By Cormac Weldon is Head of US Equities and Stephen Moore is a US Equity Fund Manager at Threadneedle Investments
Macro and political concerns continue to weigh on market sentiment, with the end of QE2 adding to market weakness and volatility during August.
Following our recent US growth forecast downgrades (to 1.5% for both 2011 and 2012), we have now reduced expectations for earnings growth to 8% for 2011 and flat to potentially down for 2012.
US equities were attractively valued relative to history and to other asset classes before the recent turbulence, and the setbacks of the past weeks have magnified this attraction. With investors able to buy high quality companies with low debt and good free cash flow levels at low valuations, this represents a good long-term opportunity.
Threadneedle's US equities portfolios have been positioned for a low growth environment for some months and continue this stance.
Focus remains on companies with exposure to secular growth trends, those operating in industries with high barriers to entry or with a product advantage.
US market sentiment has been dominated by macroeconomic and political factors recently. Investor concerns about European sovereign debt and political inertia on both sides of the Atlantic have damaged risk appetite. Meanwhile, an apparent slowdown in economic activity in the US and elsewhere has led to downgrades in corporate earnings expectations.
Injections of liquidity into the financial system have been highly supportive of equities since the financial crisis. The end of QE2 earlier this summer was therefore another factor behind the recent weaker trend in the market. With little impending threat of deflation, we do not believe a third phase of QE is imminent. However, the authorities have stated that interest rates will be on hold throughout 2012 and further stimulative measures should not be ruled out.
Having recently lowered our forecasts for US economic growth to 1.5% for both this year and next, we have also reduced our expectations for earnings growth. We are now expecting 8% growth in earnings this year, with next year flat to potentially down. US companies have a good track record of addressing their cost bases to protect margins in tougher times, and they are likely to take similar action on this occasion. Nevertheless, low nominal growth provides a difficult backdrop for aggregate earnings growth.
With global sovereign risk concerns focused on the eurozone, European equities have underperformed the US, leaving the relative valuation of US stocks versus their European counterparts at above-average levels. However, the current level is well below previous highs, suggesting that the US could continue to outperform in the absence of a solution to Europe's problems.
We believe that US banks are better placed than their European counterparts. The US banking sector is much stronger today than it was at the onset of the financial crisis and appears to be in a much better position to deal with the strains created by the sovereign debt crisis. Compared with the same sector in Europe, US banks generally have lower assets in relation to equity, indicating the deleveraging that has already occurred. They also have lower loan to deposit ratios, which means that they are less dependent on wholesale funding than their European equivalents. While we remain cautious on the banking sector, this relative strength should stand the US market and economy in good stead if the eurozone debt crisis intensifies.
We are seeing a generational valuation opportunity with US equities attractively valued relative to history and to other asset classes before the recent turbulence, and the setbacks of the past weeks have magnified this attraction. For example, using large-cap equity free cash flow yields versus Baa-rated corporate bond yields, equities are as cheap against credit as they have been since the 1950s.
Equity valuations patently include a high risk premium at these levels and, while there are genuine challenges facing the market, US companies have demonstrated in the past their ability to grow their profits over the long term. Moreover, compared with previous periods of cheap valuation, equity investors today are buying a much higher quality asset with less debt and better free cash flow generation. As such, we feel that these extreme valuations could represent a good long-term opportunity.
Current positioning
For some months we have been positioning our portfolios for a low growth environment and this stance remains in place. We are focused on companies with exposure to secular growth trends; those operating in industries with high barriers to entry or with a product advantage. These characteristics should help to deliver sustainable earnings growth despite the lacklustre economic backdrop. Examples include Apple Inc where we are expecting within the next year new versions of the iPhone and iPad and Visa Inc, the payment processing company, which benefits from secular growth in use of credit and debit cards.
We also continue to look for companies with strong balance sheets where the management is managing capital proactively, for example buying back shares, raising dividends or undertaking sensible corporate activity For example Philip Morris International, the tobacco company, has consistently bought back its own stock and recently increased its dividend by 20%.
Our stock selection efforts in light of these themes are leading to overweight positions in consumer discretionary and technology and underweights in financials, industrials and energy.
|
