Join our community of smart investors

The US - recovery gaining momentum

Despite the machinations of America's political elite, the US economic recovery is gathering pace and optimism reigns for the equity outlook
December 19, 2014

The business of government in the United Stated can appear strangely confrontational to us Brits. It was only a year ago, for instance, that bickering US politicians refused to agree a Federal budget - leading to the spectacle of a government shutdown and raising the possibility of a debt default at the world’s only remaining superpower. This year, too, the prospect of a government shutdown again reared its head as the machinations of America's political elite put a key funding bill in jeopardy. True, that risk was eventually averted when Congress, on 11 December, passed the $1.1trn bill that will fund the government through to September 2015. But it was close: the bill was passed at the last possible moment with just 13 votes to spare. With Washington's lawmakers in such a confrontational mood, and given the inevitability of a tighter monetary policy ahead, the US certainly face its share of challenges in 2015.

 

Political worries

The main political issue that has raised political tempers this time is President Obama's recently announced executive order protecting some 5m illegal immigrants. Specifically, the move is designed to allow the so called "undocumented" parents of children - who are already US citizens (or legal residents) - to apply for work permits lasting three years. But the Republicans see the order as an "illegal power grab" by the President. Indeed, some Republicans are sufficiently livid over this issue that, prior to the vote on the funding bill, it had been mooted that the so-called Grand Old Party may only agree to pass enough of the legislation to keep the government moving until mid-February. That would have allowed the Republican-dominated Congress, elected in last month's mid-term elections - but which doesn't begin sitting until January - to oppose the immigration move with the full force of its new majority.

The scope for White House-Congress confrontation has been clearly on display regarding the fate of a package of tax breaks, too. Every year Washington temporarily extends a variety of tax breaks that would be too expensive to make permanent. This time, however, Congress proposed a deal making some of the measures - supporting corporations, for instance - permanent. But President Obama has threatened to veto the package because it failed to include tax breaks for working families or the expansion of child tax credits. "It would provide permanent tax breaks to help well-connected corporations while neglecting working families," explained White House spokesperson Jennifer Friedman. Congress eventually voted to renew the tax breaks for a further year - but the issue of permanent tax breaks is likely to resurface during 2015.

Quite aside from the uncertainty generated by such Congress-White House confrontation, there's the cost. Had a deal making tax breaks permanent been agreed, it's estimated to have added up to $450bn (£287bn) to the US budget deficit over a decade. That casual willingness - from Democrats but also Republicans - to grow the country's debt burden has not gone unnoticed. "It really is a kind of shocker," remarked Maya MacGuineas, president of the Committee for a Responsible Federal Budget.

Such an attitude may even suggest that the era of ultra austerity - which was so high on the political agenda just a year or so ago amid America's round of painful sequester spending cuts - could well be drawing to a close. Indeed, it could be that some among Washington's elite are quietly preparing to roll-back some key elements of the sequester cuts. It has been reported, for instance, that the Pentagon is preparing a 2016-2020 draft budget that will violate the spending caps. Still, that doesn't mean investors should now jump back into companies - such as defence players - that have been most exposed to the cuts. Building the bipartisan support to significantly reverse sequester cuts will, at best, take time.

Certainly, John Boehner - the Republican speaker of the House of Representatives - has promised to fight the president "tooth and nail". But the passing of the funding bill suggests that the conflict between a Democrat-run White House and a Republican-dominated Congress can be managed. Significantly, the Republicans must recall how it was their attitude in Congress, and not the White House, that the electorate blamed for last year's shutdown. That blame-game can only worsen for the Republicans given their new-found majorities in both houses of Congress: the public will perceive the Republicans as being 'in power' to a significant degree and therefore responsible for any mess that comes from political manoeuvring.

