Editor’s note: The robust state of the U.S. economy is the focus of the first installment of this week’s U.S. Equity roundtable, which was convened and moderated by Morningstar columnist Sonita Horvitch. Coverage continues on Wednesday and concludes on Friday.
Jim Young, vice-president investments at Invesco Canada Ltd. He is responsible for Trimark U.S. Companies and Trimark U.S. Companies Class.
David Pearl, executive vice-president, co-chief investment officer and head of U.S. equities at New York-based Epoch Investment Partners, Inc., which manages assets for Toronto-based TD Asset Management Inc. and CI Investments Inc. Funds managed include Epoch U.S. Large-Cap Value under the TD Asset Management banner and CI American Value.
Glenn Fortin, portfolio manager at Beutel, Goodman & Co Ltd. Fortin is a U.S. specialist and member of the firm’s global equity team. This team’s mandates include Beutel Goodman American Equity.
Q: The U.S. economy is doing better than most major developed economies. Can it continue to strengthen? Will it be impacted by the slow or lack of growth in the rest of the world?
Young: The U.S. economy is growing and is in decent shape. Its domestic economy is doing quite well. The United States has some unique attributes. It’s the most important nation in terms of technology and technologically driven innovations. That is an engine of growth. Housing is starting to improve slowly. Jobs are being added and incomes are growing. Its fiscal position has improved, as well. The rest of the world is challenged. The strong U.S. dollar is a negative for U.S. exports, but this is countered by the low oil price, which is a plus for the economy.
Pearl: It’s the sixth year of what should have been a five-year normal recovery. It’s the slowest and most protracted recovery since World War ll. The onus was on U.S. monetary policy rather than fiscal policy to assist in the recovery. The U.S. Federal Reserve Board used both its quantitative easing programs and abnormally low interest rates to stimulate the economy. We’re finally at the end of quantitative easing and we have a sustainable recovery. The issue is how strong the recovery is? It’s been pretty tepid, but it seems to be picking up slightly over the past six months. The employment numbers are better. Wages are still dragging, but they look as if they’re starting to pick up.
Normally, when there’s an economic recovery, there’s a greater demand for loans, and this would cause interest rates to rise. At the end of the quantitative easing program, the expectation was that rates would pick up. But the opposite happened, because of the difficulties in the rest of the world. European government bonds have much lower yields than U.S. Treasuries. This yield differential plus the appreciating U.S. dollar has provided a positive trade for a lot of European investors. We are in a low global growth environment. The United States is clearly the best place to be. Currently, U.S. GDP is growing at around 3% and productivity is great.
Fortin: One of the critical aspects of the U.S. economic growth that we are seeing is the strength of the U.S. consumer, the backbone of the U.S. economy. Another aspect is the productivity, as David mentioned. We’re seeing a lot more investment by corporations in areas that were left behind during the U.S. recession. There is a lot of catch-up. But it’s the consumer that is driving the economy. The lower oil price and resulting lower gasoline price is a plus for U.S. consumers.
Q: Will the Fed raise its key interest rate in 2015?
Young: The Fed has said it will be data-driven, and the totality of the data is still mixed. The domestic economy is better, but the impact of what is going on outside of the United States is important. There are some signs of hope in Germany, as economic activity is picking up. If we see other regions of the world begin to improve, it’s more likely that the Fed will move in the summer rather than in the late fall.
Pearl: The Fed would like to move off the artificially low rate and raise its key rate above zero on the short end of the curve. The long end of the yield curve is being driven by the United States relative to the world, in terms of the yield differential that I mentioned.
Fortin: It’s hard to know when the Fed will raise rates, but when it begins to do so it’s going to be a prolonged stretch of increases.
Q: The benchmark S&P 500 Index had a total return of 13.7% in 2014. At the end of last year, its three-year average total return was 20.4% and it was 15.5% for five years. These numbers are far higher than those for the MSCI World Index, which captures the performance of all developed nations, including the United States. What about valuations on the S&P 500 Index?
Fortin: As of the end last year, this index traded at 17.4 times trailing earnings and 16.2 times forward earnings estimates. The 10-year average price-earnings multiple was 13.8 times.
Young: The U.S. equity market is trading at fair value. It will continue to progress with the rise in earnings and dividends. A mid-teens price-earnings multiple on forward earnings is fairly typical at this point in the cycle. The easy money in the U.S. equity market has been made. So far, you’ve had an increase in earnings off the bottom in the market (in March 2009) and an increase in the price-earnings multiples off the bottom. Given where interest rates are now and the fact that they are going to go up slowly, the current multiple is at least sustainable. In summary, the market remains attractive, though the gains will likely be more muted.
Pearl: Because of quantitative easing, valuations have gone up sharply. If you look at 2014, more than half the index’s total return of 13.7% was due to a valuation increase. Corporate earnings growth was OK, which means a low single-digit increase, maybe 4% or 5%, and on top of that you had a 2% dividend yield on average. P/E multiple expansion on the index has been a significant driver of returns over the past few years. Valuation has a high correlation to interest rates. Interest rates are likely to go up at some point. This means that valuations are topping out. There is limited upside. The equity market will be driven by earnings growth and return of capital in the form of dividends and share buybacks.
Young: Yes. Unless something happens to encourage a lot of enthusiasm for U.S. stocks and multiples go higher. You could see multiples on the steady dividend-growers, for example, possibly go beyond where they should be.
Fortin: There are pockets of the market that have gone ahead of themselves. Utilities stocks, which have attractive dividends, have seen their valuations continue to go up for a number of years. The consumer staples sector has lagged utilities. But in the last 12 months, there has been a lot of fund flow into that area. This is supporting valuations on these stocks. These companies are increasing their dividends, so the yields are higher. Investors are attracted to them. This creates a lot of downside protection for these names.
Pearl: The defensive stocks could be considered to be a frothy area of the U.S. equity market. They act as bond proxies. Investors buying a utility’s stock are looking for a stock that acts like a bond. If bond yields go up, this will put downward pressure on these stocks. This goes for real estate investment trusts, as well. In a low-growth, low-return market investors are buying these stocks for income. They are committed to owning them. The defensive sectors have been the right place to be in the past three to four years in the United States. But valuations in these groups are high relative to their valuation history and relative to the market. This has left the more economically sensitive sectors trading at discounts to the market.
Q: Are economically sensitive names now more attractive than defensive names?
Pearl: Yes, from a stock-picking perspective. But the defensive names remain attractive to groups of investors who need income.
Young: In summary, the outlook for the U.S. equity market, barring any unforeseen surprises, is steady as she goes. There is a high degree of skepticism about the market, which is healthy.