2014 has been a difficult year for most regional equity markets, with the threat of deflation hindering the eurozone, recession hurting Japan and the strong pound eating away at earnings growth in the UK.
The US, however, has built on its strong 2013 gains. According to FE Analytics, the S&P 500 is up 20.33 per cent in sterling terms year to date, while the FTSE All Share, Nikkei and MSCI Europe ex UK indices have all returned less than 1 per cent so far in 2014.
Performance of indices in 2014
Source: FE Analytics
Data from FE Analytics shows the IMA North America peer group has been the best performing equity sector this year with returns of 16.58 per cent, beating its nearest rival – the IMA Asia Pacific ex Japan sector – by 9 percentage points.
Those strong returns, along with the fact that the S&P 500 has broken through its high water mark on a number of occasions this year and as it is more expensive from a P/E ratio viewpoint, has meant many experts warned that 2015 will be a difficult year for investors to make money from US equities.
However, Simon Laing, manager of the £450m Invesco Perpetual US Equity fund, says investors are naïve to think that just because the S&P 500 has performed well this year, it won’t continue to strengthen.
Laing says recovering economic growth, the fact that any rates rises are likely to be limited, the prospect of wage growth, a weak oil price and a strengthening dollar create a very positive backdrop for US equities.
“With this economic backdrop, we see a decent year ahead for US equities,” Laing (pictured) said.
“If you think of equity returns being made up of two components, earnings growth and valuation – the price you are willing to pay for those earnings – then both should help the US equity market higher.”
“We think earnings growth for 2015 should come in around 4-5 per cent on average. When we think about the P/E ratio, we think that we could even see some expansion from the 16 times 2015 valuation. Most quality US companies convert 100 per cent of their net income to free cash flow so that 16 times P/E is equivalent to a 6.25 per cent free cash flow yield.”
Laing likes Cornerstone Macro’s analysis, which shows that equity market valuations are negatively correlated to P/E ratios. As he says inflation will remain weak next year – as a result of the low oil price and the strong dollar – then he is confident decent returns will be had from the US equity market.
The oil price has fallen more than 40 per cent in 2014 while the dollar has strengthen considerably, relative to sterling, over recent months – as the graph below shows – due to the US’s economic recovery and the prospect of higher interest rates next year.
Performance of US dollar relative to sterling over six months
Source: FE Analytics
“So, to the extent that we think inflation remains tame in 2015 that should again be supportive of higher equity valuations. In summary, we see no reason not to expect another year of decent equity returns for the market,” Laing said.
His views are supported by Felix Wintle, manager of the Neptune US Opportunities fund, who says next year’s low inflation will be a major benefit to the US consumer.
Wintle says the dollar is at the beginning of a structural bull market, as not only is the economy picking up but while the US Federal Reserve is tightening monetary policy, the European Central Bank and the Bank of Japan are about to ramp up their quantitative easing programmes.
“Large-cap growth stocks are likely to perform well in this environment. With money flowing into the US as investors seek exposure to the strong dollar and strong corporates, large caps are a natural home,” Wintle said.
“The low inflation environment may also bring with it P/E expansion, which will boost this part of the market. Many large-cap stocks have good earnings growth but are also pursuing aggressive capital return policies, which should deliver shareholders some extra returns in terms of share buybacks and dividends.”
He added: “We remain bullish on the US and the US stock market.”
Not everyone shares Laing and Wintle’s bullishness over the US market. In a recent FE Trustnet article, FE Alpha Manager Marcus Brookes said he was avoiding the North American funds.
He said that though the US economy looked good, investors should expect a period of consolidation as the equity market already seems expensive and has risen hugely since the market bottomed after the financial crisis in March 2009.
Performance of indices since Mar 2009
Source: FE Analytics
His views are echoed by Premier’s Simon Evan-Cook, who recently said the US was one area investors should be avoiding in 2015.
“It seems that a lot of investors have felt ‘why should we invest anywhere else? The [US] economy is doing well unlike a lot of other places’,” Evan-Cook (pictured) said.
“While I get that, the problem is always the price you have to pay. The S&P 500 is trading on a CAPE [cyclically-adjusted price to earnings ratio] of 26/27 times and it has only previously been that high in 1999 and 1929 – and we all know what happened after that.”
“I do understand the economic argument, but the price is simply too high. I’m sure that managers can find good value opportunities at a stock level, but if you are buying an index the US is a particularly bad choice at the moment.”
Given that the starting valuation is one the biggest drivers of future returns, Angel Agudo, manager of the £440m Fidelity American Special Situations fund, is slightly more cautious in his outlook than Wintle and Laing.
“The US has clearly taken back its leadership position in the global economy and investors are refocusing their attention on the unique structural advantages it enjoys,” Agudo said.
“These include access to relatively cheap energy and labour, as well as an institutional structure which supports innovation and a profit focus, and is flexible enough to withstand periods of crisis.”
“This positive environment has translated into sustained strong performance from US equities and the third quarter of 2014 marked the seventh straight quarter of positive market returns.
The manager added: “Against this valuation backdrop, the outlook for the broader equity market is perhaps more mixed going forward, particularly given that profit margins are at high levels.”
