Outlook 2019: US equities

• The US economy has outperformed other developed markets in 2018 and we believe it will remain comparatively stable in 2019
• We believe that earnings growth may slow as interest rates rise and wage inflation picks up
• The combination of slowing earnings growth along with severe cost pressure should provide an fertile environment for active investors next year

US small and mid-cap equities

We believe Europe’s economy should enjoy above trend growth in the year ahead given the later post crisis recovery compared to the rest of the world and the continuing domestic consumer expansion. Investors can access European equities at a five-year valuation1 low (see chart 1) following the market decline experienced during 2018.

The labour market’s strength is the main cause of a nascent increase in inflation, as wage pressures are beginning to build, particularly in the service sector. We have been hearing about this wage inflation for three years, even if it is only now visible in official data. We believe inflation should be manageable if the Federal Reserve (Fed) stays on track with its “dot plot” (the US central bank’s forecast pace of interest rate normalisation).

We believe the economy is therefore likely to deliver stable growth next year, but that the return of interest rates to more “normal” levels and higher inflation will probably weigh on earnings growth. We are already beginning to see companies with large debts suffering due to rising interest rates. Meanwhile, those companies unable to raise their prices (i.e. lacking “pricing power”) are struggling to offset higher wage bills. Also, 2018’s strong earnings growth was partly attributable to tax reforms and other fiscal stimuli, both of which will fade in 2019.

As a result, our overall view is that early estimates for 2019 earnings growth are likely too optimistic. However, provided investors are aware of their exposure to these factors, we believe that the environment could provide favourable opportunities for active investors next year.

This far into an economic recovery, with the Fed raising rates to preempt inflationary pressures, there is considerable debate around the timing of the next recession. We cannot tell you when the next recession will occur, but we are confident that the herd of strategists calling for it in 2020 will most likely be proven wrong.

Recession speculation aside, the market must continue to digest the reality of slowing corporate earnings growth, continued inflationary pressures, and a less market-friendly fiscal policy backdrop.

Through the market turbulence at the start the year, growth and large cap stocks have continued to be seen as relative "safe havens". Although “micro-cap” stocks outperformed significantly as risks around trade disputes reached fever-pitch in the second quarter, market participants have spent most of the year favouring the growth companies that do best when the economy is strong.

Will this persist? It seems likely, given the earnings pressures we are anticipating.

Debt levels amongst US companies overall are high, but particularly so in the small and mid cap space. One way to measure a company’s debt level is the debt/EBITDA ratio (which compares a company’s debt to its gross earnings). For the larger companies that constitute the S&P 500 index, the ratio is 2.3 times earnings. For the companies in the small and mid cap Russell 2000 index it is over 4 times.

Earnings may wax and wane along with the economic cycle, but debt does not. What this means is that when earnings falter, company borrowings stay the same size while interest rates continue to move higher. Debt burdens become heavier. The solution is for companies to pay down debt.

In the US small cap space a significant proportion (in excess of 40%) of total debt is on a “floating rate” (ie the interest rate payable on it changes or “floats” over time), in contrast with large cap companies (17%). Typically, companies with higher percentages of floating rate debt are more likely to have problems as interest rates rise and earnings falter.

We have made a concerted effort to make sure companies in our portfolios have lower levels of floating rate debt than their peers.

From a valuation perspective, we think companies in the consumer discretionary and industrials sectors look attractive relative to the index. In general, we will continue to look to invest in companies balancing shareholder interests with company growth.

US large cap equities

Without doubt, one of the main contributors of the strength and length of the US equity bull market has been the resurgence of corporate profitability to historically unprecedented levels. In particular, the country’s unique position as the global leader in technology and innovation has been a real source of strength. Silicon Valley is often described as the global “cradle of innovation”, and is home to some of this world’s most innovative as well as profitable companies.

In addition, the US has been particularly successful in repairing its banking sector, resulting in US bank profitability far exceeding European peers. Further, the US is home to a resurgence in oil production driven by a revolution in fracking technologies. Its relatively stable economic and political environment has attracted large capital inflows, resulting in a surge in the dollar. The icing on the cake was the significant tax cuts announced in 2017.

For 2019 we envision a change in market leadership. 2018 was marked by fast revenue and earnings growth across the board and the rising tide has lifted most boats. 2019 is likely to be a year of a fairly sharp slow down in earnings growth.

Consensus expectations call for 9% earnings per share (EPS) growth for the S&P500 in 2019 after +25% growth in 2018. We think even these expectations may prove optimistic. In light of this slowdown, we believe that attractive returns may be earned by focused stockpicking and emphasising strong pricing power, relative insulation from rising cost pressures and company-specific catalysts which will allow them to sustain above-average growth.