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Is it time to invest in US equities?

With the twists and turns of the US election now behind us it could be time to re-evaluate the US market
November 10, 2016

By the time you're reading this the results of the US election will be known. But history suggests presidential elections have a limited impact on US markets: research by exchange traded fund (ETF) provider Source has found that six months after the last 11 US elections, bonds, equities and the US dollar had all made gains, with treasuries and equities delivering a total return of about 4 per cent. So is now a good moment to jump in - and, more importantly, what is the longer-term outlook for US markets?

Jason Hollands, managing director at Tilney Bestinvest, says: "It's hard to get bullish about the US. Shares in this market look expensive compared with history - and at a time when the growth outlook is not particularly great - and profits look like they peaked earlier this year. There's no doubt the relatively strong dollar is hurting some of the competitiveness of US companies overseas, so the [economic] data is mixed. There's no sign that this is a country that's blazing on all cylinders."

A rise in interest rates also poses a risk, and the US central bank, the Federal Reserve, has indicated that this could take place next month.

"The biggest underlying problem is that the Federal Reserve has kept monetary policy too accommodative for too long, so now they're between a rock and hard place," explains Mr Hollands. "Do they tighten monetary policy at a time when the economic cycle is near its peak but while actual growth rates are still particularly anaemic? They should have raised rates earlier, then they'd have had the scope to start cutting them again. And this is arguably why they're itching to raise them in December so they can be in a position to start cutting them again."

If the Federal Reserve does raise interest rates in December, he believes this would reduce one of the key factors driving the US equities bull market - the large number of businesses that have been refinancing their debt at ultra-low rates and buying back their shares. Higher borrowing costs would reduce this type of support as well as drive the US dollar higher, hurting US companies' competitiveness in the process.

Given his concerns about the macroeconomic backdrop, Mr Hollands is not planning to increase his exposure to the US, which he currently gets through trackers such as HSBC American Index Fund (GB00B80QG615).

But he has been thinking about shifting his US allocation into an active fund because active managers may be able to select more resilient companies when rates start rising.

Whether to invest in an actively managed US fund is a tricky decision, though, because the US stock market is notoriously difficult to beat. This is because it is highly efficient, well-researched, large and liquid. Recent research by S&P Global found that 91.91 per cent of US large-cap equity funds failed to beat the S&P 500 index, and in the UK less than 7 per cent of funds in the Investment Association (IA) North America sector have beaten the S&P 500 over the past five years, according to Tilney Bestinvest.

But Mr Hollands says: "If you share my view that the market is overvalued, and we're moving into a very different phase where the massive marginal buyer, which has often been the companies themselves, is starting to weaken, do you want to be in index funds that are fully exposed to market beta?"

Ben Yearsley, founder of high-net-worth investment service Wealthclub, is also concerned about investing in the US, because of sterling's current weakness against the dollar.

"The biggest problem from a UK investor's perspective is currency," he says. "The US market is not cheap. It's around 20 to 25 times earnings and historically it has always been more expensive than the UK on a price/earnings ratio (PE) basis. And the currency situation for a UK investor buying in has made it that much more expensive again."

 

Earnings revival?

But despite his belief that the pound will remain weak against the US dollar for the foreseeable future, Mr Yearsley thinks the advantages of being exposed to the US market may outweigh the risks.

"The US has some of the most innovative companies in the world," he explains. "Just look at the [success of] the so-called Fangs - Facebook (FB:NSQ), Amazon (AMZN:NSQ), Netflix and Google (GOOGL:NSQ) - even if they are highly valued. The US has also got a banking system that is, alongside ours, among the best capitalised in the world now. A lot of people dismiss the US and don't have much of a weighting there. But when you look at the companies listed on its markets it's bonkers not to have an allocation to the US - they're such good, world-leading companies."

Tom Stevenson, investment director for personal investing at Fidelity International, agrees. He believes the size and strength of the US economy supports the case for investing in US equities, as does the country's favourable business environment, powerful energy sector and strong demographics.

"Consumption continues to be a key driver of the American economy," he says. "At 68 per cent of US gross domestic product (GDP) in 2015, personal consumption is massively important and is well supported by low unemployment, low energy prices, a healthy housing sector and positive wage growth. America has a number of structural tailwinds that support the case for its equity markets. The most important of these is the country's lead in innovation. US research and development spending is nearly a quarter of the global total. Furthermore, eight out of the 10 biggest technology companies in the world are American."

