US president Donald Trump’s 2017 tax cut boosted growth and lowered unemployment, creating greater optimism about the US economy. Yet, economic growth has showed signs of slowing down, prompting the Federal Reserve to reverse its programme of rate normalisation and begin cutting rates.
More recently, Trump’s tougher trade stance on China has spooked markets.
As such, the merry-go-round of good and bad news is a symptom of a malaise that fund manager Brass believes he has diagnosed.
“Since the end of 2016, the S&P 500 index is up [around] 32 per cent, driven by a bull market in growth stocks, whilst cyclicals or unloved areas of the market have been abandoned in a bear market,” said the manager of the $236.1m Majedie US Equity fund.
During this period, the S&P 500 Growth index is up by 49.17 per cent, in US dollar terms, said Brass noting high-growth sectors such as software, internet and data processing.
Performance of the S&P 500 style indices since 2016
Source: FE Trustnet
At the same time the S&P 500 Value index is up by just 17.52 per cent. Unloved areas such as housing, energy, construction and airlines, said Brass, are all flat or in negative territory.
He said a simple way to understand this is by considering the growth versus value dynamic.
“Many growth sectors that have been setting records such as software, life sciences, internet, and support services are all trading toward record valuation levels,” he explained.
In contrast, Brass (pictured) went on, “the many unloved areas of the market in a range of sectors such as airlines, autos, housing, construction, energy, retail and pharma are all trading toward historic low valuations”.
As a result, the portfolio manager noted, valuation spreads – the difference in valuation between the expensive and cheap areas of the market – are near record highs.
Brass said there were a number of reasons for this.
“Firstly, the economic outlook is uncertain. We are late in an economic cycle and many indicators are looking ominous,” the Majedie manager he said. “This is leading many investors to seek safety in secular growth sectors, which they believe will be shielded from any economic woes.”
Another reason, he said, is that the number of stocks offering high growth has been reducing over time, forcing investors to cluster around an increasingly narrow opportunity set.
Third, the increased influence of ETFs (exchange-traded funds) is exacerbating polarisation in the market as these vehicles are valuation-insensitive.
Indeed, the influence of ETFs shows no sign of diminishing.
During the second quarter of this year, US equity ETPs (exchange-traded products) gathered $29.5bn, according to a report by asset manager BlackRock, with $11bn funnelled into large-cap strategies and broad exposure funds garnering $8.5bn, as the following chart shows.
“These inflows continued amid growing economy and solid corporate earnings,” the asset manager noted.
Quarterly ETF flows since 2016
Source: BlackRock
The final reason, according to Brass, is that business model disruption has increased dramatically for many segments of the US market due to the challenge of online competition, or the shift to energy efficiency.
“This is creating unprecedented risk for sectors ranging from retail and autos through to healthcare distribution,” he explained.
As such, the manager said there are many exciting opportunities across the market both in growth and cyclicals for the Majedie US Equity fund.
“On the defensive end of the spectrum we find very attractive, relative value in many mid-tier growth sectors, that is at a level seemingly not high enough to attract the interest of those looking for faster growth and hence the valuations are still attractive,” he explained.
Indeed, the fund currently has large exposures to sectors including insurance brokerages, government IT contractors, online advertising, defence and financial exchanges.
“At the other end of the spectrum many cyclical stocks have sold down to valuation levels, which price in a mild recession and yet will offer substantial upside when the economy stabilises,” he added. “These include many housing related or highly cyclical technology hardware companies.”
While record valuation spreads do present a huge opportunity for stockpickers, he cautioned that “the uncertain economic environment means that investors have to navigate carefully”.
A ground rule is always to consider the risk versus the reward on a two-year basis, the Majedie manager said.
“We do this by making a detailed assessment of the range of fundamental outcomes for our investments, combined with an overlay of how our investments are likely to be valued in both an optimistic and pessimistic scenario,” he concluded.
“We favour stocks with substantial upside potential, but where the downside is relatively limited in comparison.”
The Majedie US Equity fund targets long-term capital growth and is supported by a seven-strong analyst team. Top holdings in the fund include Microsoft (6.3 per cent), Alphabet (4.7 per cent) and Facebook (4 per cent).
Performance of fund versus sector & benchmark since launch
Source: FE Trustnet
Since its June 2014 launch, the fund has made a total return of 118.14 per cent against a 105.66 per cent gain for the IA North America sector and a 121.84 per cent rise in the S&P 500 index. It has an ongoing charges figure (OCF) of 0.86 per cent.