US equities have had a very strong 2017. The S&P500 reached new highs on an almost monthly basis, spurred on by gathering economic momentum and monetary policy remaining highly accommodative.
Given the scale of the market’s rise - over 18% to the start of December - it is natural for investors to seek some guidance on its direction from here. For many, the principal focus has been on valuations, which are at relative highs.
Yet high valuations by themselves do not mean that a correction is imminent. The question is whether or not the valuations are justified. In the words of Warren Buffet, “Price is what you pay, value is what you get”. We believe there are several reasons to be positive.
Comparing apples with apples
Firstly, 2017 was marked by accelerating corporate earnings. While earnings growth was modest in 2016, the big positive surprise of 2017 has been the strength of corporate profitability. Indeed, corporate profit margins, earnings and free cash flow (FCF) generation are all at all-time highs and continue to show very strong momentum.
Secondly, it is true that US equities are expensive relative to their historic average and relative to global equities. However, US equities have a long track-record of trading at a premium to global equities, and the current premium is not much more than the average.
Investors must also be aware of the shape of the US equity market versus global peers. The technology sector is very large in US markets and it is highly cash generative. If we were to compare the US market with Europe with this difference in sector size balanced out, the valuation of the US market would look much the same. As for the high valuation relative to a historic average; many of the largest tech companies were much smaller a decade ago or did not exist at all.
In addition, we should not overlook the fact that while equities are expensive at the moment, so is everything else. One could argue that free cash flow yields for equities are compelling when viewed side-by-side with bond yields.
Source: Credit Suisse December 2017. Past Performance is not a guide to future performance and may not be repeated
Strong housing market building consumer confidence
Another area of strength is the US housing market, which is very robust at the moment. Current trends in sales - both in terms of volumes and in price - are positive, but the market does not look over-extended. We are a long way from the peaks of 2006 in terms of affordability. The shape of the housing market is very important for consumer confidence and spending. Given that consumer spending makes up about two thirds of the US economy, the housing market is a meaningful factor for equity market strength.
Source: Credit Suisse December 2017. Past Performance is not a guide to future performance and may not be repeated
Wage growth is broadening out
Finally, although we are approaching a decade of economic growth, up to this point, much of the wage growth generated has not filtered down into lower income households. This is showing signs of change; wage growth in higher income brackets has not weakened but wage growth for lower income brackets is accelerating sharply. The implication of this trend should be that consumer-facing companies outside the luxury space should disproportionately prosper.
Of course, correctly identifying the potential winners and losers from the trend is more complicated. Amongst other things, investors should consider the nature of a company’s labour pool. Widespread wage growth for lower income consumers may indeed drive higher sales for a company like Walmart or Starbucks. But earnings may improve little - or not at all - if the wage bill (for largely minimum-wage staff) is also set to rise. If on the other hand, the company has been engaging with disruptive technology - perhaps automating aspects of its order fulfilment - it may indeed see improved profitability.
Disrupting the cycle
The above example touches on the importance of recognising and engaging with disruption in an environment of elevated valuations. Although markets look well supported, current market levels do not leave a great deal of margin for error. Furthermore, even if valuations overall remain high, this can mask significant changes within the market’s composite sectors and companies that can still hurt returns.
We anticipate, for example, a major transformation in the energy and automotive industries over the next two decades. A very powerful combination of competitive renewable energy, improving battery storage costs and desirable electrically powered vehicles is emerging to forge a viable path towards de-carbonisation of energy and transportation. We do not, of course, expect the transition to be linear. Navigating the transition may be as much about avoiding the losers, as finding the winners.
We are also now familiar with Amazon’s retail model: a large warehouse is used to house stock that is distributed by to us directly by courier. The old retail model - seeking market share by rolling stores out nationwide - is far more vulnerable to changes in the economic backdrop. If fears over “stranded assets” in major energy firms are rising, are the risks any lower for redundant retail space?
These are only two examples that will change the face of markets in years to come. In our view, innovation is always at the heart of sustained growth. For companies to enhance the durability of their earnings over the long term, we believe they need to deliver innovation. Companies that innovate successfully are likely to be significantly rewarded by investors: those that don’t will almost certainly be over-whelmed by the pace of change.
Our approach
On balance therefore, the fact that US equities are at relative highs is not an immediate cause for concern for us as we approach 2018. That is not to say there are no risks. Political uncertainty has risen in again in Europe, with Germany struggling to form a new coalition. We also have a US President perhaps better known for unpredictability than political consistency. Furthermore, equity market support is contingent on inflation remaining benign; far from assured. A sharp rise in inflation could induce a change to current monetary policy support. For us, this is all the more reason to take a longer-term view, seeking companies that are less dependent on the economic cycle.
Well-managed companies, with cultures that support ongoing innovation, performance and accountability, will be better placed to deliver superior returns irrespective of the economic cycle. Our focus will continue to be on searching for these individual situations that fit our investment philosophy on a global basis, rather than attempting to time allocations to regions or sectors. In a globalized world, there are always opportunities at the company level.
