average of 2.5 per cent after fees. Even the top quartile funds underperformed, and the same was true over one, three, five and 10 years. UBS therefore recommends clients bias their allocation to US equities towards passive strategies, though they combine this with two active funds, the Findlay Park American Fund and the Threadneedle American Select Fund.

Coutts uses a more thematic approach based on companies with a big competitive advantage and own companies such as Visa and Apple, monopolistic if possible, and also preferably with high R&D expenditure as a percentage of sales.

Market signals are conflicting and complicated however, and could change overnight. “Given the US status as a safe haven, many investors are currently overweight the region,” says Patrick Moonen, at ING Investment Management, Strategy and Asset Allocation Global. “But things may change on a couple of parameters.”

“The uncertainty regarding the fiscal cliff, debt ceiling and the Presidential elections may have a detrimental impact on confidence and hence on large scale investment projects, long-term hiring or big-ticket consumer goods. In other words the perceived safety of the US market may be undermined,” he explains.

“Further, if Eurozone worries abate, investment flows may return to the Eurozone. This may lead to Eurozone outperformance relative to US equities. For these reasons we have adopted an underweight position in US equities for our global portfolios. We prefer instead to be overweight Europe where relative dynamics may start to improve.”