Markets to “oscillate between resilience and fragility”, ran the headline on a recent outlook note from Fidelity International, and there are few better examples of this tightrope at the moment than the US.
Resilience now is sowing the seeds for fragility down the line, according to Fidelity, with a cyclical recession, in which unemployment in the US rises to around 5% over the next 12 months as the most likely outcome, and a soft landing now looking highly unlikely.
On the one hand, a glass half empty view sees a dwindling money supply, consumers exhausting their excess savings and potential commercial real estate losses posing a contagion risk, says Maneesh Bajaj, portfolio manager of Brown Advisory’s US Flexible Equity fund.
The problem for economists predicting a recession is the US economy today is in a much stronger position than earlier believed possible
“On the other, we have witnessed full employment, a strong consumer with a decent balance sheet and companies reporting robust quarterly results,” he says.
Furthermore, the Federal Reserve’s hiking cycle is nearing its end, and there is a possibility of rate cuts in the near future.
Analysts at Bank of America agree consumer balance sheets are well-positioned to deal with an adverse shock, with delinquencies low for now, but warn they could rise significantly if student loan repayments resume in full, as looks likely.
Tightening in credit conditions is a near-term headwind but it reduces the risk of a build-up in leverage and a hard landing.
Hugh Grieves, manager of the Premier Miton US Opportunities fund, puts his finger neatly on the issue, however, when he says the problem for economists predicting a recession is the US economy today is in a much stronger position than earlier believed possible.
“Consumers still have plenty of cash and limited debt expense given long-term fixed mortgages. Wages are rising above inflation and jobs are plentiful,” he says.
What this period has proved is that economists are really poor at forecasting
Many of the headwinds the economy faced last year, such as higher energy costs, elevated inventories and a slowdown in government spending have gone away or become tailwinds this year, he adds.
Grieves says what this period has proved is that economists are really poor at forecasting, and it’s difficult to argue with him. A much better use of time for investors is to focus on the bigger picture; part-owning great businesses that can steadily compound earnings through good times and bad.
While the US market appears expensive by historical standards, this is due to the very largest mega-cap technology behemoths trading at very high valuations and skewing the average – because much of this year’s strong performance is down to the “Sensational Seven” of Apple, Microsoft, Amazon, Google, Nvidia, Meta and Tesla, which have accounted almost entirely for the S&P 500’s positive return.
Such a lack of breadth casts doubts on whether this bull market is sustainable, in my view. I have no doubt artificial intelligence (AI) will change the world and is a viable long-term theme, but in the short-term I think it has been overdone. I certainly wouldn’t be chasing the Nasdaq today after 30%-plus gains.
Further down the market capitalisation spectrum, however, stocks are trading at much lower valuations, in part due to the anticipated economic weakness.
“As confidence in the economic outlook improves, it is these small- and mid-cap companies well positioned to benefit, even as the valuations of the mega-caps normalise,” reckons Grieves.
The last time relative valuations were this cheap, and sentiment so poor, was followed by an outstanding period of returns for small- and mid-cap stocks
US smaller companies had started a trend of outperforming US large-caps in 2022 after many years of underperformance. However, the banking sector wobble, which started in March with Silicon Valley Bank’s problems, caused the market to question the risk of smaller companies.
Then the AI narrative gave a boost to the return expectations of the mega tech companies, causing large-cap leadership to reascend, albeit driven by a very small number of companies.
But Rupert Rucker, investment director for the Schroder US Mid Cap fund, says he believes there is continuing reason to gain exposure to US smaller companies in the cycle ahead.
US smaller companies, he points out, offer a much more diversified exposure to the US economy and today’s valuations are already pricing in a lot of bad news. Smaller companies have not been so cheap relative to large-caps since the technology bubble in 1999-2001.
“Indeed, US smaller companies trade at similar valuations to markets outside the US for the first time in years, meaning you can still invest in the US economy without paying a premium,” he says.
He has dug into the data. The last time relative valuations were this cheap, and sentiment so poor, was followed by an outstanding period of absolute and relative returns for small- and mid-cap stocks.
Over much of the last decade, investing exclusively in the S&P 500 would have been the best decision. However, change is now underway
In the seven-year period following the market peak in March 2000, small-caps were up by more than 70% whereas large-caps were up by less than 10%.
Right now, smaller, more domestically oriented US companies are better positioned to benefit from a range of changes. This includes the shift in consumer spending from goods to services, major initiatives to reshore supply chains and incentives to promote more domestic manufacturing through policies like the Chips and Science Act and Inflation Reduction Act passed in 2022. Likewise, the Infrastructure Bill of 2021 provides additional tailwinds.
Rucker says investors will do well to adapt to the current conditions: “Over much of the last decade, investing exclusively in the S&P 500 would have been the best decision. However, change is now underway.
“There are now good reasons for investors to broaden their allocations into small- and mid-cap US companies that are more attractively valued and better positioned for a changing market environment.”
I couldn’t agree more.
Darius McDermott is managing director at FundCalibre
