After a strong 10-year bull run in US equity markets, fund managers are re-adjusting their portfolios. Here's why.
For the past decade, the US stock market has soared. The S&P 500 has provided investors with generous returns over the past decade. Despite repeated warnings that the bull market is nearing its end, the S&P 500 index has managed to continue climbing, making the bull run, as at March 2019, the longest on record.
The run has been driven, at least in part, by two key factors. First, since the start of the decade the US economy has seen steady growth. Job creation has surged and US unemployment is now as low as it has been for 50 years, according to Bureau of Labor Statistics data.
At the same time, and confounding conventional economic thinking, this jobs boom has not resulted in a serious uptick in inflation. As a result, despite a monetary tightening stance since 2015, the US Federal Reserve has been able to keep rates at historically low levels.
This has continued to stimulate the economy and help keep equities attractive compared with other assets such as bonds, which typically have lower returns in low interest rate environments.
Bulls don't die of old age
However, all good things come to an end. With the stock market rally now the longest on record and the US economy's expansion also nearing a record length, surely both are due to fall back.
Financial markets and economies are generally cyclical, with a boom followed by a bust. Moreover, 10 years of share price rises will have left many equities trading at unrealistic levels and therefore due for a correction.
Last year's sharp if short-lived market rout could be seen as just the start of a big downturn. Hugh Grieves, manager of LF Miton US Opportunities and LF Miton US Smaller Companies, says that while we are probably closer to the end of the cycle than the beginning, the length of the economic expansion in the US itself does not concern him.
He points out that Australia's economy has been expanding for 27 years. He says: "Expansions are murdered by the US Federal Reserve; they don't die of old age." And the Fed, he adds, appears in no mood to kill the cycle off just yet.
As long as inflation remains low, the Fed is unlikely to raise the interest rate much further anytime soon. Grieves adds that the Fed is now aware of the risks of choking off US growth and stock market performance if it raises rates too fast.
Grieves is more focused on specific risks than on the question of where the US is in its economic cycle.
"We became more cautious about the 2019 outlook for the US economy last August/September, based on several tailwinds becoming headwinds," he says.
He notes that the tax stimulus is wearing off . As a result, earnings growth for US companies is likely to slow, news that is never greeted with enthusiasm by markets. At the same time, he cites the economic slowdown in the EU and China as factors to consider.
However, he says the potential for a global slowdown is not much of a concern in terms of the impact it will have on the US. He points out that the US economy is a relatively closed economy and much less reliant on exports than other major economies around the world.
Indeed, if the global economy does slow down, he suggests that the US may end up becoming a country investors flee to looking for relative safety.
That said, he argues that the headwinds he mentions will still probably feed into slower growth in the US. He expects a slowdown in growth from around 3% to about 2%, and that will dampen market expectations.
Meanwhile, Bob Kaynor, manager of the Schroders US Mid Cap and Schroders US Smaller Companies funds, fears the market has become too volatile. "The speed and magnitude of both the sell-off in quarter four last year and the recovery in quarter one this year signal a market environment that warrants caution," he says.
He notes that at the end of 2018, the market was quick to sell US stocks on the basis of slowing growth and tightening liquidity. Since the start of the year, however, the mood of the market has turned.
He says: "The market has quickly pivoted towards the expectation of accelerating earnings growth throughout the year, interest rate cuts and an imminent resolution to the ongoing trade dispute with China." Such a fickle market, it seems, is one to be wary of.
Angel Agudo, portfolio manager at Fidelity American Special Situations, is less concerned about the outlook for the US economy. He argues that it should continue growing, at least in 2019.
He says: "US economic indicators and earnings growth rates remain relatively strong." Agudo sees the forces that caused last year's market upset dissipating.
"Oil prices have fallen, US bond yields are back almost to where they started 2018, and trade conflicts appear to be subsiding."
