As we move through the halfway point of 2016, sentiment has been impacted by the UK’s surprise vote to leave the EU. Prior to the Brexit sell-off, markets had moved higher on the strength of improving commodity prices (crude oil rose 17 per cent for the quarter to over $48 per barrel) and indications the Federal Reserve would further delay its next interest rate hike.
A disappointing May jobs report, in which the US economy added only 11,000 jobs – its worst showing for employment growth since 2010 – had already prompted talk the Fed would hold fire, lending further support to equity markets. But if the outlook for monetary policy was cautious pre-Brexit, the vote has since shifted the backdrop to one best described as suppressed, compressed and depressed.
Heightened global uncertainty has further suppressed the potential for higher rates in the near future and, in fact, introduced the possibility of a rate cut being the next policy action. Long rates around the globe entered the third quarter at or near historical lows.
Broad risk-off selling has further compressed stock valuations, especially in sectors we favour such as biopharmaceuticals and cyclical technology, and moved investor psychology from a state of scepticism and doubt to one of panic and depression.
Brexit and the lack of conviction in risk assets globally has caused each of these support factors for US stocks to improve, extending the positive outlook for US markets. This is already playing out thus far in Q3, with the S&P500 up some 3 per cent month-to-date in July.
The spike in volatility, while short lived, is the third in a series of corrections so far this year that we feel are necessary to prolong a bull market now in its seventh year.
Last summer we stated that given uncertainty in other parts of the global economy, we believed owning US-centric companies was the best approach. The fallout from Brexit makes US stocks even more attractive compared to most other developed markets. The flight-to-safety rally in US treasuries, which pushed yields to levels last seen in 2012, further solidifies the case for owning equities at this stage of the economic cycle.
In practice, this means we will see new all-time highs for US equities during the remainder of the year. As ever, though, there are areas that will underperform and others that will excel.
Consumer staples and mega-cap technology look expensive now; however, healthcare stocks look very attractive. Within healthcare, names in both the pharmaceutical and biotech markets have been delivering solid profitability and free cash flow generation, yet still operate with the headline risk of pricing pressure.
But they could experience a real pricing catalyst later this year, with the end of this presidential election cycle. There has been a buyers’ strike in the sector, much like there was in the energy space following the collapse in oil prices. But if the result of the election is close and leads to a period of political inertia, it could provide a lift to healthcare stocks.
Other unloved sectors, including energy and materials, continue to recover, particularly those businesses being recognised for efforts to shore up their balance sheets through asset sales and capital raises. Our belief remains the value of solid companies and solid assets will eventually be monetised over time, either through price appreciation or acquisition.
Underpinning our positive view for US equities is the ongoing ability of quality large-cap companies to access cheap financing while smaller companies struggle to obtain credit. This should continue the consolidation trend across sectors. Indeed, we could witness robust M&A activity in the US over the next 18 months.
Market leadership should therefore continue to shift to companies in the energy, media, healthcare and technology sectors. And with an assist from Brexit, the factors that had made us cautious on the broader market for nearly two years – valuations, Fed policy and investor sentiment – also point in a more supportive direction for equities.
Evan Bauman is portfolio manager of the Legg Mason Clearbridge US Aggressive Growth fund