This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Old Mutual North America fund manager, Ian Heslop, comments on North America is leading the charge in the equity rally.
In a single week in mid-July, according to data reported from EPFR Global, some $17.5 billion flowed into US equity funds. That is a mother of an inflow. America is making a comeback.
It’s not hard to see why. The US economy is on a roll. House prices are rising and employment is stabilising, with of string a good job creation numbers over the past 12 months. Consumers are feeling better and starting to spend more confidently. Instead of the widely feared fiscal cliff, sequestration – as it’s now being called – has proved a boon, reducing Federal spending without the need for divisive, dispiriting political cage-fights. The International Monetary Fund now expects the US Federal deficit to fall to a manageable 2% within two to three years.
The Federal Reserve may be starting to prime the market for the end of quantitative easing, but the massive bond-buying programme is unlikely to end soon. The Fed is now openly focused on employment and, despite the recent run of good numbers, there is plenty of hard work left to do to get America back to work. We are still in a world where, to quote Fed chairman Ben Bernanke, interest rates will remain ‘lower for longer’. Neither is there any foreseeable threat of wage inflation as people who have withdrawn from the labour force are attracted back by the prospect of proper jobs paying real money.
The long-term may look even better. Recovery is focused on domestic sectors rather than importers. Oil and gas from shale, already booming in the Dakotas, is reducing costs for business and consumers and helping to drive the trend of ‘onshoring’ – the process of bringing manufacturing back to the US mainland.
Those are the arguments – and they are strong. But they beg the question. What we need to know, as equity investors, is how much of this is already in the price?
Equity performance is a product of economic activity. But it is a huge challenge to correctly predict macro environments and then to follow that up by interpreting the impact on equity markets. This difficulty has become more acute as we work through a period of highly unpredictable but highly price sensitive economic shocks. The increasing trend of global equity markets to sink or swim together adds to the problem.
In our experience, rather than trying to time the economic impact, a much better approach is to try to gauge directly the ‘temperature’ of the equity market. Are investors feeling bullish or bearish? Are they seeking risk or avoiding it?
We do this by looking at what investors are buying and selling, on the basis that following the money is the strongest signal for what people really think and feel. From this, we can form ideas about how the market is most likely to evolve and identify the type of stocks most likely to outperform in coming weeks and months.
One of the most interesting aspects of the rally in US stocks is which parts of the market have seen the best results. Even those investors astute enough to have picked the US in the early stages might well have missed the best opportunities, which have tended to be in defensive sectors, such as healthcare and telecoms, rather than the cyclical sectors, such as materials and energy, which would typically outperform in a recovery.
But if defensive sectors have led the rally, it is the more speculative stocks within those sectors which have been the top performers. In a curious kind of double indemnity, capturing the best of the rally has required investors to be both ‘risk on’ and ‘risk off’ at the same time.
Ultimately the US market is likely to remain attractive to investors in the short and medium term as the recovery continues to outpace other developed markets. Equities in general remain attractive relative to the alternatives.
The key to capturing the benefits of the ongoing rally will continue to be identifying the right signals and reading them correctly.
