Jack Byerley, Deputy Portfolio Manager
Bilal Ibrahimi, Research Analyst
US Equity Review
Since we last reviewed the US market in June 2021 the economic and geopolitical landscape has changed significantly. Inflation was initially deemed transitory, then, as it became apparent that price increases were more long-lasting, stagflation was adopted as the market narrative of choice. Finally, towards the end of last year the Fed started to see inflation as more persistent and above target, hence they pivoted, taking up a hawkish stance. More recently, geopolitics have dictated markets following the Russian invasion of Ukraine and consequent economic implications.
Understandably market volatility has spiked. From June to October it was a return to vogue for the darlings of 2020 followed by a significant shift towards cyclical and value names. Then the outbreak of war in Eastern Europe facilitated a more broad-based sell off as the consumer driven cyclical recovery became threatened by the prospect of persistently elevated energy prices.
Despite a selloff in some cyclical areas and mounting economic concerns, the US has been better insulated from the crisis than Europe or Emerging Markets. As well as being considered a safe haven, America also boasts energy independence and a lack of direct Russian exposure at an individual company level.
At a fund level, value funds continue to prosper at the top of the sector and have held onto modest single digit year-to-date gains. Outperformance that began in October continued in the first six weeks of the year as markets began to price in a faster pace of monetary policy tightening. On the contrary, long duration growth funds such as Baillie Gifford and Morgan Stanley are at the bottom of the pile, down nearly 30% in some instances.
On a five-year basis however, it is those same growth funds who still sit at the top of the table after strong performance in 2019 and 2020. They have favoured high growth sectors such as technology, with a number of unprofitable companies that have benefitted from ultra-low rates, fiscal easing and in some instances Covid accelerating trends (Zoom, Moderna, Shopify, Netflix etc.).
Looking further out helps to give context to the most recent moves. Whilst a circa 35% relative differential in performance through the first three months of the year appears to be extreme, on a longer-term basis, there is potentially a more sustained rotation to be seen.
This can be seen at the stock level too, a number of stocks are significantly below their all-time highs, yet valuations remain elevated in many cases and vulnerable to further de-rating.
One other factor that has been pronounced in the US is the underperformance of small and mid-cap companies. Even within growth, we have witnessed one of the largest divergences between mid cap growth and large cap growth in recent memory. Following the pandemic small caps outperformed significantly, but in the last 12 months have lagged their larger brethren by 17%. Those with genuine pricing power down the market cap spectrum should be well placed from here.
Interest rate rises have increasingly been priced in, hence the sell off and de-rating in growth stocks seen over the last couple of quarters. Should this continue, entry points should open up to increase exposure to growth and it is our belief that a more normal monetary environment should lead to more broad market participation. A higher level of interest rates should facilitate a regime change in markets, where earnings deliverability will become increasingly important. At some point in the next 12 months (assuming there is no significant US recession) this should lead to a less factor-driven and more fundamental market.
So, to conclude, we remain constructive on the prospects for value relative to growth, at the margin, in a rising interest rate environment after a sustained period of growth outperformance. At a more granular level we believe that there are opportunities further down the market cap spectrum, particularly in mid cap.
The US economic consensus forecast is for 4% GDP growth with bullish estimates of 4.5% annual average growth for this year (source: MRB). The US recovery from Covid has been strong, consensus real GDP should pass its pre-pandemic trend level and the output gap is set to turn positive in Q2.
Growth is likely to trend back towards the 3% historic average over time but should be supported by solid consumption growth underpinned by strong wage gains and pent-up savings. Inflation has hit 40 year highs in the US this year and we would anticipate that it settles at a higher average than the post Great Financial Crisis level of around 2%. This has led to a tightening in US monetary policy that should play out throughout this year and next.
Potential risks to the economy are Fed caused recession, new Covid variants, geopolitics (Russia-Ukraine), and a housing market downturn.
We would expect the economy to continue to be supported by the significant pent-up savings amassed during Covid lockdowns. Although the monthly savings rate has reverted back to the pre-pandemic level, excess savings still amount to more than $2.4 trillion.
The mix of spending in the US economy has also begun to change. Goods spending appears to have peaked as consumers shift back towards services and parts of the economy that suffered the most during Covid. This includes recreation and medical services spending. One interesting point that is more unique to the US is that the largest pent-up demand is from lower-income households (below).
On the fiscal front, the prospect of major legislation getting through the House and Senate over the next 12 months is low given the upcoming election and the intense partisanship in Congress. With the war in Ukraine and elevated inflation, the Biden administration’s focus on the elements of the Build Back Better program is now likely to be consigned to aspirational talking points rather than hard legislation.
Consensus economic forecasts are for inflation to ease back to 2% over the medium term (2023-24). However, we would anticipate inflation settling above this level due to more pronounced supply chain disruptions, high demand, tight labour markets, and recent ultra-loose monetary and fiscal policy.
In the short term, we would be more in line with consensus. JPMorgan argues CPI will peak at 9% by Q2 but should come back down by the end of the year. We agree that inflation is likely to be close to peaking but should slow at a slower rate and settle at a higher level than current consensus expectations.
