By Christian Preussner, US Equities Chief Client Portfolio Manager, JP Morgan Asset Management
Many investors are wondering if they should stick with US equities. We believe there are four compelling reasons to do so. To take a pulse of current market conditions: it is a more mixed earnings season in the US so far, but 72% of companies are currently beating estimates. We’re relatively optimistic on modest underlying economic growth of 2.5% GDP growth this year.
At this stage in the cycle, we would highlight the need to focus on sectors and companies, particularly cyclicals where we see opportunities.
There are four main themes currently driving US equities:
1) Energy: it’s impact on earnings and consumers is varied
2) Currency effects: strength of US dollar is hitting earnings, but the impact is different at a company level even for predominantly international companies
3) Earnings perspective: strong outlook when you exclude the energy sector
4) Valuations: not cheap but not expensive
Energy – negatives and positives
The energy sector makes up around 12% of overall S+P 500 2014 earnings and those earnings are expected to drop by approximately 50% in 2015, in reaction to the halving of the oil price since the middle of last year. We are therefore cautious on the energy sector and are actively seeking companies and sectors are meaningful beneficiaries of lower oil prices, such as airlines.
There have been concerns about the impact of falling oil prices on the US employment picture, but the energy sector accounts for only approximately 3% of new jobs created since 2010, so we would not expect this to halt momentum in the US jobs market.
Broadly the more cyclically oriented sectors, with the obvious exception of energy, are experiencing positive impacts from lower oil prices.
Currency – not an even playing field
Foreign sales exposure is a significant issue for major multinational companies that have international revenues impacted by the stronger US dollar. For example, information technology has about 60% of earnings from outside the US and materials about 50% outside the US, as an investor might expect the stronger greenback to hit the earnings results for these companies.
However, if you drill down to the stock level in the information technology sector, for many companies the earnings are factored in US dollar currency as opposed to local currency, significantly limiting their exposure to currency translation effects.
Earnings – more modest overall but consider the ex-energy sector outlook
Earnings in 2015 won’t be growing as substantially as 2014, which saw earnings per share growth of 11%. By comparison, expectations for this year are only about 4% overall growth. That might suggest there will be less momentum to support a continued US equities rally.
However, investors should consider that the energy sector is having a major impact on aggregate levels. For example, if you take the index ex-energy, projected earnings per share growth in 2015 is closer to 11%, on par with last year. And estimates for growth in 2016 are also strong.
Valuations are fair
We think valuations are in fair territory – they are not cheap and they are not expensive. At 17x price to earnings relative to a long-term average of about 16x, we don’t feel this is overly stretched, particularly relative to bonds, which continue to look extremely expensive.
If you were to drill down to the sector level, utilities, telecomm and consumer staples are very much overvalued and that is pushing up the index overall, whereas financial services and IT are still below their long term averages.
Therefore we overall feel comfortable at these levels but investors have to be selective in their exposure. Investors would be well served to avoid the highest yielding stocks – where dividends may not be sustainable – and focus instead on companies with growing earnings, strong free cash flow, modest payout ratios and the ability to provide compelling return on capital.
Stocks yielding between 2% and 4% can offer interesting total return when you combine dividend yield and the prospect for capital appreciation. Sectors such as consumer discretionary and financial services offer these companies, while the overvalued consumer staples and telecoms space should be approached with caution.