Alex Vynokur

BetaShares, a provider of Australian exchange traded products (ETPs), yesterday announced the launch of a new ASX-traded fund, aimed at boosting income over a portfolio of US equities.

The BetaShares S&P 500 Yield Maximiser Fund (managed fund) will trade under the ASX code UMAX and aims to provide investors with exposure to the stocks comprising the benchmark US Index, the S&P 500 Index, while providing regular income that exceeds the  dividend yield of the stocks alone. It also aims to provide lower overall volatility than the Index.

The Fund’s investment approach is to hold an investment portfolio providing exposure to the S&P 500 Index and at the same time, to sell some of the upside share price potential of the Index in return for additional income.  The Fund does not aim to track the Index.

The launch of the Fund comes after the success of BetaShares’ yield-focused Australian equities product, the BetaShares Australian Top 20 Equity Yield Maximiser Fund (managed fund) (YMAX), which employs a similar strategy and has attracted more inflows than any other equities exchange traded product on ASX in 2014.

The launch of the Fund comes at a time of increasing demand from ETP investors for international equities-focused funds, with around 40% of the ETF industry’s $12.4 billion in funds under management currently allocated to global equities products.

BetaShares Managing Director, Alex Vynokur, said the launch of UMAX would provide investors with further potential to enhance portfolio yields, as well as offering the additional diversification benefits of exposure to an overseas market.

“After such a strong response to the equity income strategy BetaShares introduced with YMAX, we believe there is great appetite for investors looking for a similar approach over US equities.

“This fund may suit not only SMSFs and investors who are seeking increased yield and reduced volatility over their share portfolio, but also those looking for exposure to the US market as a potential way to diversify out of Australian shares,” said Mr Vynokur.

The Fund will be the first Australian-domiciled ETP on the ASX to provide US-specific equity exposure, offering significant administrative benefits for Australian investors.

“Recent research conducted by Investment Trends indicated that the number one problem associated with exchange traded products that offer exposure to international equities, as identified by investors and their advisers, was the need to fill out US tax forms, known as W-8BEN forms, in order to qualify for reduced withholding tax on distributions received. UMAX has been designed to solve this problem. Because it’s an Australian domiciled fund, investors don’t have to worry about this paperwork as the forms are completed at the Fund level. They also have no need to be concerned about any potential US estate tax implications that may arise when investing in US-listed products.”

“UMAX fills a gap for investors looking for US shares exposure that comes with the potential for greater yield, lower volatility and reduced downside risk compared to an investment in the shares alone. For BetaShares, it also represents our first international equity offering and our 15th product overall,” Mr Vynokur concluded.

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Oil prices have responded to political volatility in the Gulf.

In 1973, Egypt and Syria launched a surprise attack on Israel during the Jewish religious festival of Yom Kippur. The swift arrival of arms from the US helped Israel repel the assaults.

Opec nations, upset at US support for Israel, cut oil production and placed a sales embargo on the US and any European country that helped Washington funnel arms to Israel. Oil prices surged nearly 400% over the next 12 months in what became known as the first oil shock of 1973-74.  The result was the stagnation of the 1970s.[1]

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• While the global economy is looking better than it has for years, relatively low investment yields from most major asset classes mean the medium term return outlook remains constrained compared to the long term bull market in shares and bonds that started in the 1980s. For example, 7.5 to 8% pa for a diversified mix of assets, not double digits.
• For investors the implications are: have realistic return expectations; asset allocation remains critical; focus on assets providing decent and sustainable income flows. Australian shares still remain attractive for income flows but for growth Asian ex-Japan shares come out best.

Introduction

Most investment analysis and commentary is focused on the here and now and the implications for investment markets just a little bit ahead. But getting a handle on the return potential for major asset classes over the medium term, ie the next five years or so, is of value from several perspectives. First, such return projections are a critical driver of the strategic asset allocation (SAA) to each asset class (shares, bonds, property, etc) within traditional diversified investment funds.

