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US equities have proven overwhelmingly popular with investors desperate for signs of economic growth. They have been the best performers in euro terms since the beginning of the year and their dominance in terms of flows year-to-date is little short of astonishing.
By the end of August, they had gathered record YTD inflows of nearly €15bn – nearly 65% of all equity flows and almost more than developed market equity ETFs in total, given the sustained outflows from Europe we saw between February and July.
Nor have these flows been limited to traditional large cap exposures – as the economic cycle has aged, investors have become more selective in their allocations with sector ETFs and, latterly, small- and mid-cap ETFs gaining traction. Sector inflows, in fact, hit a record €1.6bn YTD by the end of August, with around €900m of that going into technology. But can the run continue?
Life in the old bull yet
Despite their strength – and that popularity – we still feel there’s more to come, even at this late stage of the cycle. There is little doubt US president Donald Trump’s belated, but unprecedented, fiscal stimulus should foster more inflation at a time the economy is running at or above full capacity. Strong top-line revenues and margin expansion (as well as share buybacks) have bolstered the earnings-per-share outlook for corporates, while recovering capex and the associated upturn in productivity could help mitigate the negative effects of rising wages on profit margins. All of which suggests some further upside ahead. Little wonder investors are still being drawn to the US, despite the unpredictability of the administration on the Hill and the looming mid-terms.
So, for now at least, we’re not put off by seemingly stretched valuations, although they may limit long-term upside potential. We, like many others, have said that before, however, and the bulls have kept on running…
Recent US ISM surveys have reached new cycle highs and the job market has remained strong, suggesting solid growth in the coming months. Outside the US, business survey results such as PMI manufacturing in emerging countries and Europe have dipped on the trade tensions, but they’re still pointing to economic expansion. That could change should the trade war escalate or become more global in nature but we still think a negotiated settlement is ultimately more likely. In truth, a move from sporadic, temporary sell-offs into a lasting bear market requires a more meaningful, cyclical turn down – something we do not foresee just yet.
Choosing your vehicle
So how should you invest? Choosing the right investment vehicle in most markets is often challenging – except, that is, in the US, where active managers really do struggle to beat their benchmarks.
At the end of H1 2018, fewer than one in five large-cap managers (19%) were giving investors what they paid for. At least that’s better than the 11% that have delivered over the past decade. Small-cap managers fared a little better, with just one in four having outperformed by the end of H1 but the pattern is clear.1 Which passive vehicle should you choose?
Sophisticated investors tend to believe futures are more liquid options than ETFs and cost less overall but the results do not stack up, in our view, as often as you might believe.
Taking three of the major US equity markets as our examples, we can see that ETFs were more effective for a broad S&P 500 exposure as well small-caps via the Russell 2000. In contrast, for the NASDAQ 100, futures contracts still win out. When choosing your passively managed investment, you still need to be selective wherever possible.2
You are here
Although every business cycle is different, they do tend to follow a similar pattern. As an economy progresses through the cycle, some sectors naturally perform better than others and vice versa.
Convention has it that when an economic recovery matures, the energy and materials sectors – which are closely tied to raw material prices – tend to do well because inflationary pressures are building and demand is still solid. On the other hand, IT and consumer discretionary stocks tend to suffer because profit margins are being eroded and investors are more wary of luxury spending.
We’re seeing some of this today in the US with the recovery now entering its dotage, but there are specific issues at play helping some sectors defy convention.
Of sectors, sizes and styles
When assessing US equity allocations today, you have to factor in the fallout from the fiscal push. It helped US corporates avoid typical late-cycle issues like slowing earnings growth and a squeeze on profit margins and also ensured a favourable environment for financials and technology, through deregulation and tax reform respectively.
Quite naturally, we also favour some more conventional late-cycle calls, including energy and healthcare. Energy in particular appeals to us because of its improved corporate fundamentals and the recovery in oil prices.
There are some areas we would rather avoid too. We are wary of the consumer discretionary sector given company-specific risks and problematic valuations, particularly in e-retailing. We are also keeping a watchful eye on the most defensive sectors – especially those more sensitive to interest-rate rises including utilities and consumer staples. We had held a negative view on telecoms too, but the sector’s recent expansion and conversion to ‘communication services’ – which led to the inclusion of companies like Facebook and Netflix and the sector having more of a leaning towards growth – does change our view. That said, regulatory issues affecting data privacy still merit some caution.
Meanwhile, president Trump’s tax cuts should still stimulate additional profit growth for smaller companies, many of which benefit from a domestic bias to their business – making them slightly less vulnerable to the ongoing trade disputes.
Choose your index wisely
Precision and selectivity, then, are the watchwords at this late stage of the cycle. Look to lower cost exposures to make the most of whatever upside remains, tilt towards tech or bet on the specific issues boosting banks with indices like the Morningstar US Large-Mid Cap, the NASDAQ 100 or the S&P 500 Banks. Alternatively, you could seek to add some resilience to your portfolio with quality income or minimum variance strategies.
In contrast, the S&P 500 and MSCI USA look most exposed to those areas we favour least, while the FTSE USA Core Infrastructure comes with a 50%+ allocation to utilities.
Chanchal Samadder is head of equity strategy, Lyxor ETF
1 Source Morningstar, Bloomberg. Data from 31 December 2007 to 29 June 2018.
2 Source: Lyxor International Asset Management, as at August 2018.
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