The US holiday season, which began last Thursday with Thanksgiving, is typically a positive time of year for equity markets across the Atlantic. While market participants have been awaiting the Federal Reserve’s initial interest rate hike, the US economy has continued its recent upward trajectory, with Q3 growth last week revised up from 1.5% to 2.1%. In a world struggling to ex-tract any meaningful growth, this positivity could spur further gains for local equity markets.
Since the depths of the global finan-cial crisis in March 2009, US stocks have enjoyed largely uninterrupted returns. In fact, apart from the flat year in 2011, the S&P 500 has delivered strong double-digit gains in all cal-endar years, with the index move of 30% in 2013 the highlight. Addition-ally, the correction seen this sum-mer was just the first such down-turn for four years. High-profile US equity fund manag-ers – such as T. Rowe Price’s Larry Puglia, Neuberger Berman’s Charles Kantor and Eagle Asset Manage-ment's Ed Cowart – remain cau-tiously optimistic on the asset class going into the New Year, but they believe the importance of stock selection is increasing.
“US stock markets have performed well, as signs of economic recovery and better corporate earnings have helped equity prices. However, the current environment is less supportive of broad corporate earnings growth given the uneven pace of economic expansion. The US economy continues to advance at a moderate pace, but slower growth in China and Europe, a stronger dollar and the extreme stress in the commodity complex is resulting in a broad profit recession within industrials.
“Nevertheless, consumption – the largest part of the US economy – appears to be performing well and many companies exposed to those areas continue to deliver impressive earnings growth. Given these factors, we remain reasonably constructive, but expect a more subdued earnings environment for the market overall. “Given that backdrop and the strong returns seen since the market bottomed in 2009, the overall market is likely trading at fair valuations. Therefore, it is vital to continue to focus on investing in ‘all season’ growth companies – those with leading market positions and seasoned management teams – that are well versed in allocating capital and managing expenses and whose growth is not heavily reliant on the overall direction of the economy.”
“Regardless of the timing, we do not fear a modest increase in short-term interest rates. There have been eight interest rate cycles since the 1950s. A sustained decline in stock prices, call it a bear market, has never begun before the first interest rate increase. In fact, the stock market on average continued to rise for more than two years after that first rate increase by the Federal Reserve.
“On average, the S&P 500 has been more than 9% higher one year after the Fed begins raising rates. Of course, there is no guarantee historical precedents will hold, but if a bear market in stocks and a recession in the economy were to occur, it would happen under conditions literally unprecedented in modern financial/economic experience.
“We remain optimistic about the outlook for US stocks due to five key reasons: 1) recent earnings coming in a bit above expectations; 2) the valuation of stocks, especially compared to high-quality fixed income, are still attractive; 3) abundant liquidity held by individuals, institutions and corporations; 4) widespread scepticism on the part of retail and institutional investors [a contrarian indicator]; and 5) no sign of a US recession on the horizon.”
“With modest but still positive earnings growth forecasted for the S&P 500 in 2016, the outlook for US equities remains, in our view, constructive but requires increasing selectivity. “The corporate environment continues to be supported by solid cash flow generation and strong balance sheets, in addition to sustained profit margins and attractive returns on capital. In our view, these results are a reflection of the ingenuity of corporate leaders to push for advances in science while harnessing highly innovative technology applications to improve global business performance.
“Importantly, equity valuations are not overly demanding. Moreover, with the recent downdraft in equity prices, the valuation fulcrum has shifted – albeit slightly – resulting in an increased margin of safety versus the start of 2015. Specifically, equity valuations in the US already appear valued for very slow growth, tilting closer to the stagnation view of the world rather than a view for long-term normalisation. Thus, any sense that the global economy is not heading toward either a recession or secular stagnation could be very well received by investors in risk assets.”