4th July 2013
As the US begins to pare back its quantitative easing programme, the UK’s programme remains firmly in place. In the second part of a series this week, Cherry Reynard asks what does this divergence in monetary policy mean for the likely performance of the stock markets in each country.
Is it worth backing the US because economic growth is stronger? Or the UK because of its loose monetary conditions?
In the short-term US funds have had the edge. Funds in the IMA North America sector have returned an average of 22.9% over the past year, compared to an average of 20.2% for UK All Companies funds. The S&P is up 17.57% over the past twelve months, while the FTSE 100 is up 10.6%. Over five years, the difference is even more marked. The North America sector is up 68.3% and the UK All Companies sector up 44.2%. As has been the case historically, the US is leading other markets.
Equally, the US stock markets have economic momentum on their side. US economic growth is now gathering pace: jobless numbers are decreasing, manufacturing data is improving and the housing market is recovering. This strength is prompting the Federal Reserve to consider the withdrawal of quantitative easing and should create a benign backdrop for companies.
No such claims can be made for the UK for the time being. Although it appears to have avoided a recession, GDP growth numbers are still lacklustre. The ongoing problems in Europe are exerting a greater drag on the UK economy, austerity is ongoing and companies still face significant headwinds to growth.
However, as Dave Taylor, manager of the Chelveton UK Income fund, points out in equity markets it is often better to travel than arrive. The US is stronger, but that strength is fully priced into markets. UK equities have lagged and therefore there may be more value to be found. He adds that the UK economy tends to follow in the slip-stream of the US: “As US companies start to feel more confident they start to look at Europe and ask ‘where do we buy?’, particularly if the dollar is strong.”
The UK market may not be cheap – Taylor believes that as the FTSE 100 was nearing 6,600 it was not necessarily justified by earnings, but there is more value now the market has moved lower. Equally, Taylor believes that economic growth may be better than the public statements suggest. He is selectively positioning his portfolio towards domestically-focused stocks, having been focused on international earnings for some time. Again, he believes that stronger economic growth may not yet be fully factored into UK equity markets.
The same cannot be said for the US, where even US managers admit that valuations look aggressive. Robert Royle, manager of the Smith & Williamson North American fund, says that on measures such as the Schiller P/E – which adjusts for cyclicality of earnings – the US market is trading at high levels relative to its history. He says companies appear to be ‘over-earning’. Current valuations are only justified by current earnings and if they start to fall, share prices are vulnerable.
Royle points out that a number of exporter stocks could be hit by the higher dollar, which is likely to result from the winding down of quantitative easing. He believes that high end manufacturers and those with a pipeline will be fine for the time being, but some companies will get burnt and investors need to pick their way through the markets carefully.
He believes that current stock market valuations imply significant margin improvement among US companies. Earnings have generally been disappointing in the first half of the year and analysts appear to be relying on a stellar second half of the year to meet their current expectations. Royle adds: “It is harder to find stocks with room to grow earnings. Companies have been so efficient with their balance sheets.”
Investors also need to consider the currency element when investing in the US. If the US dollar starts to appreciate on the back of the withdrawal of quantitative easing, it will be good for existing holders of US stocks, but not good for those buying in, for whom stocks will now become even more expensive.
While the US looks like the better option in terms of economic momentum, it may be more profitable to ‘travel’ with the UK. The US has led global stock markets higher and proved more defensive in weaker times, but valuations now look extended and have little room for potential disappointment.