Second, and more fundamentally, it gives a great guide to return potential between asset classes, which helps inform asset allocation generally. For example we use medium term return projections as part of our Dynamic Asset Allocation process.

Finally, it can help provide a guide to what sort of returns investors can expect beyond the short term. After a couple of years of double digit returns from shares and balanced growth superannuation funds there may be a temptation to assume we have now returned to a world of ongoing double digit returns. But this could be mistaken if it’s not sustainable.

This note takes a look at the medium term return potential for major asset classes and what that means for investors.

Getting a handle on return potential

The first thing to note is that simply taking a long term average of historical returns for each asset class and using that as a guide may be use, but often offers little guide to their medium term outlook given the significant impact of starting point valuations (eg, if current yields are significantly lower than normal then this will constrain returns relative to any long term norm) and the broad economic environment. Another approach may be to come up with a bunch of themes and start from there. But without a framework in which to place them this can simply lead to a muddle.

So our approach is to go back to basics, recognising firstly that the components of the return flowing from an asset are the yield (or income flow) it provides and capital growth and secondly that the starting point yield is key, ie, the higher the better. Then apply themes around this where relevant. We also prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments can lead to compounding forecasting errors without any value in terms of the broad message.

• For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (which are picked up via the yield) but avoids getting too complicated.[1] The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.

Source: Thomson Reuters, Global Financial Data, AMP Capital

• For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.
• For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.
• For bonds, the best predictor of future medium term returns is the current five year bond yield. In other words capital growth is zero because if a five year bond is held to maturity its initial yield will be its return.

Medium term return projections

This framework results in the return projections shown in the next table. The second column shows each asset’s current income yield, the third their five year growth potential and the final column their total return potential. Note that:

• We assume central banks meet their inflation targets over time, eg, 2.5% in Australia and 2% in the US.
• We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8% to the return from world equities (Australian interest rates above that in other advanced countries) but detracts 1.9% from emerging equities.
• The Australian cash rate is assumed to average 3.5% over the next five years. This is one asset where the current yield is of no value in assessing the asset’s medium term return potential because the maturity is so short. So we assume a medium term average. Normally, for cash this would be around a country’s medium term nominal growth rate, but we have made an allowance to adjust for higher than normal bank lending rate margins over the cash rate and higher debt to income ratios which have increased the interest sensitivity of households, and in turn pulled down the neutral cash rate.
• The Australian equity return adjusted for franking credits (that adds about 1.4% pa) is shown in brackets.

Thematics

Several themes have been reflected in these projections:

• Low inflation – while inflation worries abound reflecting the quantitative easing programs of the last few years, this is likely to be offset by continued global excess savings and spare capacity along with central banks being mandated to meet inflation targets.
• Aging populations – resulting in slower labour force growth than seen over the last twenty or so years and a demand for yield bearing assets with less focus on capital growth.
• Slower household debt accumulation – the surge in household debt growth seen in the decades prior to the GFC looks to have run its course with tougher bank lending standards and more cautious consumer attitudes.
• The commodity super cycle has turned down – on the back of slower growth in China and increased commodity supply. This will act as a constraint on growth for some emerging markets (eg South America) but benefits commodity user regions (such as Asia, Europe and Japan). It also means the terms of trade has gone from a tailwind for Australian growth and profits to a headwind. To allow for this we have reduced nominal capital growth potential by 0.5% pa for Australian shares.
• Technological innovation – with its intensified focus on labour saving (eg robotics, 3D printing) it is likely good for productivity and corporate margins but ambiguous for consumer spending.
• Reinvigorated advanced countries versus emerging markets – while the emerging world still has a higher growth potential (reflecting its lower starting point) it’s likely to be slower over the decade ahead than last decade reflecting a slowdown in economic reforms but at the same time the US, Europe and Japan appear to be reinvigorating themselves after a tough decade (or two in the case of Japan).
• A multi-polar world – the end of the cold war and the stabilising influence of the US as the dominant power helped drive globalisation and the peace dividend post 1990. Now China’s rise and Russia’s retreat are arguably resulting in a more difficult environment geo-politically.
• Backtracking on free markets in parts of the world – a greater scepticism of unfettered markets and increased focus on regulation post the GFC.

