There are two key attributes necessary for investing in US equities this year, says Darius McDermott, managing director Fund Calibre: Patience and flexibility.
After a stellar run throughout much of the past decade US equities entered a bear market in 2022 amid decades-high inflation and an aggressive Federal Reserve response. The outlook is now murky at best for the world’s largest economy.
Three or four months ago the question would’ve been whether a soft landing was possible? Now it seems to be how deep a recession are we going to see. The best recession indicator is the inverted yield curve – with the US Two Year Treasury note continuing to offer more (4.3 per cent) compared to the US 10 year (3.6 per cent)*. For clarity, the inverted yield curve has emerged roughly a year before all recessions since 1960**.
But how deep a recession is open to debate. I’ve always held the view that the UK and Europe would have a deeper recession than the US. Central banks in Europe are dealing with inflation driven by energy prices, while the Federal Reserve is facing the challenge of a surge in consumer demand.
In attempts to tackle inflation – which stood at 7.1 per cent in December 2022 – the US Federal Reserve’s aim is to reduce aggregate demand and weaken the red-hot employment market, thus alleviating supply chain stress and spiralling wages. Go too soft and little will change, while the opposite would result in a very hard landing for the economy.
Tighter financial conditions take time to filter through to consumer behaviour, but Janus Henderson portfolio manager Doug Rao says we are beginning to see consumers spend at a rate faster than income growth, which is unsustainable. He points to personal savings being drawn down and an uptick in the use of credit card debt***.
He says: “These metrics all point to an eventual slowdown in consumer spending. We have begun to see initial signs that inflation may have peaked. The two most recent monthly consumer price index (CPI) readings have shown a moderation in prices, and we are also starting to see a decline in transactions for financeable goods.***”
The Fed raised rates to 4.5 per cent in December 2022. In its fourth quarter research update, Lazard warned that if rates pass the 5 per cent mark, it would result in a meaningfully higher chance of recession. But how will this impact stock prices following the 8 per cent fall in the S&P 500 in 2022?
This is where the uncertainty really sets in – can we trust market consensus that the Fed will switch to a dovish stance in the second half of the year? Morgan Stanley chief investment officer, wealth management, Lisa Shallet says the multiple rallies in 2022 suggest many stock investors haven’t embraced the likelihood of higher-for-longer interest rates and a materially slowing economy. She points to unattractive valuations and lofty earnings expectations as reasons for concern^^.
Rao says although not cheap by historical standards, we are seeing valuations at levels seen during the pandemic-induced sell-off in the spring of 2020***.
Franklin Templeton portfolio manager Scott Glasser believes 2023 will be a tale of two halves for US equities. The first will favour companies with solid balance sheets, durable cash flows and dividends – often in value oriented sectors. However, once investors feel the bear market is over, we may see a switch to small-caps and other higher risk stocks^^^.
Schroder US Mid-Cap manager Robert Kaynor believes a change in market leadership is already underway towards US small and mid-cap. He points to both the 1970s and the bursting of the technology bubble in 2000, as examples of when US small-caps performed much better than large-caps for a number of years^^^^.
He says the outperformance came when Fed funds rates and economic growth were both rising and falling.
“This consistent outperformance through a variety of different economic environments occurred from a similar starting point: superior earnings growth coupled with low valuations relative to their large cap brethren,” he adds. He also believes domestically focused companies in the US are likely to benefit from changing consumer trends – such as spending moving from goods to services^^^^.
There is no doubt we are starting to see some value in the US economy. This, coupled with the likelihood of a shallower recession and an unparalleled breadth of opportunities across sectors, means investors can be selective in this market in what are uncertain times.
Pros for investing in US equities
• Broadest market in terms of sector exposure
• Much more than just mega caps – significant small and mid-cap opportunities
• Recession unlikely to be as deep as Europe and the UK
Cons for investing in US equities
• Inverted yield curve indicates there will be a recession of some kind
• Most efficient market in the world – not as easy as some to consistently beat
Funds in this space
Solid building block – T. Rowe Price US Large Cap Growth Equity
This fund seeks to invest in large US firms that demonstrate innovation and change. Taymour Tamaddon collaborates with the team to build a high conviction portfolio of 60-75 stocks.
Further down the scale – Schroder US Mid Cap
The team look for companies which have been underappreciated by the market, but have attractive growth prospects, low debt and strong profit margins. They diversify these with two other types of stock: less volatile steady eddies and struggling companies likely to undergo a transformation.
Income alternative – JPM US Equity Income
The income approach means this fund will have a natural bias towards more value orientated names. It is also well-diversified from a sector perspective.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
*Source: MarketWatch.com – figures to 6 January 2023
**Source: World Economic Forum
***Source: Janus Henderson: Evaluating US growth equities in a market that remains murky – December 2022
****Source: Lazard – US Equities outlook – Q4, 2022
^Source: FE Analytics, figures in pounds sterling for S&P 500, figures from 30 December 2021 to 31 December 2022
^^Source: Morgan Stanley – Investing in 2023: A Year to be Patient and Selective
^^^Source: Franklin Templeton: 2023 US Equity Outlook: Patiently Waiting for a durable bottom
^^^^Source: Outlook 2023, US small and mid caps: can outperformance continue?
