November 2013

US EQUITIES: Counting the cranes

CraneWhen official statistics are on hold, investors can always rely on the informal crane index. Nick Fitzpatrick speaks to US fund firms about the health of the domestic market. The number of jobless in the US – a figure so essential to Federal Reserve monetary policy decisions – appears to be not so essential after all. In October, publication of the jobless rate was postponed after the US shutdown closed the US Bureau of Labor Statistics – though America has since reopened its government. The rate of unemployment is a key indicator as to when the Fed will start tapering quantitative easing (QE) – the bond-purchasing programme that is artificially keeping bond rates low. The Fed is also promising that overnight lending rates will stay low until the jobless rate drops to less than 6.5%. The September release saw unemployment at 7.3%, having fallen by a percentage point over the last 12 months. QE is, in part, supposed to drive investors into riskier, higher-returning assets like high yield bonds and equities. Many see the Fed’s unconventional monetary policy as a major supporter of equity markets.
The US has been in an equity bull–run now for many months. Some, though, think this is unfair to the asset class, and say the rise of US equities has purer drivers than central bank manipulation. “I find the idea that the stock market is up primarily because of QE ridiculous,” says Jay Feeney, co-chief executive officer and chief investment officer at Robeco Boston Partners. “On the margin, QE has helped through lower interest rates and by restoring investor confidence. But to say that QE has been the primary driver of stocks is absurd.” Growth in earnings is a more significant driver, he says. But it’s not the first time Feeney has disagreed with nearly everybody. “In 2009 and 2010, I spent a lot of time in Europe talking about the economic and equity market fundamentals of the US, and most people laughed at me.” Robeco Boston Partners, originally a US value equity specialist, offers US and global equities and was formed when Dutch asset manager Robeco bought Boston Partners in 2002. Understandably, people were nervous after Lehman Brothers collapsed and the banking crisis jumped the Atlantic to become a sovereign crisis. “It did seem like the end of the world. Lehman was a defining moment,” says Feeney. Yet at the time, US equity valuations recorded generational lows and the Dow Jones provided a once-in-a-lifetime investment opportunity – though one that it would take guts to grasp. “You make a distinction between the intrinsic value of equities and the market price.  From time to time, large disconnects can occur between intrinsic value based on cashflows or assets, or both, and the price ascribed to them by investors.  The under or overvaluation can occur due to sentiment – fear or greed – or systematic behavioural biases.” RECOVERY
He adds that Robeco Boston Partners was underweight credit-sensitive institutions as the crisis sprang from its box, but the firm moved back into financials as early as 2009. He describes the firm’s US equity sales in Europe in 2008 and 2009 as “stable”. Those who grasped the opportunity have enjoyed rising equity prices in the past few years. The Dow Jones reached a pre-crisis high as far back as February 16, 2012 when it closed at 12,903 points – a level not seen since May 2008 – following the lowest level of unemployment benefit claims for nearly four years. Since then, more people have taken note of what appears to be an earnest recovery in US equities. Recently the Dow was above 15,300. Those still concerned about the US economy could easily argue that the bounce-back of the US corporate sector is down to global earnings, because 30% of the Russell 1000, a US large-cap index, is from overseas. But this year the Russell 2000, a US small-cap index with 84% of earnings from the domestic market, has attracted huge flows. Feeney expects earnings from the S&P 500, another major large-cap index, to be about $108 this year. In 2011 S&P earnings were $92; then $40 in 2012. He says earnings growth is down to corporate management, which rationalised businesses right across the globe, ready to benefit from an upturn in consumption. MASSIVE CRASH
Matthew Rubin, director of investment at Neuberger Berman in New York, says the “fundamental” recovery in the US is spurring on more people to increase their risk. “As we’ve seen a fundamental recovery, from both an economic and earnings perspective, I find many investors are under-allocating to equities. You can very often see underinvestment in risk broadly, but specifically equities,” he says. “But that’s beginning to change. Investors are no longer looking for return of capital, but return on capital. They do not just want safety any more, notwithstanding the uncertainty that has derived from Washington recently.” He says equity investors, led strongly by dividend returns in recent years, are optimistic enough now to look beyond these. “Dividends, share buy-backs and M&A are all ways a company can be of value to its investors. Dividends will be important but investors are looking more broadly at what management is doing beyond their dividend.” For one sign of this fundamental recovery, investment providers point to the increase in household formation, which collapsed after the sub-prime crisis. In August, sales of new homes grew by 1.7%, according to the National Association of Realtors. Sales, at 5.48 million units, were at their highest level since early 2007. “There was a massive crash in household formation, though that is seeing a recovery now,” says Robeco’s Feeney. Yet mortgage rates have also risen more than a percentage point since Ben Bernanke, the Fed chairman, hinted in May at the tapering of QE. “Rising mortgage rates are a concern now,” Feeney adds. “Will they rise further and choke off the recovery?” Steve Wood, chief markets strategist at Russell Investments in New York, says Bernanke’s taper-talk was a way to push up mortgage rates to temper frothy markets. “Bernanke knows there are a lot of highly speculative and leveraged positions taking place. The Fed wants to taper sooner rather than later so as to minimise dislocation and bubbles. However, the Fed does not want to raise interest rates, so Bernanke had the market do it for him.” Taper-talk caused long-term bond rates to rise. Between February and August, the 10-year Treasury bond yield rose by nearly a full percentage point to 2.72%. “If this is a yield normalisation process after QE that’s a sign of health,” says Wood. The Fed also lowered growth forecasts for this year and next, but Wood – noting a manufacturing renaissance, an energy boom and the rise in household creation, says: “There’s no necessary reason to conclude that simply because the US is in a lower gear means it is dramatically closer to stalling. Taken alone, a slower growth rate does not mean the probability of recession has increased.” GOOD 10 YEARS
Based on this US snapshot, optimism in the country for domestic equities seems rife and belief in the economic recovery is strong. Feeney says QE has helped the economic recovery, stabilising the system and restoring confidence. Employment and productivity are up, and though public sector deleveraging has some way to go, private sector deleveraging has offset this. “US equities today look like a bit better than fair value. They are priced for about an 8% rate of return over the long term. That embodies a healthy risk premium compared to bonds and I do not believe rising interest rates will do much damage to equities.” Official statistics aside, Feeney falls back on to a tried-and-tested gauge of economic health: the cranes. Looking out across Boston, he counts 14 of them. “There was nothing going on before, but you began to see these cranes go up 15 months ago. I think the next 10 years for equity investors will be better than last 10.” ©2013 funds europe

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