Most of these will likely have the effect of constraining returns. But not universally so. Technological innovation remains positive for profits and the renaissance in the US, Europe and Japan is very positive.

Observations

Several observations flow from these projections.

• While advanced countries may have exited a secular bear market, return potential is still constrained. The starting point for returns today is less favourable than when long term bull markets started in bonds and equities in 1982 (with much lower investment yields today) & the thematic backdrop is less favourable. Our medium term return projections imply a 7.7% pa return from a diversified mix of assets. This is well below the 11.9% pa return Australian super funds saw over the 1982-2007 period which was underpinned by the combination of high starting point investment yields and very favourable investment thematics with the shift from high to low inflation, deregulation, easy credit, globalisation, the peace dividend, the IT revolution, favourable demographics and finally for Australia a surge in commodity prices.
• Sovereign bonds offer low return potential – after a thirty year secular decline in bond yields the combination of very low yields and the risk they will rise resulting in capital loss implies low medium term return potential.
• Unlisted commercial property & infrastructure continue to come out well reflecting their relatively high yields – but don’t forget their illiquidity.
• Australian shares stack up well on the basis of yield, but it is hard to beat Asian ex-Japan shares for growth potential and traditional global shares offer improved prospects.

Implications for investors

There are several implications for investors:

• First, have reasonable return expectations. The world is in far better shape today than at any time since the GFC but don’t expect year after year of double digit returns.
• Second, asset allocation remains critical reflecting: the relatively constrained medium term return potential; a likely wide range in returns between major asset classes; continued bouts of volatility (eg as extreme monetary policy conditions in the US and elsewhere are eventually unwound); and as the correlation between bonds and equities remains low (in the absence of a common driver like falling inflation provided in the 1980s and 1990s).
• Third, there is still a case for a bias towards Australian shares, particularly for yield focused investors, but with traditional global shares looking a bit healthier after a long tough patch have a bit more offshore. Asian ex-Japan shares are preferred relative to emerging market shares generally.
• Fourth, focus on assets providing decent sustainable income as it provides confidence regarding returns. Commercial property, infrastructure, quality yield shares and investment grade credit stack up well here.

Dr Shane Oliver, Head of Investment Strategy and Chief Economist AMP Capital

——–

[1] For example, adjustments can be made for: dividend payout ratios (but history shows that retained earnings often don’t lead to higher returns at the country level so the dividend yield is the best guide); the potential for PEs to move to some equilibrium level over time (but this relies on forecasting the equilibrium PE correctly which can be hard and in any case extreme dividend yields send a strong enough valuation signal anyway); and adjusting the earnings/capital growth assumption for some assessment regarding profit margins (but again this has been shown to be very hard to get right at the country level, eg US profit margins have been strengthening for decades and it’s hard to see what will turn this around). So we prefer to keep any reliance on forecasts to a minimum and to keep it simple.

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But despite the electoral rhetoric, Obama knows that his scope for manoeuvre in the face of the ‘fiscal cliff’ and the budget deficit is limited.  He has little choice but to address these challenges (as would a President Romney) by raising taxes and cutting spending.

While markets may be volatile post-election, we believe that over the longer term, US equities will gain support from the fundamental strengths of the economy. America is benefiting from a revival in the housing market and an industrial renaissance based on relatively cheap energy supplies.

Moreover, capex could pick up sharply (from the very low current levels) once the policy outlook becomes clearer post the election. In addition, the stock market should benefit from the knowledge that monetary policy will now remain unchanged.

