Financial markets have lived up to expectations of heightened volatility so far this year. US and global equities have suffered with worries over inflation, interest rate hikes, recession and geopolitical crises persisting. It is also a mid-term election year in the US, which adds to the uncertainty.
Against this backdrop, the US is seen generally as an expensive market. A closer look, however, reveals that it offers interesting opportunities in overlooked areas as the economy enters a new era of technological development.
An economic soft landing is possible
Fears of an impending recession in the US grew at the end of last year when the Federal Reserve switched its policy to a more hawkish trajectory of rate rises, leading to concerns they would effectively end up crashing the economy to curb inflation. The two-year/10-year bond yield curve did indeed invert, which is traditionally seen as heralding a recession. This part of the yield curve has since normalised, however, and a soft landing is certainly possible, with the supply shortages in the US economy improving.
Financial markets have factored in sharply rising bond yields this year. Real yields, or nominal yields adjusted for inflation, have strengthened overall from -110 basis points (bps) to around +20 basis points now, in-line with the 10-year average.
The good news is that this rebalancing means that the adverse impact of rising yields on equity and bond markets could well be largely factored in now. Rising real yields have disproportionately impacted the most speculative parts of the US market with certain sectors such as technology, software and special purpose acquisition companies (SPACs), taking the biggest hits.
Investors mainly focus on the US’ largest companies, which are listed in the S&P 500 and currently trade essentially in-line with their 10-year average. But the valuations of the next tier of US companies, listed in the S&P MidCap 400, trade at 28% below their 10-year average, offering much better risk-adjusted returns. The mid-caps deserve a closer look.
Mid-caps offer several attributes
US mid-caps have several attributes that are attractive at any time. First, they represent a sweet-spot – they are less volatile and suffer fewer failure rates than small-caps while offering higher growth potential than the large-caps.
Second, they are often in the process of increasing their market shares and improving their overall competitiveness. Third, they can reap the benefits as they grow of operating in the largest economy in the world, expanding from state champions through to regional and national ones without ever having to face the complexities of competing overseas in markets with diverse languages and laws. Fourth, they are often strongly aligned with shareholders because of higher inside ownership.
But a powerful reason to invest in US mid-caps now is that they are poised to benefit from what we call 'Digital Disruption 2.0', which is set to be the most important theme in US equities for the next decade and is a key focus for the Liontrust US Opportunities fund.
Digital disruption is moving to 2.0
Digital Disruption 1.0 was one of the most important trends of the past decade. New mobile technologies with simplified designs delivered ground-breaking apps. Digitalisation has been dominated by mega-caps such as Facebook (now Meta Platforms), Apple, Alphabet and Netflix.
These companies provided many of the building blocks for this technological phenomenon, such as the move to cloud (AWS, Azure, etc), e-commerce, social media and advertising. They benefited from significant network effects and built incredible market caps.
Embracers will benefit
However, we believe that digitalisation has now been ‘democratised’ to a large degree. Increasingly we can look to industries that have been slower to embrace digitalisation. Companies in these industries can benefit from the enhanced efficiency the cloud offers, implement software to both boost revenue, perhaps via CRM systems and digital advertising channels, and streamline operations at the back end. In this sense we believe we are entering an iterative era of Digital Disruption 2.0. This means many more, and smaller, companies can implement and benefit from the tools and building blocks/foundations that have been developed.
We search for companies that we believe will be drivers of disruption (disruptors), help fuel it (enablers) and benefit from it (embracers).
It was predominantly the disruptors, such as the FAANGs, that benefited from Digital Disruption 1.0 by introducing the innovations. However, over the next decade we shall see the embracers, which dominate the mid-caps and especially the healthcare, communication services and industrials sectors, coming into their own. These include companies such as Brinks, LivaNova, Advanced Drainage and Verra Mobility, which will be able to leverage digital innovations for their own commercial benefit and recoup the performance they ceded to the large caps over the last decade.
George Boyd-Bowman is fund manager of Liontrust US Opportunities. The views expressed above should not be taken as investment advice.