The US market’s silver lining
We are no bulls on the US market. Even if growth remains solid, our view is that US equities will struggle to post yet another year of outperformance given that valuations are already stretched, the Federal Reserve is no longer the easiest central bank in town, and the US dollar is no longer supercompetitive.
Even worse, decent growth is not a given. While we remain relatively upbeat about the US growth outlook over the next 12-24 months, we have to admit that much of the recent data has been uninspiring. While Europe and Asia have surprised on the upside this year, US data has mostly come up short. So what is an investor to do?
One option would be simply to underweight or avoid the US equity market. Indeed, we continue to recommend shifting equity portfolios away from the US and toward Asia, where valuations are more attractive, monetary policy is easing, currencies are either stable or competitive, the fall in oil prices is paying handsome dividends, and economic integration led by China has the potential to provide a structural tailwind.
But for investors who need or want to maintain some US equity exposure, where can capital best be put at risk? Recognising that there is significant overlap, we recommend the following:
1) Overweight domestics, multinationals and exporters.
Obviously the driver here is the stronger US dollar, but a healthier US consumer also plays into this trade.
2) Overweight service providers, underweight companies producing and/or holding inventories of goods.
This is not just a restatement of our first call. Sure, a lot of service providers are domestics, while a lot of goods’ producers and traders are multinationals or exporters (or compete with foreigners). But this call is also geared to recent price falls in commodities and manufactured goods. Inventory-to-sales ratios have shown a worrying rise in the manufacturing and wholesale sectors, as output prices have fallen faster than the book value of inventories (produced with materials bought nine months ago). This helps to explain why a lot of the recent US data misses have come from the manufacturing sector.
3) Overweight construction.
Much housing data has been good recently: new home sales have picked up in the last three releases after two years of stagnation. Pending new home sales have also ticked up. And house prices are showing early signs of a reacceleration, after appreciation slowed to 5% in 2014. This makes sense to us. The improved labour market situation bodes well for household formation and housing demand. With the exception of yesterday’s ADP estimate, labour market data has been strong this year. And although aggregate wage growth has been lacklustre in nominal terms, it has been strong in real terms. Plus more and more businesses are announcing wage hikes (McDonald’s became the latest example last week). Given the lull in construction following the housing bust, our estimates suggest that this rebound in demand in an environment of low mortgage rates will drive a pick-up in construction. Of course there is overlap here with our first two calls. US homebuilders are domestically focused, with almost no exchange rate exposure. For all these reasons, homebuilders may be the brightest silver lining in a largely unattractive market. Perhaps this is why the S&P 1500 homebuilder index has outperformed year to date, breaking out of its two-year trading range last week to set new cycle highs.