Plenty of road ahead
Never mind the gloom, the US economy is booming right now. Fresh from a jam-packed trip across the Atlantic, our head of multi-asset investments David Coombs thinks the country’s infrastructure is a bit of a throw-back, but there’s a definite buzz in the air.
“I feel like Doc Brown, staggering out of an obsolete contraption that took me back to the future and, well, back home again. For years I’ve believed that the US is the true growth engine of the world and the place that sports many of the very best companies.
“But it’s been a few years since I’ve crossed the pond. I thought it was time I took a first-hand look at arguably one of our most important investment markets. My six-day trip was a white-knuckle ride filled from top to bottom with meetings. Unfortunately I was zigzagging across the Atlantic and America in clapped-out Boeings, rather than a retro-fitted DeLorean.
“I was joined by our global equities analyst and Heritage Fund manager, David Harrison, an ’80s kid who probably spent more than his fair share of time watching Marty McFly. We didn’t spot any hoverboards on our travels, but we did see office scooters, oodles of confidence and quite a few great American diners. In our opinion there’s plenty of road for America to get to 88 miles per hour.
“The US is humming right now. True, Americans are known for being ultra-chirpy at the worst of times, but this goes beyond that. We met 14 companies across four states, from the East Coast to the South and the Midwest. All are excited about the future, confident of further growth in GDP and planning to invest significantly in the coming year. Many have used the recent tax cuts to boost employees’ wages and dispense bonuses. That is probably part of the reason why American consumer and business confidence measures are flying.
Figure 1: S&P 500 vs S&P 500 (excluding technology)
The exceptional performance of the US technology sector has flattered the S&P 500's returns over the past three years
Source: Bloomberg and Rathbones
Back to the future
“But in many ways, the US is stuck in the past as much as it’s hurtling toward the future. The cradle of Silicon Valley and the world leader in technology is light years behind the rest of the world in many respects. The home of Visa and Mastercard continues to use signatures for many card transactions — you can forget about contactless payments. The stomping ground of global banking giants J.P. Morgan Chase, Citigroup and Goldman Sachs still clears most business transactions with cheques. There is plenty of productivity to be gained here.
“Similarly, American infrastructure is creaking. Many of its airports, motorways and ports appear exactly as I remember them from visits back in the 1970s. The country is in dire need of public investment, but there seems to be precious little money left in the government’s coffers. How Donald Trump’s administration will deal with this problem will be extremely important for the country’s long-term prospects. Without 21st century facilities and technology, the country could fall into an inflationary trap that erodes its competitiveness, living standards and economic heft.
“For now, however, America appears to be roaring down the blacktop with flaming tyre tracks in its wake.”
Under the hood of the S&P 500
Speaking from the perspective of our investment research team and the ‘house view’, the US economy as a whole seems to be firing on all cylinders. However, a closer look under the hood of the country’s stock market reveals substantial differences between sectors. In particular, if you strip out technology shares, the performance of the average S&P 500 company doesn’t look nearly as strong (figure 1). We believe this highlights the value of researching companies (and even better, visiting them) to find the good ones, rather than passively investing in an index.
As a whole, the benchmark US index has risen by 13% over the past year. However, the median non-tech company is just 7% higher, which is more than the gain in European indices but less than Japan and Asia and only just ahead of UK small caps. More than half of the stocks in the index are still in a correction of 10% or over.
Meanwhile, the average earnings of companies in the S&P 500 have risen by 10% over the past year, but by just 6.5% for the median non-tech firm. Surprisingly, much less than the FTSE 350’s 10%. To be sure, earnings growth is estimated to be 7.0% for the average non-tech company in the S&P 500 in the year ahead, compared to 7.8% for the FTSE 350.
Still, there is also a growing debt burden among US companies (figure 2). Median leverage ratio among non-financial S&P 500 companies is as high as it has ever been across all sectors (excluding technology).
Inflation risks, stemming from rising input costs including wages, are greater in the US than elsewhere, and borrowing costs are higher. Despite February’s market correction, the US equity risk premium (the excess return that investing in the stock market provides over government bonds) is still near post-crisis lows.
This is largely due to strong upward revisions to earnings estimates over the next 12 months as markets look forward to tax cuts and strong longer-term growth expectations. As a result, there is not much of a cushion if inflation rises substantially, though we don’t think this is likely.
Figure 2: S&P 500 earnings per share (in $)
US corporate earnings have risen consistently since the statr of the decade, which has propelled the stock market higher.
Source: Datastream and Rathbones
Research and develop
Across the private and public sectors, only eight out of 96 countries spend more than the US on research and development (as a % of GDP), and the US government has an outstanding track record of working with the private sector to make major scientific breakthroughs. Yet government investment spending at 3% is below the OECD average of 3.25%.
As witnessed first hand (see “Back to the future” on page 3), the country’s infrastructure is creaking. According to OECD data for 2015, only five out of 31 advanced economies invested less in inland transport (relative to the size of their economy). According to the World Economic Forum’s Global Competitiveness Index, the US ranks only 26th in the world for the quality of its electricity supply, and 29th in health and primary education infrastructure.
Despite these longer-term concerns, for the moment US companies are busy and profitable. As David said, the recent tax cuts have been shared with workers in the form of stock awards and cash bonuses. All this has set off a wave of confidence in America that should flow through to the global economy as well.
It probably already is, with Europe recovering from its long recession and Asian growth humming, pushing up the price of oil and raw materials even further. Providing China and the US don’t get into an aggressive and escalating trade war, US consumer confidence should increase demand for the world’s factories, providing ongoing support for the global growth story.
But for reasons noted above, it will be important to separate the wheat from the chaff. And that’s why we invest in companies, rather than ‘the market’.