Investing in the US Part 1

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: There are two driving forces behind market dynamics at the moment in the short term. There is that tug of war between sentiment and liquidity. Each new injection of liquidity tends to have a lesser effect. In many ways it is funny that confidence and sentiment tend to swamp much of some of the underlying fundamentals, certainly in the short term, and actually leads many to commentate on what a poor year it has been for investing. If you look across the US landscape, returns have been very decent, yet if you were to ask the average investor whether or not that is what he felt the year has been like, that has absolutely not been the case. 

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.

The economic model of the last 30 years of credit growth, which leads to economic growth, and in turn asset growth, is difficult to run in reverse, especially when that liquidity is very different. You are only getting secured lending at the moment. For many people, when risk is completely flipped round, the risk of capital almost equals the return on capital these days: ‘I would rather get the return on my money than looking for a return on my money’.

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.

Lance Peltz: I think that QE1 was absolutely necessary. Something had to be done, and that probably did break the spiral. However, it is debatable that subsequent doses of quantitative easing have been as effective or as necessary. I suspect that Operation Twist has had a more positive impact than QE2. I think QE3 probably gets us deeper into a hole – a long‑run hole – rather than a short term benefit.

If anything, I think more importantly, the complete announcement this time round that accompanied QE3 gave much greater clarity about policy triggers that would lead to a reversal of stimulus, or a significant change. That is as important as an extra $40bn into the mortgage market.

Mouhammed Choukeir: The problem with QE3 is that essentially it is diluting the impact of quantitative easing even further, because the Fed had just said, ‘We are going to keep rates lower for as far as the eye can see, and we are going to come up with package after package to get that confidence going’. It is actually quite interesting: QE1 was about the financial system; QE2 was about deflation/inflation; and QE3 is about employment. They stated that in their statement.

The big debate right now is about whether the unemployment rate is at a structural or a cyclical high. What we saw pre-crisis was full unemployment in the US was around 4 per cent or 5 per cent. Currently it is around 8 per cent. That is just a structural shift, and maybe that is where it needs to sit. Germany sat on that unemployment rate for a very long time, and the economy grew and it did very well.

So I would argue that essentially the quantitative easing programme is not necessarily going to lead to employment. Other things need to happen – whether it from politicians, the government – to help create that structural shift in unemployment. 

The other notable difference between QE1, QE2 and QE3 is that going into QE1 and QE2, the markets, inflation expectations and economic data were all on the decline. Going into QE3, it is all the flipside. Markets are on the rise, inflation expectations are on the rise and economic data has actually been improving. A lot of it counters the reasons they did QE1 and QE2.

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.

Fannie and Freddie are backstopping the tremendous amount of mortgages that are being created in the private market, so until that changes, there are plenty of people in the US who just do not have the 20 per cent down payment to put down in order to access to those very cheap rates.

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. When you look across their balance sheet, the asset side is in relatively good health. And certainly the recovery in housing will continue to act as a tailwind in supporting this dynamic. 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.

In short, 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 am not sure that you can create something as important as the US consumer, when it is 70 per cent of the economy, but I think there are 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, it could be that that reliance will disappear. That could be quite energising for the US in terms of underlying national confidence.

Those three things in combination make me think that there is reason to believe 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.

I guess the pessimism of many commentators towards the US is probably misplaced.

Bill McQuaker: On the one hand, the state of national politics in the US seems to be unusually partisan and very divided, which makes one think, ‘The US is in a bit of trouble if they cannot agree on anything’. That conditions the way that one thinks about the US at that level. On the other hand, in terms of what is happening on the ground, once again the US seems to have been remarkably flexible and remarkably willing to change, reinvent and find some kind of economic future for itself.

Lance Peltz: That is a characteristic of the US economy; for whatever the crisis which it could have created for itself, it will rapidly fall to find a level where there is a clearing mechanism, as we saw with distressed assets, and then rebuild. 

A number of our fund managers we use, who are very much bottom-up, have been talking about a US manufacturing renaissance. It is an interesting thought for the unemployment issue, because there is a large proportion of the unskilled or semi‑skilled US unemployed workforce that was absorbed by the construction industry, where we were down to low unemployment of 4.3 per cent.

