A shadow over the US bright spot?

As the US economy shows solid signs of recovery, with positive employment and housing data, panel members consider how the Fed chairman’s talk of tapering QE will affect markets

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Adam Lewis, committee chairman and associate editor, Fund Strategy

This month the Investment Committee welcomes Neptune’s chief economist, James Dowey, as a panellist, and we look at what is happening across the pond. Rising house prices, improving employment numbers and companies with cash to spend: three reasons why US equity managers made a compelling case for investing in … US equities.

However, not a day goes by without a reference to how markets have been spooked by Ben Bernanke’s announcement last month that the Federal Reserve is considering scaling back its $85bn-a-month bond-buying programme. This has led to something of a paradox over the US economy. Often in the past year the country has been held up as the one bright spot among global economies. Now, every bit of good news seems to be taken badly by the market.

This is not the only riddle the US poses. This month its Bureau of Economic Analysis revised down its third estimate for first-quarter GDP growth from 2.4 per cent to 1.8 per cent. And what happened to the leading US share index? It rallied. There is now a perverse situation in which markets seem to like poor economic data because it could delay tapering. The spectre of a stagnating economy could therefore be a positive for asset prices, especially if you accept that the Fed’s purchases of mortgage-backed securities are helping to drive the US housing recovery.

My question this month is: Does the prospect of the Fed tapering QE cast a shadow over the bright spot of an improving US economy; how have you altered your US weightings; where in the US do you like/not like; and which funds are you using to gain exposure?

The independent view

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James Dowey, chief economist, Neptune Investment Management

The Fed was not expecting quite the market reaction it got to its announcement of its intention to wind up QE3 sooner than investors expected. The result has been a significant de facto monetary policy tightening, operating directly through market-determined borrowing costs in the real economy.

For example, 30-year mortgage rates rose to 4.4 per cent from a low of 3.4 per cent in May at a time when the labour market still has a long way to go to recovery, while inflation languishes well below target.

Two closely related questions then head the agenda for investors. Will this premature tightening threaten the economic outlook, and if so, can the Fed still do anything about it? On the first, we estimate that if the tightening is not more or less reversed, it would shave a moderate 0.2 per cent off US growth over the next 12 months. However, we expect the US to strengthen for other reasons so we would still expect a healthy enough acceleration to above 3 per cent annualised going into 2014.

Can the Fed do anything? Most likely during the next few months it will hammer home that QE3 policy is separate from future interest rate policy. A point the market is not really buying as of today, given that market-implied predictions of the first rate hike have shifted forwards dramatically since the Fed’s announcement. 

The most concrete act would be to revise down its unemployment rate threshold for raising interest rates from 6.5 per cent to, say, 6 per cent. Investors should be aware, however, that whatever the Fed does, it will do it with the US economy in mind.

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Mike Deverell, investment manager, Equilibrium Asset Management

The prospect of tapering has had a strange effect on markets where good news is currently seen as bad news. The Federal Reserve will taper quantitative easing should it believe the US economy is strong enough. As a result, good economic performance is often being seen as a negative for stocks right now. While this may cause turbulence for some time, in the long term good news for the economy really should be good news for equities. A growing economy will help companies grow their earnings and share prices should rise as a result.

Despite this, we have only a neutral position to the US as we feel it is slightly expensive relative to other markets. Based on historic earnings, its price/earnings ratio is above the long-term average, although the forward P/E still looks attractive provided companies can achieve the predicted earnings growth.

For our US exposure we typically use only passive funds as we have yet to find a mainstream US fund that consistently beats the market. We like the Vanguard US Index fund. However, we are looking into US smaller companies funds. If the US economy does improve then we think smaller companies could outperform the main market.

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Jonathan Davis, managing director, Jonathan Davis Wealth Management

The statement that the US economy is improving is not one we agree with. Its borrowing of over $1trn a year to go not very far belies the notion that it is recovering. That the growth rate is above 1 per cent is hardly astounding. Borrow a fortune and, of course, the economy will benefit in the short term. However, what happens when the borrowings slow owing to rising interest rates?

Perhaps the question should have been “Does the prospect of the Fed tapering QE cast a shadow on the bright spot of improving US equity and Treasury markets?” The answer is a resounding yes.

Short term, we see the summer cycle as more relevant to these markets than central banker speak. We are somewhat short US equities via inverse exchange traded funds and we see some more downside this summer. We are very long US medium- and long-term Treasuries via TLT and IBTM ETFs. We need to see bonds picking up soon or we will scale back significantly. If there were any logic, yields will plummet as risk aversion soars. The problem is, logic often doesn’t work with centrally planned economies and markets.

