Investors such as Peter Elston, the veteran chief investment officer at Seneca, take the view that the US economic recovery is now very mature, as signalled by interest rates going up to prevent inflation getting out of control.
Higher interest rates are bad for equities because they push bond yields up, increasing the relative attractiveness of bonds to equities. That implies the shares which perform most like bonds, such as consumer goods companies, will suffer.
Higher interest rates might be expected to push the value of the dollar upwards. That could be bad news for US companies that derive the greater part of their earnings from overseas, as US exports become less competitive.
US unemployment is currently at a level of less than 5 per cent. That implies there is relatively little slack left in the economy, less scope to grow.
The rally enjoyed by the US market over the past year has centred on a relatively small number of stocks, notably in the technology sector. Previous cycles that have had abrupt endings have also centred on a small number of shares – in 2007 it was the financial sector and in 1999 it was also technology.
Very high levels of economic growth can be bad for the stock of Donald Trump, as the market expected a raft of pro-business policies such as tax cuts and fiscal stimulus. Markets are now wary that Trump won’t have the support to implement key parts of his programme, so a rally partly inspired by politics could run aground with the rhetoric of the politician.
All of that has prompted Simon Evan-Cook, multi-asset investor at Premier, to comment that he has been pursuing an ‘America last’ strategy.
Kully Samra, head of the UK office of Charles Schwab, takes the view that the US economy is in good shape and that tech is one of the three sectors of the US market that represent value right now.
He said, ‘US equities have outperformed other markets since the financial crisis, but there is a common perception that US equities are factoring in unrealistic earnings expectations on hopes of fiscal stimulus and other changes proposed by President Trump.’
Andrew Cole, senior investment manager at Pictet Asset Management, opined that while the share prices of the tech majors have performed well, the earnings being achieved by the companies have actually outpaced the share price gains.
Mike Bell, global market strategist at JP Morgan Asset Management, believes that while the US economy is in robust health, valuations are relatively unattractive when compared with other markets. However, he noted that ‘continued healthy earnings growth – with upside risk from potential fiscal stimulus and late-cycle exuberance – certainly argues against going underweight US equities at this stage.’
Bell continued, ‘While we remain positive on the outlook for US equities, valuations are not cheap, though nor are they particularly expensive by historical standards. Looking outside the US, valuations are slightly cheaper, while the earnings recovery in Europe and the emerging markets is only just getting under way after five years of contraction.
‘With this in mind, there may be greater upside in equity markets outside the US where earnings and margins are coming off a lower base.’
Simon Edelsten, who runs the Artemis Global Select fund, is not remotely concerned about the valuation levels at which US equities presently trade.
The veteran fund manager commented, ‘We have over half our funds there and generally don’t find valuations different from elsewhere in our chosen themes. I think the reason the index looks expensive compared with Europe is simply the large internet stocks in the USA and the large number of banks in the European index.’
The market has seemingly been willing to pay ever higher multiples for technology companies while shunning banks. The preponderance of banks in the European index, in Edelsten’s view, drags down the typical valuation at which that market trades relative to other markets. But, as the fund manager has been sceptical on the investment case for banks, he believes a premium valuation for the tech sector, and so for the US market in aggregate, is justified by the earnings.
Luca Paolini, chief strategist at Pictet Asset Management, believes that the global economy is slowing down, and that the prudent course for investors is to focus on reducing risk within their portfolio.
However, that doesn’t dissuade him from investing in US shares. The top analyst remarked, ‘Despite the fact that US equities remain by far the most expensive region, and we are still cautious in the long term, they have historically held up relatively well during periods of global equity downturns. Hence, we have upgraded US stocks to neutral on a tactical, short-term basis.’
The analyst takes the view that US interest rates will rise at a pace faster than that which is presently being priced in by the market.
Darius McDermott, managing director of FundCalibre, commented, ‘The US is enjoying its third-longest period of economic expansion since 1850 and, despite the IMF cutting its forecast recently due to “policy uncertainty”, the economy is still forecast to grow
by 2.1 per cent this year and next. Unemployment is low, corporate earnings are strong and, importantly, earnings expectations remain high. Small business sentiment is as high as it has been since 2004.
