Evan Bauman: M&A to thrive in US despite volatile outlook for markets

As we start 2016, we view US equities as neither cheap nor expensive. The S&P 500 is currently trading at around 18 times forward earnings. Market leadership has been narrow, with only a handful of mega-cap tech and internet names contributing most of the gains and masking underlying weakness in the overall market.

We expect this year to start in much the same way 2015 ended, with challenges still facing equities and volatility likely to remain high due to lingering commodity weakness and the subsequent impact this has on the broader US economy.

Interest rates will initially take centre stage, with expectations of further hikes no doubt continuing through the year now the Federal Reserve has moved to raise them from the historically low levels in place since the financial crisis.

The statement accompanying its decision indicates the federal funds rate could rise another 100 basis points this year.

Where rates ultimately finish in 2016 will be dependent on the level of wage growth, inflation and other readings on the economy. We expect they will likely still remain well below historical norms for some time to come. But as we switch to a tightening cycle, the importance of fundamentals in valuing stocks remains paramount.

Even if the US central bank engages in several rate hikes this year, financing costs will remain attractive for many companies, and we expect this to fuel further consolidation across industries.

Prime candidates for this ongoing M&A activity are within the healthcare, technology and media sectors. There could also be some potential for M&A to take place across the energy space as high quality assets owned by liquidity-constrained companies will, in all likelihood, eventually be monetised through disposals.

Energy was, of course, one of the worst performers in 2015 following the collapse in the oil price and therefore it is an understandable hunting ground for investors. We believe companies like Anadarko Petroleum and Core Laboratories have the balance sheets to survive and gain share as the shake-out across the exploration and production and oil services segments continues.

There has been an expectation that macro factors such as the weak oil price will continue to support US consumers in 2016 and, while we assess companies on their own fundamentals first and foremost, the strength of the US economy compared with other international markets makes us more confident investing domestically.

In particular, we have focused on the cable and media-related consumer stocks we own as an improving job market and low levels of inflation will continue to be supportive of consumer spending.

But investors should not get carried away. Commodity weakness and the uncertainty caused by an election year could keep spending gains in check.

As part of this caution, we believe the risk reward dynamics in the consumer staples sector remain unattractive, given the rich valuations of many of the global branded companies.

A more interesting area is the biotechnology space. We have owned biotechnology companies dating back over 30 years and continue to find tremendous opportunity in the sector. We remain impressed by the innovation and scientific breakthroughs occurring among biotech and pharmaceutical companies like Amgen, Allergan, Biogen and Vertex Pharmaceuticals.

In 2015, the sector experienced a pullback caused by political comments on price controls. But, if anything, this was as an opportunity to add to certain companies, especially as we believe continued clinical success, increased drug approvals and ongoing industry consolidation will provide further long-term opportunities in biopharmaceuticals.

Evan Bauman is managing director at Legg Mason ClearBridge and manager of the Legg Mason ClearBridge US Aggressive Growth fund