25th June 2013
The US equity market may see several more tumultuous weeks before returning to growth based on improved earnings says Joanna Shatney, Head of US Large Cap at Schroders.
” We remain optimistic that further appreciation lies ahead over the long term and see the current pullback as an opportunity,” she says in a note issued this week.
“As we settle into a slightly higher rate environment, it is not surprising to see short-term market consolidation; in fact it wouldn’t be unexpected for markets to be tumultuous for the next several weeks.
“We remain believers in a stronger growth profile for the US economy, and think that continued US equity market strength could be seen as early as later this year. So far, US equity market performance has been a function of higher multiples. We believe the next leg of market outperformance will be driven by improved earnings growth, with a focus on companies that can exceed expectations with regards to earnings growth and cash redeployment.
“The US economy still has room for upside surprises and is rapidly growing its earnings base, while growth expectations in other markets have fallen short. It may be tempting for investors to chase markets that have seen big pull-backs, but we believe the US equity market remains very attractive on both an earnings growth and valuation basis. Earnings revisions for 2013 have turned down for most other regions, including emerging markets, but the US has actually begun to take up estimates. Forecasts are now for high single digit earnings growth in 2013. Valuation provides a similar attraction relative to history, with the US market trading at 15 – 16x -we are within normal ranges. Despite being up 13% year-to-date, based on a 20-year period the US is still the second cheapest market in the world on a normalised basis.”
The firm believes that the US offers a better risk reward profile for long term investors than other developed markets.
“While other markets may fluctuate, presenting opportunities for trading upside, we see steady upside potential in the US. A key factor is that margin variability in the US has proved to be less volatile than other developed markets, creating some downside protection. As investors start to think about increasing their risk profiles, this should prove appealing.
“In the intermediate term, the US is in an investor utopia on the back of an accommodative Federal Reserve with a dual mandate that focuses on growth. We are also optimistic about the long-term growth potential of the US, with 3 key secular growth benefits that other developed markets cannot fully replicate. The first – Innovation – from concept to commercialisation and protection of intellectual property, it is the main reason that US equities still dominate the global technology and healthcare equity market cap. The second – Competitive Advantage a flexible labour force, productivity gains, and a manufacturing renaissance are supporting long-term GDP potential. Lastly, Demographics – the demographic profile of the US should allow us to deal with longer-term challenges including the fiscal deficit.
The firm says that higher rates alone are not a reason to worry about equities and that the potential for growth is more important.
“Higher rates can be complementary to higher equity market returns as long as the rise in economic growth continues. It is generally expected that the Fed will remain accommodative until economic growth and employment hit healthier levels – we subscribe to this view.
“While the markets are clearly worried that higher rates mean higher discount rates on equities and investments, we are generally more optimistic , choosing instead to focus on the potential for upside surprises that higher overall growth can mean for company earnings. What we think investors are missing is that earnings estimates are now back at record levels. So while the US equity market is back towards record highs, earnings per share for the S&P500 is also expected to be near a record high. We think earnings growth will continue to outpace GDP. With unemployment above its target and inflation below, we do not expect the Fed to make draconian changes in its policy over the next 18 months. We don’t see interest rates as being draconian until treasury rates are significantly higher.”
It says that equities are attractive relative to bond markets – not just in terms of valuation, but also in the potential for cash redeployment bringing real yield for shareholders.
“This has been true for a very long-time – a favorite chart we have been using has compared yields for bonds and equities against P/E multiples – and this relative “cheapness” has not mattered to investors. However, a few quarters of lacklustre bond returns could help investors refocus on the opportunity that lies ahead for equities. In a growing economic environment rates are going to continue to rise. In that scenario, equities should offer the best overall return to investors. What might be more compelling to focus on now in the ‘bonds vs. equities’ argument, is the fact that for US companies, cash levels are at all-time highs while dividend payout ratios are at all-time lows. We never buy a stock just for its dividend – preferring instead to find companies that have multiple levers to pull to drive earnings growth, but it is important to note that the cash redeployment story is currently more compelling than ever before and this should allow stocks to break out of cyclical sector biases across almost every single sector in the US.”
Risks to our bullish base case are being debated in the markets today
“We admittedly have an optimistic view for the US economy and for the performance of US Equity markets, and there are certainly still risks to our thesis. These risks include Fed tightening sooner than we anticipate – which could spook investors in the short-term; a downturn in economic data – which may keep the Fed accommodative for longer but will be detrimental to consumer and business confidence; and any sort of extraneous shock that could lead to a level of fear and panic similar to what we experienced in August 2011.”