US volatility to present tactical opportunity

I’m writing to you from New York following a week of meetings with companies, investment banks, analysts, strategists, fund managers and executives.

The timing of the trip coincided with a bout of heavy volatility breaking out on Wall Street, largely as a result of the trade dispute. It’s helpful to be on the ground to understand what is driving such volatility and whether it provides another buying opportunity in leading US equities or it’s something more serious.

The US has the largest, deepest and most important equity markets, supported by the incredible wealth that has been created over the past century. AIM regularly visits companies across the US and engages with thought leaders in New York, the financial capital of the world.

We are also reminded that US investors have a clear home bias, for where they allocate their capital. The pro-business Trump Administration and a market friendly Federal Reserve add to reasons why the outlook for US equities is constructively optimistic. These arguments are tough to dispute at the current juncture.

Beyond this supportive backdrop, our analysis and work at a micro level is encouraging. Anecdotally, we have heard positive messages from corporates who are acting on the underlying momentum of the economy and investing. Whilst we are always monitoring risk factors and there has been nervousness around the Trade disputes, we expect the moderate growth and low inflationary period to continue to be supportive for risk assets. 

Some are even suggesting that the Federal Reserve may cut interest rates in the 2H of 2019, as inflation remains contained.

A significant focus area for markets is the US-China trade dispute, which for some, has been an excuse to take “risk off the table” and lock in profits, following a strong performance in 2019. However, the seasoned corporates and investors we met, believe that any weakness presents an opportunity to selectively add to key US equities that are not directly impacted by the tariffs. One stock that doesn’t fall into that category is Apple (APPL.US), as caution remains around its exposure to a potential escalation in the trade war. Remember the iPhone is “designed in California” but made in China and has so far been exempt from US tariffs. If the US were to implement a 25% tax on the remaining $267B+ of goods exported from China to the US, there would be considerable ramifications across Apple’s operations and supply chain. According to Morgan Stanley, one-third of Apple’s total cost of goods sold are imported from China, adding a 25% tax would see the cost of an iPhone XS increase by ~$160 (if passed on to the consumer). If Apple were to absorb the cost of tariffs, FY20 EPS would be impacted by 23%. This is assuming no changes to the current supply chain, and we note that Apple along with key manufacturers is looking at diversifying away from China. We do not own Apple.

An additional negative headwind for Apple is a US Supreme Court ruling that may allow an antitrust lawsuit against its App Store to proceed, potentially challenging the current business model. The ruling may mean consumers (as well as app developers) could sue Apple under antitrust laws related to the monopolisation of the iPhone App ecosystem by the App Store. While this issue is likely to be long and drawn out, it could potentially be significant as the App Store is Apple's largest standalone service, accounting for 35% of Services revenue. Whilst various scenarios are possible, this development adds to uncertainty surrounding Apple and its future earnings growth.

Concerns around Apple’s earnings and those of other select US corporates, as a result of a possible escalation in the trade war, were a key negative influence on US equity indices over the past week. The other clear sentiment problem was the weak listing of Uber (UBER.US). An underwater IPO is a short-term problem but not one that is insurmountable in the medium term. Remember Facebook halved from its IPO price but is now 5x that price and 10x its lowest share price after listing. The soft IPOs from Uber and smaller ride-sharing competitor Lyft, has dented confidence in higher PE tech in the very short term, but both were a touch unlucky in their listing timing in terms of a bout of volatility breaking out just as they listed. We do not own Uber or Lyft.

Despite short-term market gyrations, the research trip provided cautious optimism of how segments of the AIM portfolio is positioned, in leading US businesses. I was on the trading floor of Morgan Stanley as the Dow Jones fell 600 points. Morgan Stanley is the number 1 US equities house and the price action was orderly with most of the selling coming from index futures. It’s clear to me that US investors will favour US equities over everything else. When the trading dust settles, US equities tend to recover more quickly than other regions. I think this will continue to be the case and believe that trading dips such as the current one will be bought. US companies such as Microsoft, Amazon, Alphabet, Visa, and MasterCard for example, will likely be rewarded.

Our trip to New York gave us greater confidence in the US economy, US earnings growth and the market structure. However, I suspect sentiment from the US towards China and China facing investments to remain negative. This includes commodities, resources and the Australian dollar.

As I board the iconic Flying Kangaroo for the flight home and reflect on what we have learnt in the past week, we remain convicted on owning some of the best businesses in the world through the AIM portfolio. The short-term noise may continue, and we will be using this as an opportunity to add tactically. I thought it was important to share these insights following a significant few days on Wall Street

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