Investing in the heartbeat of the US economy

Americans celebrated Independence Day at the weekend, with parades, music, BBQs, fireworks and national holiday today. Investors in the US stock market have also had reason to be cheerful: the S&P 500 has returned 346.7%* over the past decade, led in the main by the giant tech stocks.

The FAANGMs (Facebook, Amazon, Apple, Netflix, Google and Microsoft) represent just under a quarter of the S&P 500** and some $8.8 trillion of market cap** and therefore can have a big impact on index returns. And data over the past eight years form Yardeni Research, Inc shows this quite starkly. Since the end of 2012, the S&P 500 ex-FAANGM has returned 140%** in dollar terms while the FAANGMs themselves have returned 672.8%**. The tech-heavy NASDAQ index returned 733.3%*.

But with valuations of these companies high, inflation looking sticker than first assumed, and reopening momentum in full swing, there are question marks over whether these companies can continue to deliver. Do they have the earnings to continue that growth trajectory – as demonstrated by the strong results many have had in the first quarter of 2021 – or will they run out of steam?

Mid and small caps the next to shine?

Two US managers we spoke to recently think other areas of the market will do better as the economy reopens.

Hugh Grieves, co-manager of Premier Miton US Opportunities, commented: “The US economy is really leading the world out of the post pandemic recession into a period of above average growth. Taking a step back, there's a bit of a tendency for investors outside of the US to think American companies are all about Microsoft, Apple, Google, etc. And yes, they represent a bit part of the S&P 500. But the other half of the S&P 500 – the bottom end of the market with the mid and small cap cyclicals - which most people tend to forget about, is really geared into this period of booming US economic activity. And that's where UK investors should really be focused on today, rather than the names that everybody knows and loves.

“Usually, when consumers come out of a recession, they are worse off than they were when they went in. That's not the case this time - consumers are better off. And so you've got a large number of people with significant savings and a willingness to spend them. They're going to spend on holidays, they're going to spend on going out. And that is really going to boost the economy over the next couple of years. And the companies that benefit from that won’t be the tech companies. It'll be the retailers, it'll be the restaurants, it'll be the factories.”

Bob Kaynor, manager of Schroder US Mid Cap fund, added: “The large cap index is heavily weighted towards tech, telecoms, media… all areas of secular growth. But these sectors are not really indicative of what's happening in the overall economy of the US.

“If you look at the mid cap index, 70% is weighted towards more cyclical industries - whether it's financials, non-internet consumer discretionary or industrials. And I would argue that those are the areas of the market that drive the real economy. They drive employment, they drive wage growth, they drive consumer sentiment. And that last point is the most important because we are largely an economy driven by the consumer. That's why I've always said that that mid cap stocks are the heartbeat of America.

“If you look back over the last 12 or 13 years, going back to the great financial crisis, we've really been in a period of intermittent growth – ‘stop and start’ economic growth that never really achieved that escape velocity that Ben Bernanke used to talk about. And in an environment with uncertain growth and lots of liquidity from central banks, the market really gravitates towards these areas of secular growth.

“I would say that this environment has now changed because growth is no longer scarce. We've put over $5 trillion into the US economy over the last 13 months and, frankly, I would argue that growth is going to be everywhere. What’s scarce is valuation. And so I think that, within the mid cap space, you have a much broader opportunity set to really participate in an expanding economy.”

Reasons to be cautious

Of course, there are reasons to be cautious – inflation as mentioned is currently high and could become more embedded in the system than people initially thought, meaning the Fed could raise rates faster than expected causing the market to wobble.

David Norris, head of US credit at TwentyFour Asset Management, said: “The 5% year-on-year CPI [inflation] number for May marked the biggest increase since June 2008. Base effects played a major role in the elevated number, but reopening momentum and supply chain pressures also contributed. Perhaps the biggest contributor has been the effect semiconductor shortages are having on the second-hand car market though. Used car prices shot up another 7.3% in May following a 10% jump in April.

“Companies are also finding it hard to get staff. Many reasons for this lag have been offered and generous unemployment benefits are one of the prime suspects, but these benefits are beginning to roll off in numerous states. Weekly $300 stimulus checks are being halted early by 18 states in June and a further six in July, which taken together account for nearly 30% of all unemployment benefit recipients, with the remainder set to expire in the first week of September. We would expect an improvement in the job openings data as stimulus falls off and children return to school (childcare being another likely drag on returning to the workforce). We have also seen a pick-up in wage inflation, as measured by MoM average hourly earnings data, which evidently still hasn’t been enough to incentivize a majority of the unemployed to back to work.” 

Tiffany Wilding and Allison Boxer, US economists at PIMCO, added: “The latest central bank meeting implied that the Fed could hike interest rates twice in 2023 instead of 2024 or later, as it had projected in March. In addition, Fed Chair Jerome Powell told reporters that the committee started to discuss options for ending the bond purchase program. Working backward from the new 2023 projected timing of the first rate hike, we think the first reduction in the bond purchase program could be as early as September.”

But as Julian Chillingworth, CIO at Rathbones, pointed out: “It’s always good to remember that central bankers aren’t omniscient. There are no crystal balls in the Fed’s boardroom and the future is as much a mystery to its members as it is to me or you. They are looking at the same data as the rest of us, so you should expect them to adjust their outlooks as the information evolves. Not only that, but we are talking about potential decisions years in advance, and these rate shifts rarely play out as forecast: life gets in the way. Fed policy is extremely important for markets and investments, yet that importance shouldn’t blind you to the limitations of what it can show you about the future.”

The US remains the biggest source of investment ideas in the world. By value, it represents around half of all the quoted companies around the globe. As Hugh Grieves said: “If UK investors are ignoring all of that, then they're ignoring an awful lot of potential opportunity that they could otherwise take part in.”

*Source: FE fundinfo, total returns in sterling to 25 June 2021
**Source: Stock Market Briefing, FAANGMs, Yardeni Research, Inc, 25 June 2021
^Source: JP Morgan

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 05/07/2021