I suspect we are not going to get that same volume of construction activity in the next cycle. Something has to develop to absorb that unemployment. 

The other thing going for the US is it is a structurally growing demographic, whereas that is one thing that has contributed to Japan’s demise. There are a lot of things going in favour of the US. The only problem is that I do not think it is a very contrarian view now.

Claudia Panseri: When you look to the data, statistically the US is not better positioned relative to Europe or Japan. Of course, Japan faces aging population; it is the same for Germany and Italy. It means that over the longer term I would probably expect an impact on the US market with price/earnings coming down because multiples are strongly correlated to the ratio between active/non‑active population. I think this is something that very long term investors should look at. 

Mouhammed Choukeir: Lars, you were saying there is a lot of pessimism about the US. I think we would need to put that in context of the global economy. The US actually has more optimism than, say, Europe, and potentially China. China has not actually stopped growing throughout the crisis; it is ticking up quite nicely. However, there is a lot of potential pessimism around emerging markets and the issues that a hard landing could present. 

I think the key thing here is there is not much of link whatsoever between economic growth and financial markets. To use a recent example, the best performing economy here today is actually the worst performing stock market, and that is China. It is ticking up close to 8 per cent, but its market is actually down, while the rest of the world is up. In fact, since 2009, China has grown cumulatively by nearly 30 per cent, whereas its market, as we all know, is near the 2009 lows.

The link is between what growth is and what expectations are. It is really gauging where expectations are for the economy. What is normal for the US?  It is growing, say, 2.5 per cent this year. What is normal?  Pre-crisis it was around 4 per cent. I would say that actually 2.5 per cent, given the amount of debt that is in the system and the deleveraging that needs to take place, is quite elevated. So in fact, if anything, expectations are quite elevated in the US, and they need to be revised down.

Lance Peltz: The connection also is margins, allocation and return on capital. I think China is going to be a very good example of very aggressive misallocation of capital. That is why it has not fed through to market performance.

Grant Bughman: If you look at margins around the world, US companies have held up far better than any other region. That is a big reason why the US market has outperformed markets globally, in addition to a small degree of multiple expansion in anticipation of that.

Mouhammed Choukeir: I would disagree with that. I think the margins that we have seen over the past 15 years are unsustainable. This is during a period where we have had a global debt super cycle, where everybody has been leveraging, and also we have had a couple of bubbles. So if you compare current multiples to averages over the past 15 or 20 years, even, they seem attractive. Take them back to a world where we have lower debt ratios and we do not have bubble type scenarios, multiples are quite rich, in the US specifically and then also in other regions.

Claudia Panseri: I would agree with you for Europe, but not for the US, because in the US you have a dynamic growth. Europe faces a deflationary scenario so the current 10 times P/E is expensive relative to the five or seven times we had in the past. I am expecting the US market to reflate more, and to have a sort of asset reflation with PE going up and not coming down, which is the case for Europe.

Elisa Trovato: How important are your views on the other regions of the world when deciding allocation to the US, for example?  For example, if the eurozone worries abate, do you believe investment flows may return to the eurozone and this may lead to eurozone outperformance relating to US equities?

Oliver Gregson: The drivers to world economic growth are the US and China. Europe’s economic impact or trade impact on US GDP is pretty small, but what this is coming back to is confidence: sentiment driving that lack of confidence, lack of investor faith or trust in CEOs, their muscle memory to the events of 2008. For me, critical to resolving that problem with sentiment and confidence will be a dialling down in the level of noise and rhetoric around Europe.

Lars Kalbreier: I would say, what Europe is all about is tail risk. You hence have this kind of Damocles’ Sword over the financial markets. And all markets are ultimately correlated: that means US equities markets ultimately are impacted by what is happening in Europe, even if not necessarily on the economic side. So, what I think we have seen recently is that tail risk has reduced somewhat, and ,automatically, that has fed into slightly higher confidence. How sustainable that is, I am not really sure.