Forget the mid-term elections and the $600bn QE2 frenzy, reports Gregor Watt, the real investment news in the US is to focus on figuring out the fundamentals where savage corporate cost-cutting has brought a suprisingly swift return to high earnings for many companies which are still on historically low equity valuations
Last week was a significant one for investors in the US with the mid-term elections reshaping the balance of power in Washington and the Federal Reserve announcing the latest round of quantitative easing in an effort to encourage growth in the sluggish US economy.
Halfway through president Barak Obama’s four-year term of office, the US electorate seem to have sent a message about his performance so far and that message is not particularly encouraging for him.
For two years, Obama has enjoyed the support of slender Democrat majorities in both the Senate and the House of Representatives but following the mid-term elections, the Democrat majority in the Senate has been cut to only three seats while the Republicans made significant gains to turn a Democrat majority into a reasonable working majority of 21 in the lower house.
The results will be a big blow to the ability of Obama’s administration to push through reform.
Newton American fund manager Simon Laing says the likely outcome will be political stalemate. “These Republican gains have dealt a severe blow to president Obama’s ability to push through controversial legislation. He also faces the tough task of developing a working relationship with Republican Congressional leaders – deadlock is the likely result.”
Gartmore global focus fund manager Neil Rogan says the result should be good news generally for equities but adds that gridlock is not ideal when the economy is still in a fragile state.
“With a recovering economy, a dysfunctional banking system and stresses in the real estate sector, legislative gridlock may fail to provide the direction required to put the economy back on track fully. Political squabbling and indecision on Capitol Hill usually mean that companies are allowed to get on with their business unfettered but in today’s volatile world, uncertainty and weak leadership are not necessarily the tonic the US economy needs.”
The changes to the political make-up of Congress is likely to curb or even halt some of reforms planned by Obama’s administration and this could lead to investment opportunities in some industries.
Laing is tipping energy and healthcare as two sectors that have a brighter future under the new political structure. “We expect to see the energy sector benefit, given that the Democrats have been threatening to impose tighter environmental regulations on the sector, in particular, hydraulic fracturing by natural gas drillers, drilling in the Gulf of Mexico, and an Environmental Protection Agency limit on greenhouse gas emissions. With a greater Republican influence, these are far less likely to be passed, helping the prospects of the oil, natural gas and coal industries.
“Meanwhile, after the passing of the much criticised healthcare reform bill earlier in the year, we are likely to see much better sentiment towards this sector. Although the law is unlikely to be repealed, future policy should be a lot less punitive,”
However, Psigma American growth fund manager James Abate says regardless of the outcome of the elections, he is wary of any sector which is vulnerable to political tinkering.
Abate says: “We continue to remain underweight in sectors we feel are the most exposed to selective and unpredictable government intervention from a regulatory perspective, such as financials, healthcare, utilities, even energy. This will be a dominant theme – the government through burdensome regulation and other means will seek to limit the return on equity of companies in areas where the US populace would appear to be disapproving of excess profits, especially where taxpayers’ monies were used to assist in stabilising the companies less than two years ago or whose businesses are not viewed as consumer or environmentally friendly.”
Although the political changes have attracted the most media attention, many investors say the Federal Reserve’s decision to embark on a second round of quantitative easing is the more significant event of last week for investment markets.
The Fed had been tipped to increase the supply of money into the US economy in advance of the decision.
In total, the new liquidity programme will see up to $600bn pumped into the US economy and the new round of central government stimulus is expected to boost equity markets.
Although the announce-ments were largely in line with market expectations, the day after the Federal Reserve’s announcement, both the Dow Jones index and the S&P 500 rose by almost 2 per cent.
Skandia Investment Group head of asset allocation Rupert Watson says: “The additional QE by the Fed will not in itself provide a substantial boost to the economy, which seems in any event to be recovering. However, it does underline that the Fed is willing to act on any sign of weakness. As a result, investors should feel more confident that the recovery will continue. This should boost overall investor confidence and lead to further equity gains especially as cash returns are likely to stay close to zero for some time.”
However, Abate says the real investment opportunities are nothing to do with either the mid-term elections or QE2
“Investors seem fixated with the mid-term elections in the US as well as the recent frenzy regarding the Federal Reserve’s proposed second round of quantitative easing. While both are newsworthy, investors who can focus in on fundamentals will be much better served.”
He says the effects of the recession have seen very high levels of cost-cutting in the US and, combined with historically low valuations on many companies, there are now opportun-ities for equity investors.
Abate says: “Investors need to step back and do a little simple arithmetic. In other words, the fundamental factors that drive the market are earning’s growth, dividend yield and the change in the price/earnings ratio. Add them together and you have the total return for the stockmarket. Dividends are stable but, at a yield of only 2 per cent for the S&P 500, it will not be the same historical proportional contributor to total returns because the tax code still discourages companies from increasing payouts making comparisons to history less relevant.
“With interest rates low already, we are not expecting any meaningful positive re-rating in our overall market forecast for equities but will point out that risk aversion remains high with a chance that it will abate. This leaves investors with profit growth as the main, or perhaps sole yet strong, leg of the stool supporting the stockmarket’s forward return.”
He says despite fears of a double-dip recession, the US is on the road to recovery and there are many companies well placed to benefit from modest economic growth.
Abate says: “Shallow as the economic recovery may be, the recovery is taking place. Furthermore, the benefits from the swiftest and deepest corporate restructuring witnessed during our careers are just starting to be seen as profit margins and returns on capital move higher and may eclipse prior highs for certain firms.”
JP Morgan US smaller companies trust manager Marc Shaw also says corporate cost-cutting is set to pay dividends for investors: “It is well publicised that American corporations did a tremendous job reducing costs from their businesses during the downturn. This led to strong cashflows and strengthening of capital structures as the recovery began to unfold.
“As a result, it appears that corporate America should be back to peak profit levels by the end of 2010, only four years after the prior peak.”
Edinburgh US tracker trust manager David McCraw says: “Valuations for many great businesses have not looked this attractive in recent memory. The broader-market S&P 500 index is trading currently at just over 12 times projected earnings for the next 12 months while over the previous eight earnings’ cycles, the average actual earnings’ figure has been 15 times and we believe those levels are achievable again. Given this, and the size and scale of the US economy, investors should not ignore the country.”
In addition, Abate says the exposure that many US companies have to growing consumer markets in emerging market economies give an additional reason to consider the US.
“US companies with their global market reach and dynamism displayed during the recent recession are standing head and shoulders above other developed markets. Investors looking towards the American market have not missed the boat. The benefits from the swiftest and deepest corporate restructuring witnessed during our careers are just starting to be seen as profit margins and returns on capital move higher and, as I believe there is still another 12-18 months to run, we are currently in a sweet spot for owning US equities.”