“This is a re-opening not a recovery” – it’s a line I’ve heard in many of our fund manager meetings this year, as we’ve tried to evaluate the speed at which economies have grown and, importantly, at what point they overheat?
The US is a perfect example – led by the FAANGMs, the S&P 500 has risen almost 70% from March 2020*, as the switching from off to on had an unprecedented impact on earnings.
In fact, the S&P 500 rallied at its fastest pace in the post-WWII era, having doubled in 354 trading days versus the average 1,000 required to achieve such a feat**. However, whatever measures you now use (CAPE, forward and trailing PE or price to book) US equity valuations are now trading at least a 20% premium to their median in the past 15 years***.
While I don’t want to point to history and simply say the market can only go one way from here (I’m not sure that is the case), I do believe it only takes a small jolt to knock confidence from this point – and there are clearly challenges facing the economy.
New challenges as the economy looks to put Covid in the rear-view mirror
At the end of the third quarter, consensus for 2021 was that US GDP figures would come in at 6.1%, although forecasts for 2022 rose slightly amid hopes that the economy has seen the worst of Covid. Around 60% of Americans are fully vaccinated, although the rate has slowed****. This should give rise to hopes that households could spend some of the $2trn plus in excess savings they accumulated during the pandemic****.
It is also important to note the Biden administration has continued to provide fiscal support to mitigate the impact of the pandemic. It has proposed two multi-year spending packages equivalent to 18% of 2021 GDP: the American Families Plan (US$2trn) and the American Jobs Plan (US$2.3trn) – the main purpose of both is to strengthen the recovery^.
But what of the challenges to a continued recovery? Lazard points to four standouts – many of which are applicable to the majority of the developed world.
The first is supply chain bottlenecks, with transportation and semiconductors the two prominent concerns, while the fact that there were a record 10.9 million unfilled jobs in the US suggests the labour market continues to be off-kilter^. Wages account for 50-55% of the cost of goods and are always a major contributory factor to inflation.
The first two factors lead into the concerns around inflation, which currently stands at 5.3% – although this has started to slow, many commentators do expect it to remain above the Fed’s 2% target for the next couple of years as a minimum.
The last is the implications for inflation, monetary policy and markets. Tapering of the Fed’s US$8.4trn balance sheet is expected to start at the end of this year with reductions between $15-20bn a month touted^^, while there is an increasing view that rates will rise in early 2022.
Don’t discount the positives
If we use valuations relative to history, we also have to consider other factors which suggest there is more room for growth. You may not be surprised to learn that corporate earnings for S&P 500 companies recorded their highest year-on-year earnings growth in over a decade in Q2, 2021. However, companies have also beaten analyst expectations on both earnings per share (EPS) and revenue growth – perhaps indicating that companies have the power to offset the effect of inflation on rising input costs by passing them on to their customers*. Blackrock says this surprise has not been recognised by the market due to scepticism among investors.
Much of the concerns around valuations are also tied to the large tech stocks. Although they appeared to be thriving compared to the rest of the global economy in 2020, these large tech companies were also adversely affected by the pandemic. For example, Apple closed all its retail stores and Google lost all its revenue from travel-related searches. We’ve already seen stronger growth in 2021 to prove this and we have to remind ourselves these companies are playing into a long-term theme with a huge tailwind. Here we would look to something like the Axa Framlington American Growth fund, which has a number of these major tech stocks in its top 10 holdings^^^.
There are also plenty of opportunities in the mid and small-cap market. The index is markedly different to large-cap in composition, with cyclical sectors making up more than half of US small and mid, whereas technology, internet, media and telecom – traditional growth sectors – account for less than 20%^^^^. Managers to consider here would be the likes of the T Rowe Price US Smaller Companies Equity or Schroder US Mid Cap fund.
There has also been a dividend recovery of sorts. I recently read there was a historically high proportion of Russell 1000 companies raising or re-introducing dividends in 2021. Interestingly, the average hike in dividends stands at a record 56%, compared to an average rise of 20% annually since 1980*.
I’m not going to finish by saying jump in to US equities at these prices, but there are some pockets of value, particularly further down the market-cap – where I feel investors can dip their toe in and make reasonable returns.
*Source: FE fundinfo, total returns in sterling, 23 March 2020 to 6 October 2021
**Source: BlackRock – Taking Stock (Q4 2021)
***Source: Schroders – Which stock markets look cheap – October 2021
****Source: Lazard – Outlook on the United States Q
^Source: IMF World Economic Outlook – October 2021
^^Source: Janus Henderson – The taper is (almost) here: what it means for bond investors – September 2021
^^^Source: fund factsheet, 31 August 2021
^^^^Source: Schroders – Four reasons for investing in US small and mid-caps (and four challenges)