If the Fed actually tapers, as opposed to merely talking about it, this would create carnage for both these markets. We expect it not to begin this year. If it is to happen – which is not likely in our view – we suggest it will begin no earlier than late next year.

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James Calder, head of research, City Asset Management

QE is likely to remain in place for an extended period. The Fed will start to reduce the amount of government bonds it buys in the open market when unemployment falls to 7 per cent, indicating a resurgent economy. QE is a double-edged sword; from an economic perspective the potential tapering should be seen as good news as highlights an economy in recovery. However, markets are now so used to this form of stimulus that weaning them off it will be difficult; it is likely to lead to increased market volatility.

We began increasing our weight to the US in November 2011 on the back of improving data from the housing market and currently maintain an overweight position within our multi-asset mandates. It is still our view that the US will lead the global recovery.

Fund selection is problematic within the US owing to many managers’ style biases. It is important to gain a balance. Two of the funds we have chosen are the Aviva US Equity Income fund and the CF Miton US Opportunities fund. They sit at different ends of the spectrum, with the former focusing on income generation through value investing. This gives it a defensive quality. The latter, while targeting some selective value opportunities, should be considered as a growth fund.

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Tim Cockerill, head of collectives, Rowan Dartington

The shock the market experienced when Bernanke appeared to suggest the QE programme was being wound down showed investors are not ready for it. QE has been likened to drug addiction and this seems a fitting analogy.

Rehabilitation of the US economy has been progressing well, but perhaps a little longer on the medication is required before QE can be taken away.

Looking ahead to the withdrawal of QE, it seems likely investors will look for companies that can thrive in a reviving economy. Cyclicals, consumer stocks and small caps could perform well.

Meanwhile, the US market is not particularly cheap and the next round of earnings updates may see some disappointing numbers. The slowdown in emerging markets will have an impact, as will the strengthening dollar. This could be taken as good news, however, because it will be assumed that QE continues for longer, which is of course perverse because the market and economy need to return to a normalised situation.  

So for now the threat of QE’s withdrawal does cast a shadow. But investors know that it will eventually stop and it is better to be one step ahead. Adding a small-cap fund, such as Threadneedle’s American Smaller Companies, could prove to have been a good move when looking back from the day the tap was turned off.

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Lee Robertson, chief executive, Investment Quorum

We are of the opinion that the US recovery is very well underway and that it does look sustainable. However this is proving something of a quandry for investors as the indications that the recovery is sustainable led to remarks from the Federal Reserve that they may scale back their QE  measures sooner than anticipated and this appears to have spooked markets somewhat.

We feel this will prove to be something of an over-reaction as we all knew that this would happen eventually and that we had to be ready to deal with it. Interestingly as I write this the Fed appear to be backtracking somewhat and are indicating they did not mean to imply that the scaling back was imminent and could still be some time off.

We are largely committed to global equities in any case and particularly the US. The US market advanced so strongly earlier in the year that we always felt that some form of pull back was not entirely unexpected, no matter what the Fed said about QE The US economy appears able to weather the fiscal storm of higher personal taxes and public sector sequestration cuts. Despite a weak second quarter we feel that GDP will continue to improve in the second half of the year and into 2014. Housing has been a key driver along with the improving jobs data.

To support our weighting to the US we currently favour funds such as Axa Framlington American Growth, Threadneedle American Select, Schroders US Mid Cap, Smith & Williamson North American, JP Morgan US Equity Income as well as the iShares S&P 500 Growth Index ETF.

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John Husselbee, CEO, North Investment Partners

Speculation continues amongst investors whether the Federal Reserve will begin tapering asset purchases this year and the potential impact to both bond and equity markets. For us tapering sooner rather than later puts the strength of the US economic recovery at risk.

Last week’s job report seemed to be taken well by the equity markets and less well by the bond investors with yields backing up. The numbers came in ahead of expectations but the key indicator is the unemployment rate which remained at 7.6 per cent, despite expectations of a slight fall. We know from Bernanke’s ‘forward guidance’ that asset purchases will remain in place until the unemployment rate falls to around 7 per cent.

Tapering is not on the cards whilst unemployment is above target, economic growth is slow and inflationary pressures remain low is the view of the equity markets.

Bond and currency markets seem to have taken the opposing view until the Fed’s minutes released this week and Bernanke’s confirmation that unemployment was the key indicator. Perhaps he said too much in late May and is now overcompensating for the previous overreaction then. All this is ‘fire practice’ and we – like other investors – will know what to expect when tapering begins. In the meantime, the US equities seem overvalued and we are underweight with holdings in passive funds and active value manages. Despite the market gyrations we have also been happy to hold US dollars instead of Sterling cash.