Although some investors worry that US equities are too expensive, Mr Stevenson thinks they are worth their high price tag, particularly if profits continue growing.

"American shares have above-average valuations, but they are not excessively high by historic standards," he adds. "At the same time, company balance sheets are strong with manageable debts and, in some cases, high cash reserves."

The managers of CF Miton US Opportunities Fund (GB00B8278F56), Nick Ford and Hugh Grieves, expect the S&P 500's earnings per share (EPS) growth to accelerate in 2017, leading to a major market rally which could lead to a rise of more than 10 per cent.

"Earnings have been depressed for the past four quarters by weakness in the energy sector," they comment. "In the third quarter, EPS growth, with 71 per cent of companies already having reported, is on track for 5.1 per cent, assuming the remainder of the earnings season continues to beat expectations. This, however, would increase to 8.7 per cent if you were to exclude energy. Looking forward to 2017 earnings, the energy sector moves from an earnings headwind to a tailwind.

"Current projections call for S&P 500 (ex-energy) EPS growth of 11.6 per cent, but this increases to 14.8 per cent when the energy tailwind is included. Even taking into account Wall Street's typical early over-optimism of about +500 basis points, this still represents a sharp year-on-year increase."

And despite the current US bull market being one of the longest on record, the lower than normal growth since the financial crisis suggests it could have further to run.

"Economic growth is still there, you have strong consumption and accommodative money policy," says Adrian Lowcock, investment director at Architas. "And the presidential candidates both talked about fiscal policy, so there will be investment in fiscal spending coming through. Ultimately, the US economy is still pretty healthy. There are job vacancies, business confidence is good, consumer lending is still good, earnings were growing last quarter - the first time in about six quarters - so you've got a stronger, better environment.

But wage growth and rising inflation means the Federal Reserve is likely to have to raise interest rates soon, which will negatively affect some companies' profitability.

"One of the areas you need to be careful about is equity income in the US," explains Mr Lowcock. "Equity income tends to come from more defensive assets - companies that are low growth. But if interest rates rise then the cost of borrowing goes up, and if low growth or no growth companies' cost of borrowing rises but their sales don't, this will compress their margins."

The fact that these so-called bond proxies are already trading at very high valuations makes them even less appealing. Conversely, one of the least loved areas of the market - financials - should benefit from rising interest rates as these boost their profit margins, adds Mr Lowcock.

He also thinks the case for holding an actively managed fund in the US is increasing as a new growth-focused environment will lead to greater ability to differentiate between companies' earnings.

"2016 was a year, basically, driven by the central banks and macro factors," says Mr Lowcock. "There wasn't any real need for strategy [in the US] as the expensive areas got more expensive. It wasn't really a good environment for differentiating between companies, but going forward I think that should count a lot more. You would have more of a strategic stockpicking environment."

 

US equity funds

Artemis US Extended Alpha Fund (GB00BMMV5G59) uses hedge-fund-style techniques, as well as investing in shares.

"This fund can get up to 150 per cent exposure to the US market by buying stocks and using derivatives, but will also go as much as 50 per cent short, whereby its manager Stephen Moore sells company shares to make a profit," explains Mr Lowcock. "The fund remains between 90 and 110 per cent exposed to the market, but the manager has a lot of flexibility on where he can invest, as well as being able to profit from rising and falling share prices which suits an expensive US market."

A fund that could do well in a more growth-orientated environment is JPM US Select (GB00B2Q5DR06).

"This fund follows a 'growth at a reasonable price' approach, which has suffered recently as the focus has been on high-beta stocks and the rebound in commodities," says Mr Lowcock. "Its process is very analytical and looks to take the human element out of most of the investment process as people tend to make mistakes. And the fund's managers are supported by a good solid research team."

JPMorgan US Select is focused on pharmaceuticals, technology and software, and its two largest holdings are Microsoft (MSFT:NSQ) and Alphabet (Google).

Old Mutual North American Equity Fund's (GB00B1XG9G04) managers use a systematic investment process, and select shares by analysing company data while taking into account the macroeconomic environment and investor sentiment.