 

The economy

But while "uncertainty about fiscal policy and associated political brinkmanship could return in early 2015," reckons the IMF, the US economic recovery is, nonetheless, still making decent progress. In October, for instance, the IMF upped its forecast for US economic growth during 2014 by half a percentage point to 2.2 per cent and maintained its estimate for 2015's growth at a fairly bullish 3.1 per cent. That should be compared to the IMF's rather more subdued 1.8 per cent growth estimate for the eurozone in 2015. Moreover, recent data confirms the progress: in October 214,000 jobs were added to the US economy and the unemployment rate fell to a six-year low of 5.8 per cent

But that progress also raises the inevitability of a tightening monetary policy environment. At the end of October, for instance, the Fed announced that it was bringing its quantitative easing programme - a huge bond-buying programme, designed to stimulate the economy - to an end, after 10 months or so of already having 'tapered' the programme down. With the economy demonstrating growing resilience then interest rate rises are also back on the agenda. The Fed has signalled that it expects to begin raising the key federal funds rate during the first half of 2015. Since December 2008, the Fed has been targeting a funds rate of between zero and 0.25 per cent, but a Reuters poll last month suggested that a majority of those Wall Street banks that deal directly with the Fed think the rate could reach 1 per cent by end-2015. That said, a persistently low inflation rate - driven significantly by low energy prices - could yet delay the start of rate rises.

 

Market confidence

But even if rates do start rising, they're hardly set to soar - leaving investors still likely to remain keen on seeking out yield by punting on equities. It's a trend that has been very much in evidence during the course of 2014, despite wobbles in the autumn. During this year, the S&P 500 has risen over 12 per cent, for instance, while the Dow Jones Industrial Average has risen more than 8 per cent. And the Nasdaq Composite index has jumped more than 14 per cent since the start of January. Neither did October's market wobbles - partly fuelled by global growth fears - make much of a dent for long. Since mid-October’s woes, the Nasdaq Composite has recovered by over 12 per cent while both the S&P 500 and the Dow has jumped in excess of 10 per cent.

Wall Street isn't short of bulls who expect the good news to continue in 2015, too. Adam Parker, Morgan Stanley's chief market strategist, is a good example. "We head into 2015 bullish for the third straight year," said Mr Parker in Morgan Stanley's 2015 Global Strategy Outlook report. Indeed, he's forecasting a 12 month forecast target for the year-end 2015 for the S&P 500 index of 2,275 - some 10 per cent upside from current levels. In fact, based on 7 per cent earnings growth, he's expecting the market's average forwards earnings multiple to reach 17 times - compared to just over 16 times now and a 10-year average forward multiple of little more than 14 times.

But while such a rating expectation seems elevated by historic standards, Mr Parker is convinced that his bullish stance is justified To begin with he points to positive economic factors, such as consumer confidence, and falling bad debts, as well as the fact that consumers look more financially insulated than some may think. That's because 75 per cent of their financial obligations are in the form of mortgages and that around 90 per cent of those mortgages are on a 30-year fixed rates, based on the lowest interest rate ever. He also points out that US corporate capital spending still remains muted and that takeover activity is still nascent - suggesting that corporate priorities in the US are focused on longer-term expansion. "The core of our thesis is that we are in the middle of a long US expansion, one that may last until 2020," reckons Mr Parker.

 

OUR TOP FIVE US PICKS FOR 2015

While the activities of America’s political elite could yet mean market hiccups, the increasingly entrenched nature of the US economic recovery should offer plenty of longer-term defensive opportunities for investors. So, below, we’ve identified five US stocks - in safer-looking big companies but with solid prospects, nonetheless - that could deliver a decent return for investors during 2015.

Google (US:GOOG)

Admittedly, Google’s shares have hardly impressed of late: they're down almost 13 per cent since mid-September. And there's certainly plenty going on at the social media giant that has left investors worried: from concerns among European regulators about the group's market dominance to pricey looking ventures such as the development of self-driving cars. But despite that, analysts reckon Google's earnings will still grow by 16-18 per cent a year over the next half decade as the core search engine business makes hay, driven by such factors as an explosion in smartphones. That's a rather more attractive pace than the market more generally, yet the shares trade on about 18 times forecast earnings compared to about 16 times for the market overall. Sure, don't expect big short-term gains but - longer-term - that modest premium doesn't do justice to the group’s superior growth profile.

