Threadneedle: Outlook for the US equity market

Cormac Weldon, Threadneedle's Head of US Equities: We have been of the view for some time that we are in the midst of a prolonged economic downturn. Even when the recession is technically over, ongoing consumer deleveraging means that growth will remain at sub-trend levels for an extended period. This remains our view today, despite some tentative signs that the rate of deterioration may be slowing in some areas.

Companies in good shape

The good news is that companies entered the recession in relatively good shape from a financial perspective. Indeed, corporate balance sheets have been strengthened since the turn of the millennium and company finances are certainly in much better shape than those of the average consumer. We continue to bias portfolios towards companies with strong balance sheets and healthy cash flows, where we are confident that they will not only survive the downturn but emerge stronger in the next phase of the market.

Profitability to fall further

Corporate profitability was at historically high levels when the downturn began and we believe that it has significantly further to fall. This will limit the scope for multiple expansion. Having said this, the valuation bubble has now corrected and, on a range of measures, many stocks are cheaper than they have ever been.

Reporting season brings some good news

Investors have cut their forecasts for corporate earnings dramatically over the past year and expectations are now at much more realistic levels. In fact, the current quarterly reporting season has already delivered some positive surprises. It is evident that companies in many sectors have swiftly adjusted their cost bases. The US labour market is one of the most flexible in the world and US companies in areas such as technology have good recent experience of cutting costs. Indeed, technology is an example of an industry where over-investment in the late 1990s had been worked out, leaving companies well positioned to deal with the recession. Hence, technology is one of our key overweights.

Flexibility is key

Prompt management action has protected profitability and we expect further positive surprises as the earnings season unfolds. But of course, it will not all be good news and there will be no shortage of negative surprises. Many of these are likely to come from companies with less flexible business models, which are unable to size their businesses correctly for the economic environment. Thus, our stock selection is also focused on identifying companies with a flexible business model and intelligent management that understands the need to adjust costs.

Recently added to cyclicals

While the overall bias of portfolios is still relatively defensive, recent purchases have included a number of cyclical stocks where we believe that valuations more than discount the difficult economic background. Some well managed companies that happen to operate in cyclical industries are being priced as though they will never grow again. Clearly, this represents an opportunity. We will continue to add to good quality, cheaply valued cyclicals when opportunities present themselves.

Underweight banks, overweight insurers

News flow from the banking sector has been volatile in recent weeks and we remain cautious on this part of the market. The long-term structure of the industry is still not clear, many companies are vulnerable to a continued deterioration in the housing market, further capital raising may be necessary and there is little transparency into earnings. Price to book multiples are not particularly attractive given the uncertainties facing the sector, so we remain underweight. We are finding much better opportunities in the insurance sector, specifically property & casualty companies, many of which are trading at or below book value with clean balance sheets, little or no gearing and a positive pricing environment.

More constructive on the dollar

We have recently become more optimistic about the prospects for the US dollar. The new administration appears to be taking a more positive stance towards the currency and seems keen to preserve its status as the world's reserve currency of choice. Moreover, with the Fed Funds Target Rate already close to zero and other regions' rates falling, interest rate differentials are narrowing, easing selling pressure. A more stable or stronger dollar supports the case for investing in US assets for international investors.

Good performance continues

Our US equity performance remains strong, with the American and American Select Funds outperforming the S&P 500 by a very impressive 8.2% and 9.4% respectively in the first quarter alone. Longer-term numbers are equally strong, with both of these long-established funds comfortably outperforming the index over all standard time periods out to ten years. In addition, the American Extended Alpha Fund, our 130/30 offering in this market, has outperformed by more than 20% since its launch in October 2007 and by 9.1% over the first quarter.

Summary

The US economy is some way from a meaningful recovery but equity valuations are presenting us with many good long-term opportunities. The portfolios are still relatively defensively positioned, with a bias towards companies with strong balance sheets and healthy cash flows, but recent additions have been focused on oversold cyclicals. We have become more constructive on the outlook for the US dollar and our excellent track record in US equities means that our funds are likely to be of considerable interest to investors who are looking to raise their exposure to the US market.