Mitt Romney had pledged to remove Ben Bernanke as chairman of the Federal Reserve and was opposed to Quantitative Easing, which has proven supportive of both equities and the housing market.

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Ironically, the state of the American economy and stock market could influence the election outcome. In the past, the lower the level of inflation and the higher the level of economic growth, the greater the incumbent’s share of the votes has been.

There is a common perception that the Republican Party is more pro-business, deregulatory and tends to support lower taxes and takes a more limited role in governance. The Democratic Party, on the other hand, is seen as more willing to regulate business, support higher taxes and play a more active role in government. The implication is that a Republican outcome should be better for stock markets.

However, the evidence does not bear this out. Over the past twelve elections spanning 48 years, the S&P 500 has delivered a higher average annual return under the Democrats.

At present, spread betting markets have offered relatively accurate predictions for the outcome of recent elections. The market odds for Barack Obama being re-elected continually fluctuate and these odds are very well correlated with the performance and level of the S&P 500. The latest (Intrade) odds of 57% (as at 4 September) suggest Obama will win. Any material fall in the US stock market would hurt Obama’s chances.

Some academics have theorised a link between business cycles and election cycles. Since the 1960s, the US economy has experienced seven business cycles with an average length of 75 months, or a little over six years. Unfortunately, this theory is not borne out in reality. Similarly, history shows that unemployment is a relatively poor predictor of election results.

Whichever party wins the US election, they will have some hard economic work ahead of them.

Future challenges – the fiscal cliff
Tackling what has been labelled the fiscal cliff in a way that does not do further damage to an already weak US economy is the biggest challenge faced by the next administration.

They will have a choice; they could let sequestration kick in, which will indiscriminately see tax increases and spending cuts across the board. The Congressional Budget Office has estimated that this would see the US economy shrink by 4% in 2013, which makes this an unpopular option. At the other extreme, cancelling the automatic tax increases and spending cuts would stoke the US budget deficit and perhaps lead to a further sovereign rating downgrade.

The Republicans want to cut spending significantly and avoid raising taxes, while the Democrats want more limited spending cuts combined with tax increases.

An ideal outcome would be to phase in tax increases and spending cuts over time, and target cutbacks in areas where the economy is least sensitive, to minimise economic damage. While both parties want to avoid the ‘fiscal cliff’, finding an agreeable compromise on the issue will be difficult.

If Congress fails to find a solution to the fiscal cliff, spending cuts and tax hikes will be enacted indiscriminately across the board under sequestration.  And this could be extremely damaging if it adversely affects the most productive areas of the economy.

This becomes a higher risk if a clear election outcome is not achieved.

The market after the election – sector specific
How the US stock market performs after the election is also of interest to investors. History tells us that the stock market is likely to rally if the incumbent wins re-election. But, empirical evidence also suggests that the US stock market has historically delivered its strongest returns on the third year of an election term. This effect might be tied to the incidence of government spending within the presidential cycle, as most government expenditure occurs during the first and second years of an election term.

The biggest stock market effects this time, however, will probably be felt at a sector level – healthcare, financials and defence are sectors likely to be most affected by the election result.

Healthcare – the Affordable Care Act that was passed in 2010 (dubbed ‘Obamacare’) was designed to give 30 million of the poorest Americans access to healthcare. Opposed by the Republicans, it was criticised for being uncompetitive, inefficient, expensive and bad for the healthcare industry. They have challenged its legality as it makes buying healthcare insurance compulsory. The Act also expands the safety net of Medicaid, which provides healthcare for the poorest Americans. The election outcome is a key battleground that will have deep ramifications for the healthcare sector.

If Obama wins, companies that support Medicare and Medicaid should benefit, including pharmaceutical companies. It could also be supportive for jobs as additional hospital staff would be needed to cope with increasing patient numbers. Private health insurance companies would probably lose out.

