Although the US economy seems likely to tip into recession in the not too distant future, there is optimism the country will rebound quicker than others
The world’s largest economy and its equity markets are facing the same issues as other countries around the world. Rising inflation and interest rates, the fallout from the Russian invasion of Ukraine and the looming threat of recession have hit investor confidence, and stock valuations have plunged as a result (see Morningstar column below).
Like other central banks, the Federal Reserve has been taking aggressive action to combat inflation and seems unlikely to change course. “Inflation hitting 8.2 per cent – and more concerningly core inflation rising to 6.6 per cent from last month’s 6.3 per cent – leaves little doubt that the Fed will continue its hawkish path,” says Thomas Gehlen, senior market strategist at Kleinwort Hambros.
Strong economy
Yet, at the same time, US labour statistics surprised on the upside for the fifth month in a row in September as employers added 263,000 jobs, hardly an indicator of an impending recession.
The Fed’s seemingly one-way journey towards policy tightening could well hasten an economic slowdown, says Mr Gehlen, but private and corporate balance sheets remain sufficiently healthy to weather a moderate downturn in growth, and, compared to other developed markets, the US economy remains relatively well-shielded against the energy market shocks sparked by the war in Ukraine.
Nevertheless, despite recognising the resilience of the US economy, he remains cautious about US equities as valuations remain elevated and he considers earnings expectations optimistic in the context of the inevitable growth slowdown ahead.
“Investor sentiment is at long-term lows, though US equity fund flows hardly suggests a capitulation similar to those seen across other developed markets such as Europe,” adds Mr Gehlen. “All of this points to more volatility and potentially further downturns in the short term as the soft-landing strip for the Fed continues to narrow.”
It is likely to take a long time for the Fed to see inflation drop to its target rate of 2 per cent, says Saira Malik, chief investment officer (CIO) at US asset manager Nuveen. “The Fed has been clear: it will continue to raise rates to battle inflation, even if that comes at the cost of a recession,” she says. “That is just a price that we’ll have to pay.”
We have not reached the point of recession yet, adds Ms Malik, and when it does come, it should eventually squash inflation. But she sees opportunities within, and outside of, equities, and cautions investors to be careful of trying to time the market and missing out when it rebounds.
The US is also something of a safe haven, she says. “Although the US is facing headwinds, other parts of the world face greater ones. If you look at the EU, it has the same inflation problem, but the US has stronger growth rates.”
Europe is also more affected by the war in Ukraine, while China is acting as an anchor to Asia as it continues with its zero-Covid policy. “If I’m looking outside of the US, the one area I tend to like is Latin America,” adds Ms Malik.
Bigger picture
Although 2022 has been a tough year, it is necessary to look at what has happened to markets since 2020 and the start of the Covid pandemic, says Grant Bowers, lead portfolio manager of the Franklin Growth Opportunities fund and the Franklin US Opportunities fund.
“We saw a huge fiscal and monetary response to the pandemic, but it created a lot of inflation and pushed asset prices up,” he explains. “Everybody was feeling good because of this easy money but now we’re paying the price. Unfortunately, the back half is never as much fun.”
Mr Bowers has been running his Growth Opportunities fund since 2007, and says it is “crazy” just how many periods of stress and volatility there have been since then. There was the credit crunch leading into the global financial crisis of 2008, the Covid pandemic and now the issues we face today, but he says this latest crisis is the most “normal” he has seen, with all the hallmarks of a true economic cycle.
In terms of positioning his portfolio, because his fund targets growth companies, Mr Bowers will not be going too defensive, though he has taken some profits and brought his technology weighting down a little.
“Right now, we want to own the businesses which will emerge from this period stronger,” says Mr Bowers. “High-quality companies that will not only come through this volatility better than a lot of their peers, but will also gain market share.”
Though it has been hit hard in recent times, Mr Bowers likes certain parts of the technology sector. Being based in California, he claims to have a “front-row seat” to what is going on in Silicon Valley and sees no let-up in the transition from an analogue to a digital world.
“We think that the fundamentals are actually quite healthy in the technology sector and spending remains robust. And as companies which invest in technology tend to achieve better productivity and lower costs, this could be a big focus in tougher times,” he says.
In any case, the tech sector has become such a large part of the broader US equity market that it is sometimes hard to differentiate one from the other, says David Bizer, managing partner at investment management firm Global Customised Wealth.
“Broadly speaking, the outlook for tech stocks is the outlook for equity,” he says, pointing out that the IT sector now comprises more than 25 per cent of the S&P 500. The next largest sector is healthcare, at 15 per cent, then consumer discretionary, at 11 per cent.
“Technology figures as an even greater fraction of growth equity, at 43 per cent and growth has been disproportionately hurt relative to value,” explains Mr Bizer.
Growth equity tends to be highly sensitive to interest rates, because many younger companies do not pay dividends or have near-term prospects for dividends, so payout prospects are more distant and therefore more heavily discounted, he explains.
“Thus, one can view the downturn in technology as being caught in the growth-to-value rotation we have seen since the beginning of the year,” adds Mr Bizer.
Long-term optimism
The falling markets of the past few months have seen equities as cheap as they have been for some time, says Laird Bieger, portfolio manager of the Baron Discovery Fund, which invests in small-cap companies.
“For those with a six-month time horizon, this might not represent a buying opportunity because everyone is nervous about when the Fed might stop raising rates and when inflation might start to come down,” he says.
But for those with longer time horizons, anything from three to five years, he believes there is a lot of money to be made by finding good secular growth companies and holding them for the long-term.
