James Sullivan and Peter Geikie-Cobb examine the US market and explain why they are underweight the US within their fund range.
What are your views on the US stock market?
James Sullivan: Broadly speaking, it’s an expensive equity market. Even stripping out certain sectors, such as technology, it’s still hard to make a compelling case for investment. It is, however, the more domestically focused indices that jump out as extreme. One can point to one of a number of traditional valuation metrics to underpin that view. The market is priced for near perfection, and what we witness when companies fall short of analyst expectations is a sizeable leg down in the share price. There is little, if any, room for disappointment. The corporate debt profile is also far from appealing in an environment where rates firmer.
What is your outlook for the US economy and monetary policy?
Peter Geikie-Cobb: The US has been the main driver for world growth this year following President Trump’s fiscal boost, the benefits of which are beginning to fade. The US economy is showing some signs of slowing in areas such as housing and industrial production although, with full employment, consumer confidence remains pretty robust. Markets have priced in another 3 rate hikes by the Fed, taking short rates to 3%, a real yield of 1%. At this stage we think that will probably be enough for this cycle given the likelihood of a continued slowdown next year and the surprisingly well behaved nature of inflation, at least at the measure that the Fed looks at. This was implied by Chairman Powell in his speech on 8th November when he said that short rates were close to neutral.
How will this impact the investment environment going forward?
PGC: From a yield perspective short term bonds in the US are beginning to compete with their equity counterparts and continued tightening of global liquidity is likely to see more volatility and much more diversity in terms of performance within asset classes as higher rates begin to challenge some of the zombie entities. The current economic cycle has been a long one, albeit a more shallow one than normal, and with tighter liquidity, a slowdown from here seems natural. Although global debt has continued to grow at an alarming rate since 2008, the financial system is in much better shape. The quality of US mortgages, for example, has improved markedly. The current debt issue now resides mainly with governments. Therefore, we anticipate slower growth but not a 2007/08 style meltdown.
So you are ‘underweight’ the US market?
JS: We have no exposure to US equities at present. We have a risk budget for each mandate which we have chosen to distribute amongst better value markets. Being negative on the US equity market doesn’t make us ‘bearish’, it just makes us selective when it comes to deployment of our client’s capital. We collect our US exposure through the bond and currency markets instead.
PGC: Longer dated bonds continue to offer little value against a background of government debt mountains. The deterioration of the US fiscal position may well weigh heavily on the longer end of the US Treasury market at a time of increased funding requirements and much less demand from sovereign wealth funds, particularly China. As mentioned before, short dated US bonds, however, represent fair value and this is where we are positioned in the Funds. A credit rating driven steepening of yield curves is more than possible given the weight of refunding. We remain in short duration instruments, negating the interest rate risk in the market. We believe that a real yield of 2% represents fair value in government 10 year bonds. Assuming central banks achieve their 2% inflation targets over time, this would equate to 4% nominal yields on 10 year G7 government bonds.
That’s a contrarian stance?
JS: We care little whether we’re contrarian or consensual. What matters is the price we pay for assets. We don’t know the direction of markets in the short term, but we can try and stack the odds in our favour by using value as a key driver within our investment process.
So you think the dollar strength will continue?
PGC: We have been long the USD in recent months, as both growth and interest rate differentials have supported the currency. However, we have been taking profits back into GBP as we think the US economy has peaked and that the end of the rate cycle has been, or nearly fully priced in. UK assets are very under owned by foreign investors and GBP is cheap on a purchasing power parity basis. We think that most of the bad news with regard to Brexit is discounted and that the risk for UK investors is being underweight GBP. Consequently we have, and will continue at selected levels, to take profits on USD.
You spoke about allocation of your risk budget to other regions…?
JS: It’s obvious where the value in markets is, what is not so obvious is when that value will be recognised and rewarded. We’ve identified domestic UK, Japan and certain parts of the emerging markets as materially cheaper than the US market – both in absolute terms and acknowledging the premium the US market trades at to such markets… they offer our funds a much more attractive trade.