If Romney wins, he may try to repeal the Act and replace it with an alternative. Companies from a variety of sectors that have lucrative contracts supplying Medicare (for the elderly) and Medicaid (for the poor), could be adversely affected. Pharmaceuticals would be negatively affected because there would be fewer medically insured people. Private health insurance companies on the other hand, would probably benefit – taxes, fees and regulation under the Affordable Care Act would probably be dismantled.

Financial reform – the Dodd-Frank Act passed in 2010 is the main financial service reform proposed by the Obama administration. However, it is complex and it has been difficult to implement. Romney has already vowed to repeal the Act if he is elected, criticising it for being overly burdensome. A repeal of the Act is unlikely, however. Wall Street firms have spent a huge amount of time and resources adhering to the new rules, so reform is still more likely than repeal under Romney.

Despite his threats, even the controversial ‘Volcker Rule’ that bans banks from proprietary trading probably is unlikely to change under Romney. Such a move would be politically unpopular following recent bank scandals. However, Romney would have influence over the Financial Stability Oversight Council, benefitting non-bank financial companies, such as asset managers and insurers. If Obama is elected, plans to shift OTC derivative contracts onto exchanges would benefit the clearinghouses.

Defence – attempts to cut programs, such as missile defence under Obama, would require strong Democratic control of Congress and polls suggest this is unlikely. If the Republicans take control of Congress, defence cuts would be tempered, even under Obama. Many companies could benefit under both Obama and Romney, which is a reflection of the geopolitical tensions that still pressure US policy at present, not least in the shape of the Iran-Israeli nuclear crisis.

Firms that specialise in drone aircraft for military surveillance are likely to benefit regardless of the outcome. Funding the development of cyber security also enjoys bi-partisan support. Additionally, US defence companies will also benefit from equipping the depleted weapon inventories of close NATO allies.

If Romney wins, it is likely that he would support weapons exports to compensate those contractors adversely affected as wars in Iraq and Afghanistan wind down.

A contentious point, many analysts feel that a Romney victory would be more likely to bring about military conflict than an Obama one, presenting a potential boon for the defence industry.

In conclusion, the evidence suggests that the state of the US economy going into an election can influence the votes of swing voters and help to determine an election outcome.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  2012 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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So said Cormac Weldon, Head of US Equities for Threadneedle Investments while in a general discussion about why the United States’ ability to bounce back from economic setbacks is placing US equities firmly on the investment agenda.

“The American economy is once again demonstrating its ability to renew itself and is emerging from the credit crunch with a new technological revolution underway. Meanwhile, consumers are reducing their debt and corporate America is cash rich. Perhaps we shouldn’t be surprised at this turnaround because America has consistently bounced back from previous setbacks. This resilience has been underpinned by factors such as strong population and immigration growth, the mobility of its workforce and a robust productivity culture,” said Mr Weldon.

He went on to say that three key themes emerging from the US indicate that the economy is on the move – leading Threadneedle analysts to consider US equities well placed to deliver healthy returns to investors.

These three themes are:

• Cheap energy is driving economic growth. The shale energy revolution means that, unlike other industrial economies, the US now has increasing access to cheap oil and gas, which has the potential to drive industrial and employment growth for years.
• Dynamic labour markets are supporting industrial revival. Improving labour market conditions are being driven by a flexible labour force, and nowhere is this better demonstrated than in the automobile sector. Not so long ago the survival of GM and Chrysler was in doubt, yet today the big three Detroit automakers are reporting significant profits on the back of rationalised production, reduced capacity and lower labour costs.
• The banking sector is returning to health and the housing market is stabilising. Domestic banks have recapitalised, and while loan growth remains weak, the expectation is that it will pick up. Currently, while house prices are very affordable and mortgages are cheap, new household formation remains low. However this should change as new jobs are generated, people feel more secure about their employment prospects and the become increasingly confident that the homes they plan to buy will not fall in value.

These themes all paint an encouraging view of the US economy, but Mr Weldon acknowledged that strong economic data isn’t the only factor to consider.