‘The US dollar is seen as a safe-haven currency and the economy, while not perfect, is arguably more solid than any other in the developed world right now.’
He has reduced his exposure to the technology parts of the market. He said, ‘Tech is one of the most cyclical sectors, and also one of the most expensive in our view, having returned 35 per cent over the past 12 months. While the long-term case for tech remains on track – with the sector set to benefit from the digital revolution and have the highest expected return – tactically this is the time to take some profits.’
Samra opined, ‘While there is no doubt that valuations are above both the median and the mean levels of history, the current climate is very supportive of equities. You have low interest rates, low inflation and decent economic growth. Very high or very low levels of growth are bad for equities, but the current level is positive.’
Very high levels of economic growth can be bad for the stock market because it drives interest rates upwards at a rapid pace. Samra told What Investment, ‘I suppose the bear case for US equities is that the [bond] yield curve is flattening, but that is happening because inflation expectations are low, not because the economy is slowing or investors are moving to risk-off.’
The yield curve flattening means that investors are buying bonds, and this is traditionally viewed as a sign that the market is concerned about the outlook for the economy and so are buying assets that are perceived to be lower risk, such as bonds. But the attractiveness of bonds also increases when inflation expectations are low, as the value of the fixed income is not eroded by rising prices.
Samra added, ‘A key measure for us is the consumer spending data. In the first quarter this grew by 1.1 per cent, but in the second quarter it grew by over 3 per cent. That shows the consumer is in good health, and that is where the growth can come from.’
He noted that while the gains have to a large extent been driven by the technology sector, ‘The growth in tech is secular; it is not just about being on the right side of the economic cycle. And there are signs now that some other sectors are starting to do the
Samra then turned his thoughts to the sectors he believes represent the best value in the US market. He continues to have a preference for large-caps, and is keen on technology stocks ‘due to the levels of growth they are achieving’.
He added, ‘We like the bank stocks because interest rates rising is beneficial for them, and we like the healthcare sector. It is a very unloved sector, and I guess the outcome of the reforms of Obamacare will have a big impact either way. But demand for healthcare is rising and the dividends are rising.’
George Boyd-Bowman, global equities fund manager at Neptune, elaborated on the notion that the rising interest rate environment, which may be viewed as a threat to the returns of certain sectors, presents an opportunity for the US banks.
He commented, ‘The US economy is performing well, bond yields have been rising and we expect them to keep rising. The US bank shares performed very well in the aftermath of Donald Trump being elected US president. This is because the market expected corporate tax cuts, and the US banks would be very big beneficiaries of this because almost all of their earnings are domestic.
‘We also thought that inflation and bond yields would rise as the economy would be strong, and that there would be a change in the regulatory environment.’
He continued, ‘The strong performance of the banks reversed a bit this year because bond yields went back, and there is more scepticism about the ability of Trump to deliver.’
The fund manager remarked, ‘After years where banks were required [by regulators] to hold more capital, they are now in a position where they have excess capital, which they can return to shareholders. One of our holdings is JP Morgan, which increased the dividend by 17 per cent. We simply don’t think you can get earnings growth like that elsewhere.’
He added, ‘The key is that a change in regulatory environment can be implemented without congressional approval. Trump can change the heads of the various regulatory bodies without Congress having to approve it. The US banks have been regulated more than their global competitors. They had the global regulation and then domestic regulation, so a change could really benefit them.’
Boyd-Bowman believes that the US economy will continue to perform strongly, and that should mean inflation continues, and that interest rates and bond yields rise.
This leads him to declare that the shares of Wells Fargo, another US bank in which he is invested, are ‘very undervalued’ by the market. The fund manager’s view is that Wells Fargo has a deposits base (from US savers) that is ‘unmatched’ in the market.
Rising interest rates and bond yields increase the income that Wells Fargo can achieve from those deposits. This is because the customer cash it has on deposit is placed into low-risk assets such as short-dated government bonds, and a rise in bond yields would achieve a higher return on that cash for Wells Fargo.