Portfolio Adviser • Portfolio Adviser Magazine November 2022 • Head to head

Adam Lewis asks Paul O’Connor of Janus Henderson and T Rowe Price’s Eric Papesh if now is the right time for investors to put their faith in US assets

As the S&P 500 returned more than 260% over the past 10 years, it’s fair to say investing in the US has been a favourite activity of fund managers and asset allocators alike.

Fuelled by the technology boom and the performance of growth stocks, allocations to the US have tended to dominate most global portfolios – and investors have reaped the rewards. However, as market volatility has surged in the past 12 months, and growth has underperformed value, appetite for risk assets has waned.

According to FE Analytics, despite a brief surge in US growth stocks in July, over the year to 20 September 2022, the S&P 500 Index is down 7.99%, while the IA North America sector has fallen 8.13%.

Set against a background of rising interest rates, surging inflation and a likely recession, is now the best time for investors to put their faith in US assets? In this month’s head to head, Janus Henderson Investors’ Paul O’Connor explains why he remains underweight the world’s largest economy, while Eric Papesh of T Rowe Price, makes the case for the US and discusses how he is navigating today’s market.

The persistent outperformance of US equities for over a decade can be explained to a large extent by relative sector and style characteristics. Compared with other equity markets, the major US indices are overweight technology and other disruptor sectors, and underweight old economy sectors and value stocks.

These have all been winning tilts since the financial crisis. Still, while these exposures have underpinned the relative earnings trends that have sustained the outperformance of US stocks, it is worth noting that this exceptionalism has been narrowly based.

Both the earnings outperformance and the superior investor returns of US stocks have relied heavily on the performance of a handful of huge, listed US technology and media companies. Away from these mega-caps, the performance of US stocks has not been soexceptional.

We are underweight US stocks as, from here, we see greater valuation and earnings risk than in most other global equity markets. While US stocks have de-rated this year, they still look expensive versus other equity markets, and do not yet seem to have fully adjusted to this year’s rise in real bond yields.

Meanwhile, we see mounting cyclical risks confronting complacent-looking consensus earnings expectations. A number of the key drivers of the secular upswing in US earnings trends now look fatigued, and cyclical risks are mounting as US fiscal support fades and surging mortgage rates smother activity in the US housing market.

While US stocks have outperformed other equity markets this year, once again, we would be wary of extrapolating this trend much further. For one thing, the relative performance of regional markets this year has been significantly driven by difficulties outside the US, such as the war in Ukraine and China’s struggles with Covid and its unfolding property correction.

Many of these themes are now priced in. Further-more, it is worth noting many of the broader market themes that have supported US outperformance in recent years now look less supportive.

Some of this year’s trends, such as rising commodity prices and bond yields and the outperformance of value stocks over growth, are developments that would typically be associated with US stocks underperforming.

In our multi-asset funds, we typically use both active and passive instruments to achieve our desired US equity exposures. Right now, we see the current market volatility and the growing importance of identifying winners and losers in an increasingly complicated economic environment as offering great opportunities for active managers. In our multi-manager funds, we are currently using Janus Henderson US equity growth strategies, with the Dodge and Cox US Stock Fund as a value play and GQG US Equity Fund for a dynamic style-agnostic approach.

As we enter the final months of the year, it is hard to avoid the conclusion that investor sentiment and positioning regarding US stocks is fairly depressed. This can be seen in fund flows, options prices and investor surveys.

While these indicators offer contrarian support for a tactical rebound in US equities, an improvement in macro or markets fundamentals is probably needed to justify becoming more strategically constructive. One path to a more optimistic view would be if we could be more confident that markets have priced in the peak in the US interest rate cycle. Another would be if we could believe US market valuations were reflecting more realistic growth expectations.

While significant progress has been made on interest rate pricing, valuation pressures and earnings downgrades are likely to remain significant headwinds to the absolute and relative performance of US stocks in the months ahead.

A world of elevated inflation and rising interest rates is unfamiliar territory for many investors today, given the prevailing landscape in the US for the past 30-plus years.

Indeed, we are likely on the cusp of regime change, and with such change comes uncertainty. In our view, we are somewhere near the middle stages of a bear market and potential recession, which has little recent precedent. We have seen periods of volatility and uncertainty before. While market downturns are an unpleasant reality of equity investing, the associated volatility creates opportunities for active investors to position portfolios for meaningful long-term success. The impact of rising interest rates is weighing on investor sentiment. However, there are good reasons to suggest businesses are better positioned to navigate this rate environment than at similar times in the past.

For the past nine months, the Federal Reserve has been telegraphing the fact it is on a tightening trajectory. Anticipating an eventual end to the low-rate environment, many companies pre-emptively moved to fix their debt, locking in low rates and extending maturities. This means they are less vulnerable to rising rates than might have been true in past cycles.

Also, while consumers may see the impact of rising rates in areas like credit card debt, the much larger household budget item – the mortgage payment – is less of a risk. Following the global financial crisis, US homeowners reverted to traditional fixed-rate mortgages.

Accordingly, less than 10% of all US mortgages are now floating rate. This means more than 90% of US households have locked in fixed mortgage payments at rates well below those being quoted today. This is a key point, given all the noise around rising interest rates and the potentially debilitating impact of this on US household finances.

As often tends to be the case during periods of broad-based selling, a lot of high-quality companies have been sold off indiscriminately over the past year. Valuations, in some cases, have fallen to levels not seen in years.

The opportunities span the market spectrum – from more cyclical stocks we believe are pricing in a deeper-than-anticipated recession, to higher-growth stocks, where multiples have compressed substantially, but where the underlying fundamentals of the business do not appear to have been materially impacted.

Despite the more challenging economic environment we are experiencing, we continue to find attractive investment opportunities across the US equity landscape. Indeed, our quality-oriented, stockpicking approach has historically worked well in the type of environment we are experiencing currently, when the market moves in broad unison and there is concerted, indiscriminate selling.

Our largest sector allocations are in healthcare, financials, industrials and business services, which collectively account for 45% of the portfolio. Within healthcare, medical equipment, pharma and managed care companies account for most of our exposure. Our names stand out in this volatile market owing to the combination of attractive valuations and high visibility on future cashflows.

Our financial holdings include primarily a mix of banks and insurance companies. The former are expected to benefit from higher interest rates and a steepening yield curve, and the latter are favourably exposed to increasing price trends in the property and casualty insurance market.

Our industrial investments range from machinery companies to transportation businesses and other conglomerates. In each case, we believe the stocks are trading at valuations overly discounting an economic slowdown.

Unfortunately, no one rings a bell at the bottom. As long as it persists, we will take advantage of market volatility to position our portfolio in the stocks we believe offer the most attractive risk-return trade-off.

3.08% Effective US Federal funds rate on 26 Oct ’22 Source: New York Fed

8.2% US inflation, 12 months to Sep ’22 Source: Statistica

7.32% Average 30-year fixed US mortgage rate as of 27 Oct ’22

2.65% Lowest annual average 30-year rate – 2021

16.63% Highest annual average 30-year rate – 1981