US stock markets have continued to power ahead in 2023. If the environment has been fragile, they have been seen as a source of stability; if investors have been more optimistic, they have seen US companies as a source of growth. They have outpaced their peers even as inflation has rebounded, interest rates have leapt higher and the country’s debt burden has expanded.
This has led some to conclude that there needs to be a reckoning for US markets. Investors will eventually tire of the country’s high valuations. The dominant technology sector must eventually flag, or the country’s debt will weigh on growth. There is also a potentially divisive election just round the corner.
This reckoning is possible, but US markets have some qualities that make them uniquely resilient. Fraser Thomson, client services director, US equities at Baillie Gifford, says: “The US is still the innovation capital of the world. It is a factory for big business. That comes from the strength of its academic institutions, its position as the destination of choice for people who want to start businesses around the world. It also has the venture capital ecosystems on the East and West coasts and it has the right cultural identity.”
Equally, fund managers push back against the valuation argument. Fiona Harris, managing director, US equities at J.P.Morgan Asset Management (which manages the JPMorgan American Investment Trust) says: “The valuations in the US market have consistently looked high because it is a high quality market. It hasn’t stopped the market returns. Investors forget to look at what they’re buying for that price.” NVIDIA’s price to earnings ratio, for example, reached 240x in July. Even though the shares have rallied considerably, it is now half that level[1]. Harris says: “It has earned so well and exceeded expectations.”
Fragilities
However, the idiosyncrasies of the US markets create some fragilities. The dependence on the consumer, for example, could be a source of vulnerability. Fran Radano, manager of The North American Income Trust, points out that the pandemic savings built up by households across the US are almost spent. “It is only really in the top quintile of wealth where there is anything left.” The consumer is showing cracks as a result, he says.
Equally, rising borrowing costs also pose a problem. The yield on US long-dated bonds has been rising in expectation that interest rates will be ‘higher for longer’. This creates competition for capital with the equity market, but also sets up problems for companies with debt they need to roll over.
The dominance of a handful of large technology stocks is also an issue. It means investors who take an index approach are getting relatively narrow exposure. It is a major challenge for active managers who cannot hold these companies at their index weighting for risk management reasons. Nasdaq has tried to address this by rebalancing the weighting of the megacaps in its Nasdaq 100 Index[2], but the S&P 500 has not yet taken similar steps.
Finding growth
Each fund manager will navigate these problems in a different way. For example, Radano looks for companies with idiosyncratic factors that help them deliver more than the market. He says: “Walmart probably isn’t going to deliver much more than 1% either side of retail sales, whereas Restaurant Brands International has been through a difficult period, seen significant under-investment, but now has a new chairman who has come in from Dominos and is making changes. It could see an expansion of sales, margins or its multiple as a result.” He also holds Keurig Dr Pepper, which has a significant and fast-growing coffee business sitting alongside its mature soft drinks business.
For Radano, balance sheets are now particularly important as borrowing costs continue to rise. “Balance sheets don’t matter until they really matter. If interest payments double, it is a significant cost for companies. We keep a careful eye on credit ratings. It also means that organic growth becomes more valuable because it is more difficult to grow through debt-funded acquisitions.”
Middle ground
Harris says that investors are clearly nervous about the dominance of the ‘Magnificent Seven’ – those AI-focused technology giants that have soared ahead this year – and their team has observed significant flows into the ‘large cap blend’ area. For her, this suggests investors are concerned about valuations, but are not yet willing to commit to ‘value’ after a long period of weak performance: “They are derisking from growth, but are less willing do value. There are too many questions there,” she adds.
The team’s solution to navigating this environment is to target areas of structural growth: “We want companies that are aligned with secular growth drivers. Is a poorly-run regulated utility really going to stand the test of time?” In contrast, she says, Trane Technologies, which makes energy efficient heating, ventilation and air conditioning systems is in prime position as households adopt lower carbon solutions.
They are agnostic on growth in the US economy, preferring companies with strong cash flow that can thrive whatever happens to growth: “That leads us to quality companies, with good balance sheets, that will be profitable in the near term.”
Thomson is not avoiding the ‘Magnificent Seven’, but instead is being selective. Baillie Gifford is still adding to Amazon, for example, believing the share price doesn’t reflect its ongoing growth potential. He adds: “Growth is not spent for these companies.”
That said, he believes an environment of higher interest rates and tighter liquidity means growth is less abundant. He gives the example of the food delivery sector, which has become a very difficult place to make money. The Baillie Gifford team is now concentrating on one or two likely winners, who are benefiting as competitors fall by the wayside.
He says the uses for AI have been quite narrow to date and they are seeing this broaden out, providing another source of opportunities. The Baillie Gifford US Growth Trust is invested in a D2C beauty business that uses AI to personalise its products for each customer. There are also opportunities emerging in personalised healthcare given the cost deflation on genome testing. Both Baillie Gifford and JP Morgan Asset Management are focused on the energy transition as the incentives from the Inflation Reduction Act start to emerge.
It is tempting to conclude that the US wins whatever happens to markets, and whatever happens to the world economy. However, investors cannot overlook its fragilities. Finding active managers that can play to its strengths is likely to be increasingly important.
[1] https://ycharts.com/companies/NVDA/pe_ratio
[2] https://www.proactiveinvestors.co.uk/companies/news/1021346/nasdaq-rebalance-to-reduce-weighting-of-tech-mega-caps-microsoft-apple-nvidia-1021346.html