“Of course, a strong economy alone doesn’t always translate into rising share prices. But we are confident that US equities can deliver healthy returns to investors. The free cash flow yield of the US equity market compared to the yield provided by the US corporate bond market reveals that equities are at their cheapest level in more than 50 years. In addition, our bottom-up research has identified a number of very attractively-valued companies with excellent growth potential. Our focus is on companies exposed to faster-growing industries emerging from cyclical lows, and innovative growth companies with strong business models.”

Mr Weldon concluded by saying that, while the future for US equities looks rosy, challenges do remain.

“The Eurozone is top of mind given its uncertain political, fiscal and monetary situation,” he said.

“The possibility of an administration change in the US also has the markets concerned, in particular in relation to how the big issues of deficits and tax cuts might be addressed come November.

“Nonetheless, we firmly believe that US equities can make further progress this year. Positive factors include: continuing earnings growth in the mid-single digit range and the likelihood that profit margins will be stable; as well as the robust health of the corporate sector. In addition M&A activity has started to pick up and the valuation of the market is undemanding. For investors, now is the time to consider allocating to the US.”

26 July 2012

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While the recent rebound in the US equity market is already impressive, Fidelity’s US portfolio managers believe there is potential for further gains.

“The case for US equities is compelling; it remains the location of choice for leading brands and technology firms and it offers exposure to the wider global equity market,” said Fidelity US Portfolio Manager, Aris Vatis.

There are a range of investment themes, says Mr Vatis, that investors can benefit from:

Tapping into emerging market growth – Some investors are concerned with the risk of a ‘hard landing’ in China, yet still believe in its long-term growth story. However, investing in high-quality US stocks can offer exposure to Chinese growth drivers and wider emerging market consumer growth, without exposure to the higher volatility associated with direct investments in the region. 

Multinationals like Coca Cola, Proctor & Gamble, Johnson & Johnson and McDonalds now generate large portions of their revenue from emerging markets. Most of these companies are considered stable, safe businesses. Demographically, emerging markets provide a massive source of demand for the goods and services these companies provide.

A technology leader – In technology, the US is a leader. Assembly may be increasingly done in China, but much of the intellectual property rights and the returns on capital typically reside in America. Smartphones and tablets are a good example of this with Apple and Google key players in this market. Demand for these products has been driven by the evolution of the mobile internet.

Supporting this growth, President Obama has revealed ambitious plans to connect virtually all Americans to the “wireless web” in five years. Already, billions of dollars are being invested into the country’s communications infrastructure, which will not only support mobile internet users, but also offer access to cloud computing services; the ability to store content and remotely access it via multiple devices.

There are other companies beyond the obvious that are benefiting from this growth, which investors can consider. For example, Qualcomm is a leader in mobile phone semiconductors and is now expanding into tablet devices – the company benefits from strong free cash flows, driven by royalties generated by handset vendors using their chips and patented technology.

Leading the multimedia revolution – Improving broadband download speeds has led to a revolution in how multimedia content is delivered and consumed. The rise of smartphones and tablets has also helped to support this trend. MP3 players created a profitable market for legally downloaded music, which cannibalised the sales of traditional media, such as CDs. These disruptive technology shifts create excellent investment opportunities. And this is exactly what is happening in the multimedia space right now.

Increasing demand for video content has led to fierce competition between multimedia distributors like Netflix, Apple, Amazon and even Wal-Mart. And America can lay fair claim to being the “content king” thanks to its movie industry. Stocks like the Walt Disney Company and Time Warner are good examples of businesses that are likely to benefit from the royalties earned from distribution rights. Both companies have seen huge increases in demand for the content they produce. Although this is a sector that is still in its early days, it has tremendous growth potential, which should be realised in the years to come.

Energy Independence for the US – There is a strong possibility that the US will become energy self-sufficient in the future. This is based on the commercialisation of shale gas discoveries, rising domestic oil production and renewable natural resources. 

