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European selectors warming to US equities

Pan-European fund selector sentiment towards US equities has moved up into the low to neutral territory from a negative position according to latest Last Word Research.

This is first time the asset class has not been in negative territory since Donald Trump won the presidential election in November 2016.

The shifting sentiment towards US equities comes as the market has staged a steady recovery from its volatile start to the year when the S&P 500 recorded is biggest monthly fall in two years during February. By contrast on Wednesday, a string of solid earnings reports from the big US banks saw the S&P 500 reach within 2% of its all-time high made back in January.

Dislikes change

Last Word Research found that during the first quarter of 2018, US equities were the second most disliked asset class, but they have now moved down to be the fourth most disliked, having been overtaken by developed market corporate bonds, developed market government bonds, developed market high-yield bonds as more disliked.

In Q2 of 2018, sentiments towards US equities have improved. Fewer investors expect to reduce their allocations and more are looking to add to their weightings causing the net sentiment line to move upwards towards neutral.

[visualizer id=”7574″]
Source: Last Word Research

Sentiment for the asset class was the most negative in Q2 of 2017 when almost half of fund selectors expected to reduce their US equity fund allocations. A further 41% looked to hold, 7% to increase, and 3% did not use the asset class.

Strong economic growth

Stefan Schrader, who is managing director at investment firm Titus Gesellschaft für Finanzdienstleistungen said he increased his US equity allocation from zero to 10% in mid June.

Schrader said he bought the JP Morgan US Technology Fund in June as US profits were expected to reach 20% compared to European equities at 8%.

“While people are worried about valuations, growth and earnings are bigger than the growth in equity prices,” Schrader said.

VZ VermogensZentrum associate director, Michael Ausfelder, also said he has started to increase his US equity allocation as, over the last two to three months, earnings were strong.

Growth supports

Cooperative credit bank Caja de Ingenieros fund selector, Sergi Biosca, said he increased his US equity allocation as indicators showed that economic growth was its highest level in the past decade.

“However, protectionist measures could generate an inflationary environment which could put pressure on operating margins and therefore, put a risk on the maintenance of the current growth rate,” Biosca said.

Schrader said that due to the US tax reforms introduced at the end of 2017, small and mid-sized companies would benefit and the technology fund only invested in those companies.

Schrader noted that compared to blue chip firms, small and mid-sized companies had higher organic growth, less volatility and had a higher return on equity.

JP Morgan US Technology Fund v sector performance three years to 30 June 2018

Source: FE Analytics

Small caps favoured

“We also prefer the small to mid-sized companies over blue chips because we are worried about the impact of ETFs on blue chips and they are one reason why volatility will stay higher in blue chips,” he said.

“I’ve experienced some crisis as an active manager and I think the ETFs will be a bad surprise. Sometimes we have one position in micro caps as they’re not covered as much as blue chips and the in and out flows are not so dependent on the ETFs.”

Tech fund returns

The JP Morgan US Technology fund had has returned 67.1% over the three years to 30 June 2018, compared to the tech equity sector at 43.9%.

Ausfelder also said that IT was the place to be due to the sector’s growth. He said his increase in US exposure was through the GuardCap Global Equity Fund that has a 28.5% allocation towards information technology. The fund also has its highest country weighting towards the US at 69%.

GuardCap Global Equity fund v sector three years to 30 June 2018

Source: FE Analytics

The GuardCap Global Equity fund has returned 46.2% over the three years to 30 June 2018 beating its international equity sector at 13.2%.

Ausfelder also said he had increased his passive holdings for US equities with an S&P 500 ETF.

“Outperformance is not easy in a very efficient market like US equities, so having the ETF creates a mixture of risk so we have one hard active US equity fund and one passive fund,” he said.

“However, with ETFs you have to decide on whether you believe in the trend of tech as most of the money is going there.”

Quality for late cycle

According to JP Morgan Asset Management global market strategist, Nandini Ramakrishnan, the US is pulling ahead of other geographies in terms of GDP and was expected to grow 3%, while the rest of the world is tipped for 1-2% growth.

Ramakrishnan noted that, while things were going well in the country and growth was robust, there were risks, largely that the general economic cycle is ending and some pricing within the equity market was very high.

“As we think about later cycle mentality and a playbook for when US growth slows down, quality as a factor is key,” she said.

“It (quality companies) tend to outperform in times of US recession and is one area that might not have been a focus when the synchronised recovery was in full force and we were in early mid-cycle but now a bit more focus on quality stocks is appropriate.”

On tech, Ramakrishnan said valuations for some firms were quite high and it was tricky to see the upside during this late stage of the economic cycle.

“I wouldn’t say that as a sector that it screams an attractive opportunity, it is dependent on the company itself and how it is geared into global forces,” she said.

Value in non-FAANG market

Dublin-based boutique investment manager KBI Global Investors chief investment officer, Noel O’Halloran, said while there were good reasons to be positive on the US in terms of the economy, inflation, and the Fed’s decisions, he did not see the US being more attractive than other geographies.

O’Halloran noted that selectors should be worried if a fund was investing in the same way in US equities as it did three years ago as there was now a dislocation in the market through a narrowly-led bull market. He put this down to impact of the FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks, and pointed out if the FAANG stocks were excluded, the US market would actually be down this year.

“The real value in the US is the non-FAANG market. People are complacent about FAANGs and when I look at some of the profit-to-earnings ratios I don’t think they’re a good investment,” O’Halloran said.

“I’d be more value oriented across all sectors. I’m not negative on tech but I’m negative on a very narrow leadership within tech. There are plenty of attractive stocks that are not FAANGs like Microsoft that are paying very attractive dividend yields and have strong cashflows.

“In a few years time the FAANGs won’t be seen as the market leaders for creating value which is why I would look to other tech stocks.”

Challenges

Schrader said fund selectors should look out for funds that were not benchmark related.

“If you look at the S&P 500, you’re not getting more than 5% year to date, but if you look at Amazon it performed 56% so there are a lot of positions that still had reasonably losses since 1 January,” he said.

“Selectors should choose active managers that look for these chances (like Amazon) because the market has been running like this for quite some time.

“It’s very tech driven which have had extraordinary performance over the last years, but there are still quite a lot of chances.”

Biosca said US equities was one of the most difficult assets to generate alpha on a recurring basis and said qualitative analysis was needed in the fund selection process

“It’s important for us to understand the nature of the portfolio, the investment philosophy, the portfolio strategy, the firm’s history, as well as the ownership structure,” he said.

“A qualitative analysis does not mean that mathematics isn’t used. We look to see if the strategy has become constant from the life-being of the fund, by using holdings based and returns based analyses.”

Biosca noted that the great challenge for the asset class would be an earlier recession than expected.

He said president Donald Trump’s trade policies could affect the path of US interest rates and potentially slow down the global economy.

“The biggest opportunity lies in valuations. In the current environment, we have seen a flight-to-quality that has created a high overvaluation of growth companies and provided a great opportunity to defensive and value companies,” he said.

While Biosca said he did not have preference for value or growth, in the mid-term he had a better outlook for value stocks.

However, Ausfelder and Schrader said that they preferred growth funds due to the current rally.

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