Neptune’s Wintle: Is the run for US passives over?

Felix Wintle

The US Federal Reserve chair Janet Yellen has been clear in her message during the recent market volatility: rates are going up before the end of the year, with further increases in 2016. The impacts of such a move are of course far reaching, but one thing is for sure it is a game-changer for investors who have come to rely on passives for their US equity exposure.

Trackers, particularly those focused on US markets, have become increasingly popular in recent years, with investors understandably impressed by the gains. As is so often the case however, the wave of buying has come at the wrong time. 

Much has been said about active US managers’ inability to outperform in recent years, with many pointing to the efficiency of the S&P 500 as the principal reason for the disappointing results. Such a conclusion has been heavily overstated in my opinion. 

It has been an extremely difficult environment for stock pickers to add value, but I envisage far more divergent stock performance in the coming years, which could spell trouble for passive investors. Correlations in the stockmarket were extremely high in the years of quantitative easing (QE) between 2009 and 2014. Since the taps were turned off we’ve seen more divergence, but I expect this trend to continue and indeed accelerate. 

History tells us that there are stark winners and losers in a rising interest rate environment. Why? As rates rise, so does the cost of capital. In other words, the cost of credit to corporates. This causes problems for companies that rely on raising capital to run their business, are highly leveraged or do not make a return in excess of their cost of capital. 

Energy, materials and industrials are particularly at risk, which passive investors automatically have sizeable exposure to. Companies across these three sectors make up around 20 per cent of the S&P 500. Healthcare, consumer discretionary and technology are less sensitive to this trend, and so these sectors will be a more fertile hunting ground for stockpickers. 

Finding attractively valued quality companies that crucially do not rely on the cost of capital to prosper will be the key to success over the next phase of the cycle. This is what differentiates two high-quality companies such as Caterpillar and Apple. 

Caterpillar – an industry leader in construction and mining equipment – is extremely dependant on commodity prices and its return on investment has historically struggled to keep up with its cost of capital. Tech giant Apple, on the other hand, has a strong record of returning in excess of its cost of capital, and is therefore better positioned for the next phase of the cycle. Getting on the right side of this cost of capital trade will be one of the keys to outperformance in the coming years in my opinion. 

It is not only the rising cost of capital that will cause major stockmarket divergence in the US. Our independent real world research suggests the massive but largely unheralded substantial improvement in shale oil extraction techniques will result in sub-$50 oil being the new norm for the next decade or two. Needless to say, this will create major headwinds for much of the energy sector, which currently has a 7.3 per cent weighting in the S&P index. 

Where there are risks there are opportunities, however. The collapse in the oil price is unambiguously positive for the US consumer and stocks in consumer sectors – particularly the restaurant and retail spaces – are especially well positioned at the moment. 

For the market as a whole, I think investors have plenty of room for optimism, especially in light of the China-fuelled equity market selloff, which has pushed a number of quality US companies onto more attractive valuations. 

The benefits of simply tracking the market are a thing of the past and the need to be selective is now absolutely crucial. The powerful structural forces which are holding down the oil price and the rising cost of capital are creating a potentially poisonous cocktail of factors for passives.

Felix Wintle is head of US equities at Neptune Investment Management.