Beyond the Magnificent Seven: riding the wave of the surging US economy

The US economy has had a barnstorming quarter. It grew at 4.9% from June to September*, outpacing economists’ expectations. Growth has been driven by a blend of rising consumer spending, increased inventories and exports, plus residential investment and government spending. It could be a reason to give US markets another look.

The US economy has shown itself capable of astonishing regeneration. The consumer has proved resilient in the face of interest rate rises, accounting for 2.7 percentage points of the total GDP increase last quarter*. Consumer spending rose 4%, having risen just 0.8% in the second quarter*. The various fiscal spending programmes are also providing support to the economy. The Inflation Reduction Act and the Bipartisan Infrastructure Deal are creating demand in areas such as construction and manufacturing.

The other good news was there was nothing in the latest Commerce Department report likely to scare the Federal Reserve into raising rates. Inflation has ticked higher in the US, but mostly because of higher oil prices. Raising interest rates has relatively little effect on global oil prices, so is unlikely to push the US central bank to raise interest rates further.

Consumer weakness?

This would seem like a perfect moment to re-examine the US market. However, there are some caveats. This economic strength is unlikely to last indefinitely. Consumer spending has been supported by households’ war chests, built up during the pandemic. The latest study of US household finances by the Federal Reserve has shown that those savings have now run out for 80% of households**. While people still have jobs spending can continue, but it leaves households vulnerable to any downturn in the labour market.

Equally, the pause in student loan repayments came to an end in October. This was a condition of the debt ceiling negotiations and is likely to impact consumer spending. Around 12% of the population has student debt, worth a collective $1.7 trillion***. Data from Barclays suggests this could reduce household spending power by $15.8bn per month***.

Neither of these factors are disastrous in themselves, and there are clear signs that manufacturing is picking up steam****. This may help compensate for the weakness in the consumer. However, interest rate rises operate with long and variable lags and it is likely that the US economy has not yet felt the full force of tighter monetary policy. Expecting the current level of economic growth indefinitely appears optimistic.

Stock market is not the economy

Nevertheless, it creates a fertile environment for companies to grow their earnings and profits, and should be a good moment to re-examine the US market. But here too, investors should exercise caution. The US stock market is not the US economy. The US stock market is focused on large global technology and consumer companies such as Apple, Microsoft or Amazon, whose fortunes have little to do with the US economy and much more to do with factors such as interest rate expectations, the trajectory of AI, or global investor risk appetite.

These companies have done well for investors over the past decade and, more recently, have been supported by the excitement over AI. However, the apathetic market reaction to their latest set of results shows that relatively high expectations are already in the price. They are perhaps not the route to exploit opportunities in the US economy.

For that, investors will need to hunt among the active funds, rather than simply picking a passive product – like an S&P 500 tracker. While this has undoubtedly been a good, cheap option over the past decade, active managers may be in a better position in today’s environment.

Bob Kaynor, manager of Schroder US Mid Cap, tells us why he believes now is the time for active management on the ‘Investing on the go’ podcast.

A range of active options

In selecting an active fund, investors have a number of options. The first is to go for an all-out growth fund, such as Baillie Gifford American. Gary Robinson, manager of the fund, says: “The US remains the most fruitful place in the world to look for exceptional growth companies. When you look at the raw data, it is clear the lead the US has in terms of its contribution to the global innovation ecosystem.”

He points to areas such as the number of ‘unicorns’ – privately listed companies worth more than $1 billion – which shows that no-one comes close to the US in terms of generating this type of fast-growing, innovative businesses. He believes the US will continue to dominate because it has a strong combination of ingredients, including strong academic research, a well-developed venture capital ecosystem, a business-friendly environment, plus a culture of optimism and ambition^.

This style has been extremely out of favour, but this can be a good moment to look at it again. Gary says: “I can’t think of a time in my career where the market has been so influenced by a small number of macroeconomic statistics. But we think this is a temporary thing rather than a new normal…we think we’ll come through this cycle just like we’ve come through previous cycles.”

The other option for investors is to look at a value or equity income approach. This gives investors access to more domestic, high quality industrial names, such as Johnson & Johnson, Morgan Stanley, or ExxonMobil, which all feature in the top 10 for the JPM US Equity Income fund^^. These companies may prove more defensive should the economy turn down. The fund also has a meaningful weight in the industrials sector, which could benefit if manufacturing revives.

Another option is to look further down the market capitalisation scale. Small and mid-cap US companies will often have greater exposure to the domestic economy. Premier Miton US Opportunities and Schroder US Mid Cap both have significant holdings in smaller companies.

Hugh Grieves, manager of the Premier Miton US Opportunities, says: “When people were worried about Silicon Valley Bank, it’s like being on the Titanic. Everyone rushes to the lifeboats, which were the so-called Magnificent Seven (Apple, Amazon, Alphabet, Meta, Microsoft, Tesla and Nvidia). They provided almost all of the gains for the S&P 500 for this year. But for the last three months, they have rolled along with everything else.

“So what happens next? What gets people out of lifeboats? It’s confidence in the US economy. Markets need to get more comfortable, then we’ll see people moving into the rest of the market…if you look underneath those seven stocks at the average stock in the S&P 500, it’s below historic averages. We’ve never seen such a big gap between the average valuation in the S&P 500 and the aggregate index number.” His view is that creates an opportunity elsewhere in the market^^^.

He admits ‘no-one rings a bell’ as to when this might happen, but it will be a gradual realisation that the environment has changed. Investors should give the US another look, but be careful how they approach it.

*Source: CNBC, 26 October 2023

**Source: Bloomberg, 25 September 2023

***Source: FT, 30 June 2023

****Source: Reuters, 2 October 2023

^Source: Baillie Gifford, June 2023

^^Source: fund factsheet, 30 September 2023

^^^Source: Premier Miton, September 2023

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