"The team at Old Mutual stands out for its highly innovative and systematic approach to investing," says Mr Stevenson. "Two main characteristics distinguish this group's quantitative approach from others in its peer group, namely the dynamism of the team's model and the uniqueness of its stock selection strategies.

"The investment model has the ability to read the current state of the equity market and allocate risk in the stock selection strategies most likely to outperform."

IC Top 100 Fund Fidelity American Special Situations (GB00B89ST706) is one of the few active funds to have had some success in beating the S&P 500 index. It holds just 30 to 50 companies, and focuses on underperforming businesses where other investors don't expect a recovery. It invests in companies at different stages of turnaround, so even though it is a value fund it has the potential to outperform through different macroeconomic environments.

Its manager, Angel Agudo, also takes the potential downside risk of a company into account, favouring strong balance sheets or resilient business models.

Other funds that have beaten the S&P 500 over five years include Legg Mason Opportunity (IE00B3FHNC91), Legg Mason ClearBridge US Large Cap Growth (IE00B19Z9505) and Dodge & Cox Worldwide US Stock (IE00B50M4X14).

Mr Yearsley says an alternative way of getting US exposure is to choose a fund that invests in a sector such as technology or biotechnology, which are areas where US companies dominate.

Options include Polar Capital Technology Trust (PCT), Polar Capital Biotechnology Fund (IE00B42P0H75), Pictet Biotech Fund (LU0448836352) and AXA Framlington Biotech Fund (GB00B784NS11).

Mr Hollands thinks that small- and medium-sized US companies, which tend to be less well researched than large-caps, could be an area to consider. He likes T Rowe Price Funds SICAV - US Smaller Companies Equity (LU0860350650), which has a good track record, and Loomis Sayles US Equity Leaders (GB00B8L3WZ29).

 

Passive options

If you would rather avoid active US funds because of their poor record at beating their benchmarks, then you could consider a passive ETF such as FTSE RAFI US 1000 UCITS ETF (PSRF).

"This ETF holds 1,000 shares listed in the US but weights them not according to market cap but rather on four fundamental factors: dividend, profits, cash flow and net assets on the balance sheet," says Mr Hollands. "It's a passive fund, but selects companies that give more of a skew towards value and have more conservatively financed balance sheets. So if you want to get your US exposure via passives and take a more defensive approach, this might be the option for you."

FTSE RAFI US 1000 UCITS ETF has an ongoing charge of 0.39 per cent.

Other passive options include BlackRock North American Equity Tracker Fund (GB00BPFJD412), which invests in US and Canadian stocks and tracks the FTSE World North America Index. Its main sector exposures are financials, technology and consumer services. It has a very low ongoing charge of 0.07 per cent.

Also see our IC Top 50 ETFs for a further seven passive North America options.

Fund1 year total/share price return (%)3 year cumulative total/share price return (%)5 year cumulative total/share price return (%)Ongoing charge (%)
**BlackRock North American Equity Tracker24.4155.40122.710.07
PowerShares FTSE RAFI US 1000 ETF24.6950.97129.330.39
**Legg Mason Opportunity 2.0027.72154.801.15
Polar Capital Technology Trust30.6772.83126.91*1.1
Old Mutual North American Equity24.0964.34150.361.00
Pictet-Biotech-11.3840.73161.651.22
Polar Capital Biotechnology 1.6695.85 1.17
AXA Framlington Biotech -12.9749.22222.340.83
Legg Mason ClearBridge US Large Cap Growth22.7870.37150.351.73
T. Rowe Price US Smaller Companies Equity24.9250.31137.321.11
JPM US Select 22.5057.70133.210.93
CF Miton US Opportunities28.7857.18 0.85
Artemis US Extended Alpha 28.01  0.87
Fidelity American Special Situations24.3472.25156.600.95
Loomis Sayles U.S. Equity Leaders28.7373.59 1.00
Dodge & Cox Worldwide US Stock 28.5655.80146.560.70
IA North America sector average20.9148.58111.27
IA North American Smaller Companies sector average21.4836.68104.00
MSCI North America Index23.5853.05118.94
Russell 3000 Growth TR USD21.2859.90133.84
S&P 500 Index24.3259.79136.67

Source: Morningstar as at 4 November 2016, *AIC

**Performance is that of an older share class rather than the one indicated in the text