Top US funds are up sixfold over the past decade
|Total returns (%) over:|
|Morgan Stanley US Growth||IA North America||106.61||168.73||604.27|
|Vanguard US Opportunities||IA North America||78.08||135.94||592.72|
|Morgan Stanley US Advantage||IA North America||85.65||153.47||518.98|
|T Rowe Price US Large Cap Growth||IA North America||94.37||151.15||505.81|
|T Rowe Price US Blue Chip||IA North America||87.19||150.69||485.41|
|Baillie Gifford American||IA North America||107.28||168.73||483.20|
|T Rowe Price US Smaller Comps||IA N Am Sm Cos||67.84||109.41||463.69|
|JPMorgan US Small Cap Growth||IA N Am Sm Cos||110.90||112.97||454.79|
|Brown Advisory US Smaller Comps||IA N Am Sm Cos||73.54||112.38||441.02|
Note: table shows top performers from the IA North Am and IA North Am smaller cos sectors, ranked by 10-year returns. Source: FE Analytics, as at 31 March 2019
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Grieves, expecting lower economic growth, anticipates lower returns. He argues that investors can no longer expect to "shoot the lights out". His focus now is on "capital preservation in a lower-return world".
He anticipates investors taking far fewer risks, and becoming less speculative and therefore less focused on high-growth investments with large price-to-earnings ratios such as tech sector stocks.
As a result of this more cautious attitude, he argues, there are now "opportunities in more defensive growth ideas that can grow despite a slower economy". Such companies’ earnings are, historically at least, less dependent on the economic cycle.
Adrian Lowcock, head of personal investing at Willis Owen, agrees: "During the latter stages of an economic cycle, defensive sectors such as consumer staples, energy, utilities and healthcare tend to perform, while the consumer discretionary and technology sectors have historically been poor performers."
Lowcock expects such sectors to easily outperform should the US enter recession. While over the past 10 years consumer discretionary and technology stocks have soared, there has been a protracted underperformance in energy and consumer staples. Those may be due a rebound.
Kaynor also expects slow growth; he is taking a defensive approach by focusing on companies with less debt. Highly indebted firms are particularly at risk in a downturn. Echoing Grieves, Kaynor says he is positioning his portfolio for companies able to grow independently of strong economic growth.
Agudo, too, argues that high-growth tech stocks will soon fall out of favour. He believes value investing - his favoured style of investing – will start to see more upside. He notes that the past 10 years of performance have been driven by growth businesses, "in particular in the technology space, with mega-caps such as the FAANG names being notable contributors".
The dominance of these has made life difficult for value investors. He says:
"A lack of exposure to these mega-cap growth names has been a major headwind."
But market leadership could be changing. He adds: "A potential easing of these headwinds - combined with a decent economic backdrop and more attractive valuations after the sharp falls of 2018 - suggests an improving backdrop for the months ahead."
Fund suggestions for shifting sentiment
Darius McDermott, manging director at Chelsea Financial Services, believes a return to value investing is possible but will depend on inflation and the Fed's response. He says: "If the economy accelerates and we start to get more inflation, we could see a sudden reversal. Then expect cheaper cyclical value sectors such as ‑ financials to do well."
If there is a "snap-back to value", he says Brown Advisory US Equity is a fund investors should take into consideration. A return to value, however, is not a given. McDermott says it is also likely that the Fed will hold or even cut rates further. He adds:
"If you believe interest rates have peaked for now, you might want to consider AXA Framlington American Growth"
Ben Yearsley at Shore Financial Planning believes the US market is too expensive. He says:
"It has been on a strong run for the best part of a decade and looks more expensive than many other developed markets."
Yearsley admits the premium on US stocks is somewhat justified, noting the high weighting towards tech stocks and higher US growth in general. But he struggles with the idea of buying into the US based on its current rich valuations.
The cyclically adjusted price-to-earnings ratio for US stocks sits at around 31. While the ratio is not the highest it has ever been, it remains way above its historic norm.
However, that doesn't mean having no exposure is a good idea. He says: "I've been playing it slightly differently in the past year, with a 130/30 fund that aims to capture most of the upside while also profiting to a degree from falls in markets: Artemis US Extended Alpha."
Lowcock, meanwhile, says Aviva Investors US Equity is a good late-cycle choice. The fund, which looks for dividend-yielding stocks across sectors, "can lag in rallies but tends to hold up well in challenging market conditions, thanks to its downside protection measures".
Another fund to consider is Merian North American Equity. Lowcock says it has a flexible approach. It can shift between value and quality to capitalise on a changing market environment. "The flexibility and dynamic nature of the approach has helped our team avoid areas prone to overcrowding and mitigate risk in falling markets," he says.
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