May 2012

US EQUITIES: Made in America

HorsesA renaissance in manufacturing, boosted by cheap energy, is firing up the US economy and raising stock prices. But can America survive its looming debt problem? George Mitton reports. US equities came galloping into the year like a herd of wild horses. “The world’s most attractive asset class,” boomed one asset manager. Sure enough, the S&P 500 had its best first quarter since 1998, rising 12% in a three-month rally. It seems hard work is digging the US economy out of the hole left by its housing bubble. American companies are “onshoring”, bringing manufacturing back to home soil because productivity is so high. Jeffrey Immelt, head of General Electric, boasted in his annualshareholder letter that workers in Kentucky are close to producing a refrigerator in three hours instead of nine hours in offshore plants. And yet some investors are worried. Was the first-quarter equity rally out of proportion to an economic recovery that has been moderate at best? “For those of us who are cynical, it looked like ‘here we go again’,” says Judith Vale, fund manager at Neuberger Berman’s small cap team, referring to the stock market rise in the first quarter. “It reminded us of the ebullient effect from the Fed’s QE2 initiative, which gave us a six-month rally before a fizzle.” Vale admits to having a pessimistic disposition and is so singularly focused on long-term investing that she refers to three-month price data as a “five-minute rally”. But some of her doubts are justified. She says the first-quarter growth, which coincided with the European Central Bank establishing the long-term refinancing operation (LTRO), came because Wall Street strategists made the premature and dubious assumption that the LTRO has taken away the need to worry about Europe. In fact, she says, the fundamental problems in Europe have not been solved and the LTRO might well turn out to be “a Band-Aid that buys you time and doesn’t solve anything”. There is another spectre looming over the American economy: debt. The US has the largest general government budget deficit among the Organisation for Economic Co-operation and Development countries, at 9% of its GDP, and unlike the austerity-hit European states, it has yet to address the debt problem with spending cuts. Tim Drayson, economist at Legal & General Investment Management, is worried the debt problem will undermine the US economic recovery. “The current consensus is that the US is doing better than Europe, therefore, buy US equities and sell European equities,” he says. “But the optimism in the US is misplaced. They haven’t even begun their fiscal tightening.” Fiscal tightening means less government spending and higher taxes, which would reduce demand and reduce company profits, ultimately depressing equity prices, says Drayson. Instead of buying US stocks now, he advises waiting and buying when the market hits bottom. “Buy when the market cheapens up, and not at these levels,” he says. “At these levels, the returns will be dismal.” And yet, there are promising signs in the US. The housing market, which crashed in the late 2000s, threatening to take the world financial system with it, seems on some measures to be reviving. “Housing permits are up year-on-year across the States, even in the more distressed areas such as Florida, Arizona and Nevada,” says John Jostrand, fund manager at Chicago-based firm William Blair. “The housing market is healing.” And the productivity advantages that Jeff Immelt talked about are real. Labour costs in the US have been flat or have even declined in the last ten to 20 years, while in almost all other developed economies they have risen. Data from New York-based research house Empirical Research Partners says revenues per employee of large US companies have risen to $500,000 (€381,000) in the past decade, up from $300,000. Jostrand says the gains have been driven by management techniques that “empower teams on the factory floor to improve efficiency, take steps out, take costs out. Those techniques have been aggressively introduced down to medium-sized companies.” But it is not only productivity that has drawn manufacturing back to the US. Wage inflation in China, said to be running at 15% or more, has made it less cost-efficient for American firms to build goods there. In addition, high oil prices have increased the cost of shipping goods from China to the US. There is another promising long-term trend that could support American manufacturing growth. Energy independence, a great dream of President Richard Nixon in the 1970s but for long thought impossible, now looks like achievable, perhaps even by 2020. The reason is that the US may be able to exploit more of its resources of oil and gas than in the past using new technology. “Fracking”, the process of injecting water down a pipe to free shale gas, could roughly double America’s exploitable resources of natural gas. The country has already seen an increase in natural gas supply that has brought prices to levels one fund manager describes as “basically free”: $2 per million British thermal units compared with about $9 in the UK and $15 in Japan. Low energy prices make it more appealing to locate factories in America instead of the Far East. New techniques
These new extraction technologies are controversial, though. Fracking uses hundreds of chemicals in the water it injects underground, and up to half this water stays below the surface, where it has been linked with pollution of groundwater supplies. The 2005 Bush/Cheney Energy Bill controversially exempted the fracking industry from the Safe Water Drinking Act, and the industry does not have to disclose the chemicals it uses. There are also hopes that new techniques, such as exploiting tar sands in Canada, could increase North America’s oil reserves. Reducing the US dependence on unstable nations in the Middle East for oil is a crucial political objective and could help insulate the country from price volatility. However, becoming self-sufficient in oil is a long-term dream and, in the meantime, the US is still dependent on foreign imports. If oil prices continue to rise, they could “snuff out” the recovery, warns Henry Sanders, who manages Aviva Investors’s US equity income fund.
Sanders, a value investor, takes a cautious view of the US recovery. There are many promising signs, he says, but it is too soon to be sure the economy has mended itself – there is a risk of an equity correction that could cause the stock market to move sideways.
“We’re in the midst of a moderate economic recovery, but the stock market has had a stupendous recovery,” he says. “There’s some risk that the market is a touch ahead of itself.” But Sanders does not believe a modest correction would damage an economy that is broadly recovering. The debt problem is an obstacle, certainly, but an obstacle the US can and will overcome. It is in the American character to rise to the challenge. “The US tends to be more entrepreneurial and more innovative,” he says. “People don’t just sit by, saying, ‘woe is me, the economy’s crappy’. You bust your butt to try to make the situation better.” ©2012 funds europe

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