The value in US markets

  • Performance in the US market has been strong, but there are fears of overheating
  • This recovery may have been long, but it has been weak relative to history
  • There are many opportunities in the US market for investors willing to delve deeper

By Fran Radano, Senior Investment Manager, The North American Income Trust plc

The US stock market continues to outpace its global peers, but there is an increasingly insistent drumbeat among investors: is it over-heating? Is the party about to end? To our mind, there are a number of reasons why people shouldn’t leave the dancefloor just yet.

The most recent economic growth figures surprised even the optimists. At over 4%, the US economy is growing at its fastest pace for almost four years (1.). However, while apparently good news, this has brought fears that the economy is over-heating, that interest rates will have to rise faster than expected. This was notable at the start of the year, when higher wage figures prompted a significant wobble in markets.

These concerns are well-justified. There have now been 42 quarters of positive GDP growth in the US (2.), but these figures bely the weakness of this expansion. This growth has been lacklustre and it comes from a low base. When people point out it has been the longest expansion ever and assume it has to end, they need to remember it’s been the slowest recovery in history.

On The North American Income Trust, we believe progress on capex and productivity could continue. An important part of this is the stimulus from tax cuts. This worked to boost in corporate earnings in the short-term, as well as dividend increases and share buybacks. Perhaps more importantly, it is has helped step up capital investment, which is up by double-digits this year. Companies are spending on automation, on technology, on their supply chain. This should improve productivity and lower the cost of business, which in turn should support the economic cycle for some time.

The tax cuts haven’t all been good news. We believe that investors need to be wary where tax cuts are simply being used by companies to buy back their own shares, particularly where it appears to be done to pay compensation for senior executives. We prefer companies such as Microsoft, which are delivering solid pay cheques to their investors via dividends. In finding the right companies, a valuation discipline is crucial.

Higher corporate debt has been a concern, but here too, we believe the problem may have been overplayed. Certainly debt is optically high – as high as it was before the financial crisis – but borrowing costs have been low and we see many companies where debt is being progressively paid down. Companies had often borrowed in the US while holding large cash balances abroad, knowing that to repatriate that capital would cost them more than servicing a debt in the US. Now the corporate tax rules have changed, we expect to see capital brought back from abroad. Of course, there are some companies with high and possibly unsustainable debt, but they are not in our portfolio.

The potential for a prolonged and destructive trade war looms large for some investors, but here too, the numbers do not look as troubling on second sight. The trade war looks set to cost $27bn. This is dwarfed by the level of tax cuts, which sit at almost 10x the tariffs. That said, it needs to be factored into investment positioning as it will affect certain sectors more than others.

The final problem has been the dominance of the FANG stocks. These large technology companies have, by and large, continued to lead the market higher, but have shown signs of weakness more recently. In some cases, earnings have missed expectations and there have been worries over governance.

For our portfolio, where we have never held the FANG stocks because they don’t pay dividends, this is a welcome development. It may mean that investors see the value in the growing businesses that sit in our portfolio, all of which are trading at more attractive valuations. This is companies such as BB&T Corp, Cisco Systems or Johnson & Johnson, which pay attractive dividends, have lower debt and enduring growth, but the market has overlooked in its enthusiasm for ever-higher revenue growth.

It has been a difficult time for investment approaches such as ours, that focus on dividends and value. We have continued to perform ahead of our benchmark and to deliver a high and growing income in spite of a market that hasn’t particularly valued the type of companies in which we invest. If the market came round to our way of thinking, it would be welcome, but we believe we can continue to deliver good returns whatever the market weather.

In finding businesses that can grow sustainably over the long-term, we believe incorporating criteria such as the way a company is governed and its environmental footprint is increasingly important. We now have a dedicated person in our fund management team to monitor this part of our company analysis. To our mind, this is as much about risk management as making the world a better place. Lax enforcement attracts bigger fines and companies need to pay attention.

The market has bounced around this year, but we are focused on style rather than fashion. There is still much to be excited about in the US market.

  2. NBER, BEA Strategas, July 2018

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