Already, thanks to improving technology and new discoveries, the US has almost eliminated the need to import natural gas. As new projects to access previously inaccessible oil reserves approach maturity, US oil production is also set to increase. Additionally, large-scale projects to improve infrastructure are required to support these projects.

This is not a trend limited to the US – demand for oil globally is likely to continue to grow in the coming years. This is good news for companies that specialise in drilling technology. For example, National Oilwell Varco has a 50% share in the global oil drilling equipment market. Strong barriers to entry into the industry should serve to protect the firm’s current market position, ensuring the continuation of high returns on investment capital and strong free cash flow generation.

“US companies are in great shape, they are international in scope and they are operating in a host of attractive industries that are benefitting from favourable multi year thematic drivers,” says Mr Vatis.  “Regardless of where an investor lives then, US equities deserve to be a key component of a well-diversified equity portfolio.” 
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Injections of liquidity into the financial system have been highly supportive of equities since the financial crisis.  The end of QE2 earlier this summer was therefore another factor behind the recent weaker trend in the market.  With little impending threat of deflation, we do not believe a third phase of QE is imminent.  However, the authorities have stated that interest rates will be on hold throughout 2012 and further stimulative measures should not be ruled out.

Having recently lowered our forecasts for US economic growth to 1.5% for both this year and next, we have also reduced our expectations for earnings growth.  We are now expecting 8% growth in earnings this year, with next year flat to potentially down.  US companies have a good track record of addressing their cost bases to protect margins in tougher times, and they are likely to take similar action on this occasion.  Nevertheless, low nominal growth provides a difficult backdrop for aggregate earnings growth.

With global sovereign risk concerns focused on the eurozone, European equities have underperformed the US, leaving the relative valuation of US stocks versus their European counterparts at above-average levels.  However, the current level is well below previous highs, suggesting that the US could continue to outperform in the absence of a solution to Europe’s problems.

We believe that US banks are better placed than their European counterparts. The US banking sector is much stronger today than it was at the onset of the financial crisis and appears to be in a much better position to deal with the strains created by the sovereign debt crisis.  Compared with the same sector in Europe, US banks generally have lower assets in relation to equity, indicating the deleveraging that has already occurred.  They also have lower loan to deposit ratios, which means that they are less dependent on wholesale funding than their European equivalents.  While we remain cautious on the banking sector, this relative strength should stand the US market and economy in good stead if the eurozone debt crisis intensifies.

We are seeing a generational valuation opportunity with US equities attractively valued relative to history and to other asset classes before the recent turbulence, and the setbacks of the past weeks have magnified this attraction.  For example, using large-cap equity free cash flow yields versus Baa-rated corporate bond yields, equities are as cheap against credit as they have been since the 1950s.

Equity valuations patently include a high risk premium at these levels and, while there are genuine challenges facing the market, US companies have demonstrated in the past their ability to grow their profits over the long term.  Moreover, compared with previous periods of cheap valuation, equity investors today are buying a much higher quality asset with less debt and better free cash flow generation.  As such, we feel that these extreme valuations could represent a good long-term opportunity.

Current positioning
For some months we have been positioning our portfolios for a low growth environment and this stance remains in place.  We are focused on companies with exposure to secular growth trends; those operating in industries with high barriers to entry or with a product advantage.  These characteristics should help to deliver sustainable earnings growth despite the lacklustre economic backdrop. Examples include Apple Inc where we are expecting within the next year new versions of the iPhone and iPad and Visa Inc, the payment processing company, which benefits from secular growth in use of credit and debit cards.

We also continue to look for companies with strong balance sheets where the management is managing capital proactively, for example buying back shares, raising dividends or undertaking sensible corporate activity For example Philip Morris International, the tobacco company, has consistently bought back its own stock and recently increased its dividend by 20%.

Our stock selection efforts in light of these themes are leading to overweight positions in consumer discretionary and technology and underweights in financials, industrials and energy.

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