Much has been made of the effects of deglobalisation as companies rush to onshore supply chains following the Covid-led disruptions. This should add support to inflationary pressures over the next decade. Whilst unlikely to last the full decade, supply chain constraints have already dragged on far longer than initially thought. It now seems probable that they too should add to pricing pressures at least into the middle of next year, particularly if China maintains its strict Covid measures.
In addition, the US labour market is already extremely tight. The US job vacancies rate is at a historical high, however, the supply of labour has been hit due to people permanently or semi-permanently leaving the labour force since the pandemic. Whilst both are expected to improve, they will do so very gradually thereby keeping inflationary pressure up in the short to medium term.
We may also see an uptick in services inflation as pent-up spending is released, this would add further pressure to inflation in the next few quarters.
The Fed is waking up to this reality hence Powell’s hawkish pivot in Q4 2021. This week we saw a 25 basis points rate hike and with expectations ranging from five to upwards of nine rate hikes this year. Four more hikes are currently priced in for next year taking us to 2.75% by end-2023.
However, as concluded above, we believe inflation will be higher than what the Fed is currently expecting, putting it “behind the curve”. The past few years of Fed behaviour would suggest we have a reactive Fed as opposed to a proactive one. Thus, should higher, more persistent inflation become the Fed’s base case, we could see further upward revisions of rate hike expectations.
Risks to the Economy
We are conscious of the risks to the US economy and whether or not a recession is approaching. One renowned consumer confidence survey fell to the lowest level since 2011 in March, with more than half of Americans expecting their income to lag inflation, with a third expecting worsening finances – twice as many as a year ago. Although underlying demand is holding up well in activity surveys, the concern is that the economy slows or even falls into recession as the consumer is squeezed by rising prices.
This could also be exacerbated by the Fed having to induce a recession to supress demand and rein in inflation. They do not have a successful track record of achieving a “soft-landing”, however, this is more likely to be a 2023 or even 2024 concern, despite their recent hawkish tone.
However, as noted earlier, consumer balance sheets remain strong, we believe inflation is close to peaking, demand is high, particularly for services, housing is fairly robust and labour markets are tight. All of the above should support the economy through an inflation induced slowdown in Q2 and into reacceleration in Q3.
Secondly, future Covid-19 variants remain a risk to the US economy albeit the economy is more resilient to Covid shocks now than ever before. For example, the Omicron wave peaked much faster than the Delta wave, a trend we expect to be the norm moving forward. Hence, we remain cautiously optimistic.
Thirdly, the largest risk of the Russia-Ukraine crisis to the US economy is energy price spikes reducing non-energy disposable income thereby depressing expected levels of consumption. The consumer is less vulnerable to energy spikes than in the past; during the Iran oil crisis of the 1970s, US consumer spending on oil was 9% versus 4% now. The US household balance sheet is strong, with excess savings and lower debt, helping it withstand some shock whilst maintaining purchasing power. Another impact of the crisis is that the US does a large amount of trade with Europe, therefore, if European economies are depressed it will indirectly impact the US economy. Overall, the longevity of the crisis will determine the extent of the impact on food and energy, however, the US is better insulated than other global markets.
Finally, a large portion of US consumer income is used for mortgages, therefore, a rising rate environment could negatively impact our growth assumption as housing slows. The 30-year mortgage rate is low versus history at 3.9%, and a greater proportion of mortgages are now fixed implying the consumer can weather a higher rate environment. Rates are also rising in tandem with a strong consumer balance sheet and strong income growth. Therefore, so long as interest rates do not rise excessively, strong demand should support the housing market.
Overall, our analysis of the current state of the US economy encourages us to be cautiously positive for the rest of this year. The strong consumer and pent-up demand for services should stave off a recession, however, demand for goods is likely to wane and many “Covid beneficiaries” could come under pressure as incomes are squeezed by rising energy and food costs.
Valuation of the US Market
We have cautioned for some time that the US market appears expensive, particularly, in large cap growth. The index has de-rated somewhat, although sits at a fairly hefty premium to history and other developed markets.
As long as the war between Russia and Ukraine drags on, the US appears to be a reasonably well insulated from direct impacts. However, should there be a resolution, it will most probably lag. This is for a number of reasons, the obvious one being that it has fallen less and doesn’t have the immediate bounce-back potential that Europe has. Otherwise, the US will be left as the economy in the midst of the most aggressive tightening cycle, faster wage inflation, restricted fiscal manoeuvrability and potentially facing a slowdown in housing. All of which are likely to raise the risk of a recession in one way or another, which the US market is yet to fully discount.
Relative to the RoW, the US has the highest EPS growth expectations for 2022 and 2023 as well a higher return on equity than other developed markets. Earnings expectations are still as high as 10% for this year and next (source: JPMorgan) and ROE has reached 20% (see chart below). Both of these attributes have supported the US and contributed to its safe haven status as a high quality market.
As highlighted above, valuations within large caps seem expensive, with the US at a 30% premium PE ratio to its 20 year average. This is similar across the market, with Energy being the only large cap sector still at a discount to its median since 2006. However, within the market, mid cap companies have been unloved and de-rated relative to large caps in recent years, with the gap now being the largest it has been for a decade.