“I’m optimistic simply because, for example, if you pick the software sub sector, these are businesses that at one point were trading at double digit or greater multiples of revenue, that today are trading at, in some cases, three- or four-times revenue,” says Mr Bieger. “So they went from multiples that were probably a little too expensive to today, multiples that are a little too cheap.”
But these companies continue to grow and so he feels longer-term investors going in at these levels are going to be richly rewarded.
Balance sheet strength is vital though, warns Mr Bieger. “We want to buy a company that we know from the second we invest has enough capital to get to whatever we think breakeven is. It is very rare that we’ll buy something with the knowledge that the company is going to have to raise additional capital.”
The one exception to that rule tends to be in the biotech space, where this is simply part of the business model. But everywhere else, any firms looking to raise additional capital in the coming months are likely to struggle, he says.
Higher interest rates exert downward pressure on all equity valuations, but they are particularly damaging to the valuation of unprofitable companies because all of the terminal value lies at some distant point in the future and there are no near-term cash flows, says Anthony Kingsley, CIO of investment firm Findlay Park Partners.
“Rising interest rates and slowing growth have largely closed the capital markets to unprofitable companies, forcing them to pivot towards profitability much faster than they intended,” he says.
Unprofitable companies will need to prioritise profitability over growth and restrain hiring, customer acquisition spending and marketing investments, he says.
Investing in businesses where there is a high degree of confidence in the long-term outcome is the approach favoured by Mr Kingsley, as these will be the companies that can live with in any economic environment.
“For example, we are now witnessing a much stronger political and economic push in the US towards incentivising domestic production, upgrading infrastructure and improving economic security – policies that garner, rare, bipartisan support,” he says.
The likely increase in infrastructure and manufacturing activity within the US therefore creates an opportunity. “Our American Fund owns a number of companies which we believe are well placed to benefit directly from greater manufacturing and industrial activity in the US,” he says.
Recession-proof
Recession-resistant companies are one area of focus for French funds house Carmignac, says its head of equities, David Older, although there will be plenty of investors crowded into these names.
One area he particularly likes is pharmaceuticals, which tend to perform steadily and many have tailwinds coming out of the pandemic. The new wave of obesity drugs coming to market at the moment show huge potential, says Mr Older.
“The data from these drugs is incredible and will be a real game changer for obesity,” he says.
The drugs are expensive, but while only around 30 per cent of insurers currently pay for their use, he expects this to rise to 100 per cent because of considerable health benefits to those who manage to lower their weight, leading to lower pay-outs for heart disease or hip replacements.
Powering portfolios
Energy-related names are also interesting. “I think it’s become pretty clear that we need a bridge to a renewable energy future,” says Mr Older.
“There’s just not enough capacity being created. And the only way to get there is through more investment in in oil exploration.”
This need not mean investing in oil and gas companies themselves, rather he points to the tech companies enabling more accurate oil exploration.
What he terms “visible growth stocks” are another key group, says Mr Older, as investors will be prepared to pay for those companies which continue to do well. Companies with pricing power, for example, could thrive in an era of rising inflation and slowing growth. He highlights cloud infrastructure, e-commerce and software sectors as areas of interest.
VIEW FROM MORNINGSTAR: Style matters in a falling market
As inflation, monetary policy, and economic growth concerns roiled markets during the first nine months of 2022, US stocks hit new lows at September’s end.
The year-to-date sell-off is notable both for its depth and length: the 24 per cent cumulative drawdown for the S&P 500 ranks is nearly as bad as those associated with a handful of the US economy’s most severe recessions. The 2002 tech bubble’s collapse included a stretch of seven money-losing months – the most since the mid-1970s. With three months left in 2022, a new record in the recent era is possible.
Few equity portfolios have gone unscathed, but their tilts toward or away from stocks with certain characteristics have made big differences in their results.
Among the most reliable predictors of a US equity fund’s relative success this year has been whether it leans towards value or growth stocks. Did the fund embrace stocks trading at relatively low multiples of their earnings or dividends? Or was it chock-full of companies with paltry earnings, but high expected growth rates, and elevated price multiples? Even with the typical value stock’s steep 18 per cent loss for the year so far, it has shown far more resilience than the average growth stock, which dropped 30 per cent.
Take, for example, two of the market’s purest aggressive growth plays, ARK innovation ETF and Morgan Stanley Institutional Discovery. In 2022, both funds have plunged roughly 60 per cent, twice as far as the iShares Russell Mid-Cap Growth ETF, a good proxy for the category’s investable universe. On the other end of the spectrum, deep value fund Harbor Mid Cap Value lost a relatively mild 13 per cent.
There were other ways to outperform. Hotchkis & Wiley Mid-Cap Value benefited from its longstanding devotion to energy — the only sector to rise in the year-to-date, with an extraordinary 35 per cent gain. The fund had four times as much money in energy stocks as the iShares Russell Mid-Cap Value ETF did at the start of the year, which explains the fund’s 13 per cent loss — among the category’s best results.
But the sector’s run-up was a relative disadvantage for Mairs & Power Small Caps, which owned no energy companies. Still, that fund has beaten three-fourths of its small-blend category peers by emphasising well-established businesses with modest stock-price volatility — other factors that have been in favour this year.
These funds’ relative 2022 performance are mirror images of their results from 2020, when energy stocks plunged as the overall US stockmarket retreated and speculative growth stocks vaulted highest in the wake of the pandemic-induced drawdown.
The market is fickle and can sour on favoured stocks of all flavours quickly, which makes portfolios concentrated on one or two stock types hard to stomach over the long term. Diversifying by style and sector is easier on investors’ stomachs.
Robby Greengold, fund analyst, Morningstar
