This autumn’s sell-off (which erased the S&P 500’s YTD gains) hasn’t dampened enthusiasm for US equities. They’ve proven overwhelmingly popular since the beginning of the year with investors desperate for signs of economic growth. Their dominance in terms of ETF flows year-to-date remains little short of astonishing. And, with the results from the mid-terms largely what the polls predicted, that dominance could endure for a while yet. After all, a split Congress has, historically at least, often been bullish for equities.
By October 23, they’d gathered YTD ETF inflows of nearly €20 billion in Europe* – that’s nearly four times as much as global equities and far more than any other major individual market. Nor have these flows been limited to traditional large-cap exposures – as the economic cycle has aged, investors have become more selective in their allocations with sector ETFs and, latterly, small- and mid-cap ETFs gaining traction.
Life in the old bull yet
The sell-off was, in our view, excessive and we remain confident the stress is temporary and that there is more upside to come, even at this late stage of the cycle. The fundamental picture has not changed and, even though it may have lost some of its momentum, Trump’s fiscal stimulus should still foster more inflation at a time the economy is running at or above full capacity. That said, he is likely to find his room for manoeuvre more limited from here. Any additional tax cuts between now and 2020 will be much harder to push through. Strong top-line revenues and margin expansion (as well as share buybacks) have bolstered the earnings-per-share outlook for corporates, while recovering capex and the associated upturn in productivity could help mitigate the negative effects of rising wages on profit margins.
So, for now at least, we’re not put off by seemingly stretched valuations, although they may limit long-term upside potential. We, like many others, have said that before however and the bulls have kept on running...
After reaching a cyclical high in August, the US ISM manufacturing survey has stalled but is still indicative of strong economic expansion. The job market is also robust, with the rate of wage growth about to pass the 3% threshold for the first time since 2009.
Outside the US, business survey results in emerging countries and Europe have dipped on the trade tensions, but continue to point to economic expansion. That could change should the trade war escalate or become more global in nature but we still think a negotiated settlement is more likely.
In truth, a move from sporadic, temporary sell-offs into a lasting bear market requires a more meaningful, cyclical turn down – something we don’t foresee just yet.
Choosing your vehicle
So how should you invest? Choosing the right investment vehicle in most markets is often challenging – except in the US, where active managers really do struggle to beat conventional benchmarks.
At the end of Q3 2018, fewer than one in six large-cap managers (16%) were giving investors what they paid for in Europe. At least that’s better than the 10% that have delivered over the last decade. Small-cap managers fared a little better but, with just one in four having outperformed by the end of Q3 this year, the pattern is clear – at least among the broad benchmarks*. But which passive vehicle should you choose?
Sophisticated investors tend to believe futures are more liquid options than ETFs and cost less overall but the results don’t in our view stack up as often as they’d have you believe. Taking three major US equity markets as our examples, we can see that ETFs were more effective for a broad S&P 500 exposure as well as small-caps via the Russell 2000. In contrast, for the NASDAQ 100, futures contracts still win out. When choosing a passively managed investment, you still need to be selective wherever possible.**
You are here
Although every business cycle is different, they do tend to follow a similar pattern. As an economy progresses through the cycle, some sectors naturally perform better than others and vice versa.
Convention has it that when an economic recovery matures, the energy and materials sectors – which are closely tied to raw material prices – tend to do well because inflationary pressures are building and demand is still solid. On the other hand, IT and consumer discretionary stocks tend to suffer because profit margins are being eroded and investors are more wary of luxury spending. We’re seeing some of this today in the US with the recovery now entering its dotage, but there are specific issues at play helping some sectors defy convention.
Of sectors, sizes and styles
Q3 earnings results were positive overall, with nine out of 11 sectors beating expectations. However, the positive results were overshadowed by weakening prospects; with some companies warning that a higher US dollar and rising input costs may dent profit margins in the coming quarters. So where are the opportunities today?
When assessing US equity allocations right now, it’s important to be selective. Even with the push petering out, we still favour those sectors – like Financials and Technology – that have most enjoyed its support, regardless of their seemingly stretched valuations. Financials will also benefit from the higher rate environment. Quite naturally, we also favour some more conventional late-cycle calls, including Energy and Healthcare. Energy in particular appeals to us because of its improved corporate fundamentals and the oil price recovery.
There are some areas we’d rather avoid too. We’re wary of the Consumer Discretionary sector given company-specific risks and problematic valuations, particularly in e-retailing. We’re also keeping a watchful eye on the most defensive sectors – especially those more sensitive to interest rate rises including Telecoms, Utilities and Consumer Staples.
Meanwhile, Trump’s tax cuts still have enough energy left to stimulate additional profit growth for smaller companies, many of which benefit from a domestic bias to their business – making them slightly less vulnerable to the ongoing trade disputes.
Choose your index wisely
Precision and selectivity then are the watchwords at this late stage of the cycle. Look to lower-cost exposures to make the most of whatever upside remains, tilt towards tech or bet on the specific issues boosting banks with indices like the Morningstar US Large-Mid Cap, the NASDAQ 100 or the S&P 500 Banks. Alternatively, seek to add some resilience to your portfolio with quality income or minimum variance strategies, which have outperformed broad indices recently.
Why Lyxor for US equities?
If you still see the US as a land of opportunity, look no further. Our US equity range opens up 14 possible routes to travel, across mainstream and more specific indices from just 0.04%. And, because we’ve been managing ETFs in the region for over 17 years, and run over €9bn*** in assets, we may just be the guide you need.
Visit www.lyxoretf.com to download our full US equity spotlight for our latest outlook for the US equity market, a look at active vs passive performance, key ETF flows and the main indices available to investors.
* Source: Morningstar & Bloomberg, data from 31/12/2007 to 29/06/ 2018. Full report and methodology available at www.lyxoretf.com
**Source: Lyxor International Asset Management, as at August 2018. Detailed methodology and assumptions made available on request. Market conditions may change and have an impact on performance of ETFs and futures. Past performance is no guide to future returns.
*** Source: Lyxor International Asset Management. Data as at end August 2018. TERs correct as at 29/10/2018
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