Energy and financials still most attractive in U.S.

By Sarah Cunningham-Scharf | February 21, 2017 | Last updated on February 21, 2017
3 min read

After the U.S. election, Peter Hardy expected near-term volatility to rock markets. He was positive on sectors like energy, financials and healthcare, but was also keeping a close eye on interest rates.

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Fast forward to today and his approach hasn’t shifted much—even though U.S. President Donald Trump’s win caused an unexpected boost in market returns. After all, the election results have had little impact on the U.S. growth climate, says Hardy, who’s vice-president and client portfolio manager at American Century Investments in Kansas City, Missouri.

He isn’t surprised that growth prospects haven’t changed significantly. “GDP growth for 2016 was about 1.6% in total; it came in at 1.9% in the U.S. for the fourth quarter and is expected to accelerate to 2.1% for the year of 2017. That’s a solid, but somewhat muted, growth environment,” he explains.

Read: Don’t be too bullish on 2017 growth

But, “what has surprised us is the market reaction […] resulted in a pronounced return in equities,” says Hardy, whose firm manages the Renaissance U.S. Equity Income Fund. As of February 17, the S&P 500 has risen nearly 11% since November 1, while the S&P/TSX Composite has risen about 9% over the same period.

Further, volatility has remained muted, he adds. “If you look at the VIX, [that index] dropped from roughly 22 to 12” between November 4, 2016 through to the beginning of February. As of February 17, the VIX index has returned to about 12 after reaching a low of 10.74 over the last few weeks.

Read: Why to expect currency volatility

What’s more, “corporate profit growth has accelerated from negative earnings growth [in] the second quarter of last year to mid- to single-digit earnings growth,” says Hardy.

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Hardy has continued looking for businesses that offer the best risk-return scenarios. He’s aiming for “an income-oriented and low-risk equity portfolio, [given it] tends to protect in periods of market volatility and does well over time. But, in periods where the markets are going straight through the roof, our conservative biases tend to be a headwind.”

Currently, he prefers companies with normalized earnings potential and is avoiding those that are over-performing.

Says Hardy: “When we’re looking at how we’re valuing a business, we’re looking at their cash flow potential over their tangible asset base. We’re looking at the financial returns [a] company can generate.” When commodity prices are high, for example, the energy sector over-earns and has increased cash flow, says Hardy. He compares that performance to the sector’s “normal earnings potential to avoid investing when the risk is high.”

Read: Why these two managers wouldn’t buy Saudi Aramco

Since the U.S. election, the energy and financial sectors have under-earned and remained attractive. For energy, this is due to oil prices remaining at about $50, versus past highs of about $120. Also, “Natural gas has fallen from [about] 13 Btu (or British thermal units) to roughly 3 Btu, in the current environment,” says Hardy.

For financials, their underperformance is due to low interest rates, which inhibit the earnings growth of many banks, he adds. “They require higher rates to earn net interest margin off of their deposit base[s]. Earnings growth for banks has been below what our normal expectations [are], so, because of that, financials have appeared attractive.”

Read: Trump’s policies could influence Fed, says Yellen

Conversely, low interest rates have caused certain market sectors to over-perform, he explains. For example, real estate is an over-performing sector to avoid as companies benefit from low rates and are able to reduce debt costs.

So, says Hardy, “in this environment, their ability to earn spread between their low debt costs and what they receive in terms of rent […] has been good. The dividend yield orientation of these companies has received a premium valuation relative to [historical averages].”

Read: Will Trump’s deregulation really matter?

Sarah Cunningham-Scharf