Google
Market valueShare price2-year earnings growth*2015 forward PE*2014 prospective yield*
$357bn$527+37%16nil
*Based on JPMorgan's estimates

 

Bank of America (US:BAC)

Despite weakness at its investment bank, Bank of America has continued to recover. Credit quality, for instance, is improving rapidly and the group's bad debt charge for the nine months to end-September fell 26 per cent year-on-year. Cost-cutting is also under way and the third quarter net interest margin grew seven basis points quarter-on-quarter to 2.27 per cent. While a Basel III-basis core tier one equity ratio of nearly 10 per cent leaves the bank looking solidly capitalised. Sure, the bank has been hit hard with huge redress-related costs for having mis-sold mortgage-backed securities prior to the financial crisis. But, unlike for the UK banks, that pain now looks largely in the past for the big US lenders. An accounting glitch earlier this year also meant that the Federal Reserve Bank blocked the bank's dividend and share buy-back plans - so the yield of around 1.2 per cent (based on the third quarter annualised payout) isn't great. Still, that payout is set to improve to 41¢ (26.2p) by 2016 and the shares, trading on under 1.2 times JPMorgan's end-2014 net tangible assets estimate. With a recovering US economy set to drive credit demand and improving credit quality, that's just too cheap.

Bank of America
Market valueShare price2-year earnings growth*Price/2015 NTA*2014 prospective yield*
$183bn$17.25+69%1.151.7%
*Based on JPMorgan's estimates

 

American Electric Power Co (US:AEP)

As is the case in the UK, investors often look to the solidly-defensive utilities to protect against uncertainty. And for those that aren't so keen to punt on the sustainability of America's economic growth profile, then it's possible to do the same in the US - and few utility plays looks as well placed as American Electric Power. It's actually one of America's largest electric utilities and is responsible for providing some 5.3m customer in 11 states with power. It also owns the country's largest electricity transmission system. True, earnings aren't exactly forecast to soar - JPMorgan expects earnings to grow around 5 per cent between end-2014 and 2016 - although the group's growing transmission system does offer some growth potential. But the shares do yield almost 4 per cent based on 2015's forecast payout and the shares - trading on about 15 times 2017's expected earnings - are rated at a "mild discount", says JPMorgan, to the those of its peers in US regulated utilities sector. Definitely one to snap up and tuck away for the long-term.

American Electric Power Co
Market valueShare price2-year earnings growth*2015 forward PE*2014 prospective yield*
$28.8bn$58.87+8%173.40%
*Based on JPMorgan's estimates

 

General Electric (US:GE)

Amid better economic conditions, industrial giant General Electric is doing rather well. Indeed, demand for GE's industrial products - which includes such items as jet engines and gas turbines - is growing strongly and third quarter orders grew over a fifth year-on-year to a huge $250bn. The group is also restructuring itself: that includes selling its Electrolux unit for $3.3bn and cutting down its financial services offering (significantly, the group is ditching its store cards operation, Synchrony Financial). Earnings are also forecast to grow by a reasonable enough 6 per cent during 2015, according to JPMorgan, and there's a decent yield, too: 2013's 79¢ dividend equates to a 3.1 per cent yield and JPMorgan expects that payout to rise nearly a quarter by end-2015.

General Electric
Market valueShare price2-year earnings growth*2015 forward PE*Yield*
$256bn$25.49+5%143.1%
*Based on JPMorgan's estimates

 

Home Depot (US:HD)

Better economic conditions should mean an increasingly buoyant housing market and, for those that want to play that housing story without taking on direct exposure to housing, Home Depot could be the answer. The idea is that once homeowners start to feel more financially comfortable then they'll be keen to splash out doing up their homes with new kitchens and renovations. On that basis, they're likely to head down to the Home Depot - the world's largest DIY retailer - which should provide a robust growth fillip. Trading already looks robust and, with its third quarter figures, pre-tax profit for the nine months rose nearly 15 per cent year-on-year. Analysts are expecting more to come, too, and JPMorgan expects earnings to have risen 19 per cent during 2014 with a further 16 per cent earnings hike forecast in 2015. True, trading on about 22 times 2014's forecast earnings, the shares are rated at a premium to the sector. But, as JPMorgan points out, "HD [Home Depot] remains one of the best long-term stories in retail given company-specific sales and margin initiatives". The investment bank's price target stands at $110, too.

Home Depot
Market valueShare price2-year earnings growth*2015 forward PE*2014 prospective yield*
$130bn$99.2+38%191.9%
*Based on JPMorgan's estimates