European fund selectors have been expressing a strong intention to decrease their US equity holdings since the final quarter of last year, with sellers outnumbering buyers in every single European country. As of this year, this negative attitiude towards stocks from across the Atlantic has started to show in mutual fund flows too. In the first four months of the year, European investors took a more than €15bn out of US equities, while European equity funds received a similar amount of net inflows.
“It comes down to a valuations point and there being better alternatives out there [than US equities],” said Matthew Page, manager of Guinness Asset Management’s Global Equity Income Fund. “The US positions that we own are at the more expensive end of the fund. While 18 months ago we had 55% of the fund exposed to the US, it is now 45%, and we have added to Europe and Asia.”
“US companies are finding it harder and harder to maintain profit growth, and with the Federal Reserve poised to begin a cycle of interest rate hikes, equity valuations in the US may be vulnerable,” added Valentijn van Nieuwenhuijzen, head of multi-asset at NN Investment Partners.
The US equities market has relied on three key factors – earnings and margins growth, loose monetary policy, and narrowing high-yield and investment-grade bond spreads – to drive its recovery over the past six years, and van Nieuwenhuijzen believes that these elements are finally starting to run low on fuel.
“Since March 2009, when US stock markets bottomed out and the S&P 500 sank to a sinister intraday low of 666, equities have risen threefold, their comeback driven by three strong forces,” he expanded. “Today, however, these three drivers appear to be losing steam, at least in the US. Earnings growth in the US is likely to slow to a nearly negligible 1% in 2015, followed by a sluggish 5% in 2016. These figures pale in comparison with the eurozone and Japan, where we expect double-digit earnings growth this year and next.”
Hands against the ceiling
Considering the US’ billing as the free trade capital of the world (albeit self-styled, depending on whom you ask), it is impossible to imagine investors shunning it completely. But where do you look in a market that is supposedly touching – if not pressed up against – full valuation?
JP Morgan Asset Management’s Garret Fish, who runs the firm’s American Investment Trust, says that while discernible value is hard to come by, it is multiples potential where investors should be directing their focus. “We are six years into an economic cycle and definitely in the second half, so multiples have risen,” he explained. “But recessionary indicators are non-existent, so there is still room for multiples to go higher.”
“Looking at current multiples on an earnings basis, real earnings yield and price-to-book – is the US so far above average that it is at a red flag? No. That said, while there is still decent value in the market, we have to be mindful of the economic forecasts and the price being paid for the expected growth and cash flows.”
However, David Coombs, Rathbones’ head of multi-asset, believes that investors on the whole are being too cautious. “The US is far from cheap, but we do not buy into the consensus that Europe is cheaper than the US on a forward-looking basis,” he said. “Moving money from the US to Europe on the basis that valuations appear cheaper is a far too simplistic view. When you look at the stocks and sectors in both markets, the stats are very different.”
That said, Coombs – whose medium-risk portfolio carries a 17% US equity weighting against 4% in Europe – is wary of a potential US interest rate rise. “In a rising interest rate environment, investor focus needs to be on companies that are growing both their revenue and profits and are not reliant on credit,” he expanded. “It is about generating sustainable growth and dividends. Companies that benefit from cyclical growth are fine, but, while you may pay a little more, quality stocks should take up more of the portfolio.”
Computing the numbers
While neither Page nor Fish are going for US equities guns blazing, they agree that there is plenty of potential of the information technology sector. “There is a line between what the top-down view tells us and the candidates for adding into the portfolio,” said Page. “We added a large-cap US-listed IT company three months ago on 11-times earnings with a 3.5% dividend.”
“Relative to the S&P 500, there will be better than expected growth in IT as a whole,” added Fish. “Valuations have moved up and growth has not been great over the past three or four years, but, particularly from a hardware standpoint, earnings growth is positive and multiples are lower. It is my largest overweight and I am continuing to find new opportunities.”
Coombs shares their positivity on IT, but – somewhat unsurprisingly – it is financials that he tips to hold firm against rising interest rates. He said: “On a three-year view we like technology, ex-pharmaceutical healthcare, consumer discretionary and financials – the latter will be the least negatively impacted by an interest rate rise.”
“While financials is not a growth sector like the other three, it should outperform in a rising interest rate environment. Naturally the rest of the market knows this so there is a bit of that in the price, but we made the call over a year ago and are not changing our stance. “We would only alter our view if the interest rate curve steepens, in which case we would go underweight US. Peak rates for this cycle looks as though they will be 2-2.5%, but if that went to 3.5-4% then our view would change significantly.”
Catching the red-eye
So, if you are convinced that the US still deserves a big place in your portfolio, in which fund should you make the transatlantic flight? “While the US is not overvalued, it is very much up to speed with events,” said Tony Yousefian, investment consultant and fund analyst at Abermarle Street Partners.
“The market as a whole has defensive characteristics, and when the equities market goes down the US tends to hold up pretty well. Because of those safety features we recommend a degree of exposure to the US, but would certainly not recommend being overweight. “Investors should avoid high-yielding funds, which tend to carry ‘bond proxies’, because a US interest rate rise is now a matter of ‘when’ not ‘if’. Stockpicking managers are absolutely crucial – particularly those who target growth-orientated stocks that will benefit from an economic growth environment.
That said, there may now be a bit of a summer lull kicking in and investors should maybe not go in straight away. Yousefian continued: “I would recommend either Artemis US Equity or, in particular, US Select, both of which are run by Cormac Weldon. However, if investors are looking for longer-term returns I would recommend Stephen Moore’s Artemis US Absolute Return, which is a 50-50 fund. Both managers have a good track-record from their time at Threadneedle [now Columbia Threadneedle] and have added a lot value for their investors.”
So it seems that even in the wake of a wave of money flooding out of the US and washing up on European shores, by selecting an appropriate boat and paddling up the right creek, investors can dig their oars in against the current and hope to land a marlin or two.