Despite debt, U.S. stocks look good

While all eyes are focused on the political battle over the U.S. debt, it’s understandable that investors may be reluctant to invest in the American markets. But there are also ample reasons to add exposure to U.S. equities.

Back in May, Republican Congressman Kevin Brady tabled a bill that would encourage U.S. corporations to repatriate profits held by overseas subsidiaries. If passed, the bill would impose a tax of only 5.25% on these profits. Usually, these profits would be subject to the difference between the America’s 35% corporate rate and the rate already charged in the foreign jurisdiction.

The argument in favour of the bill is that the extra cash—estimated at up to $1 trillion—could be used to create more jobs at home.

Critics of the bill—and there are plenty—point out that the last time a tax holiday was granted, virtually all of the repatriated capital was spent on dividends to shareholders.

From an investor’s point of view, this is hardly a bad idea. Economically, it might also make sense, as investors would likely either spend the dividend cheque, use it to pay down debt, or invest.

“There’s a huge dichotomy between the underlying economic weakness and the profitability of corporations,” says Angela Maitland, vice-president and portfolio manager with Fiduciary Trust Company of Canada. “What we’ve seen is a pretty robust earnings growth environment in spite of weak underlying demand. That has created record stockpiles of cash on corporate balance sheets.”

These cash balances have been created by global economic growth and a weakening U.S. dollar, which has stimulated American exports, and massive cost cutting that began in 2008.

“In the absence of positive net present value projects to invest in, that cash is going to start coming back to shareholders in the form of dividend increases or in share repurchases,” says Maitland.

This process has already begun, she says, with roughly one third of dividend-paying corporations increasing their payout in the second quarter. This trend is bound to continue, irrespective of any repatriation tax holiday, as too much cash is sitting idle, with as cash balances as high as 7%.

The problems with a repatriation tax holiday are largely political, as America’s wide income disparity would leave many feeling the wealthy had received another benefit on the government dime.

“Ultimately, money coming back to the United States will be good for the U.S. economy,” says Steve MacMillan, portfolio manager for Pyramis Global Advisors and manager of the Fidelity Small Cap America Fund. “But this, in and of itself, may not be a catalyst for the U.S. market.”

There are more compelling reasons to invest in U.S. equities right now, he says.

“When commodities are not going up, Canada is not a very attractive market to invest in,” MacMillan says. “After a strong bull market, people have forgotten the core tenant of diversification.”

Judging by the flows into the U.S. equity fund category over the past decade, most Canadian portfolios are currently underweight in U.S. equities. In that time, investors may have been well-served by focusing on Canada, as commodities have provided domestic returns.

Meanwhile the loonie soared from about 60 cents to over $1 versus the greenback, eating up most returns earned in the U.S. market.

“To believe that’s going to happen again over the next decade, you have to believe that the Canadian dollar is going to go to $1.50 and oil is going to go to $200,” says MacMillan. “At this point, Canadian investors have to think about the amount of risk they are taking, by being invested in Canadian equities. I think investors and advisors are very focused on the risks in the U.S. without looking at the risks they are taking domestically in their portfolio.”

Typically, a Canadian equity portfolio will have a hefty exposure to energy and materials—often around 50%. These are highly volatile sectors, he points out, and subject to changes in the global economic cycle.

More stable sectors—such as healthcare, consumer staples and technology—are virtually absent from the Canadian economy, but they make up the core of most U.S. equity funds. Because of the very divergent natures of the two economies, their equity markets are quite complementary.

“The biggest misconception, I think, is the perceived risk level difference between the two countries. If you look at a Canadian large cap index and compare it to the Russell 2000 U.S. small cap index, volatility in Canadian dollars of the two is actually the same. You’re taking as much risk, as measured by volatility, owning a U.S. small cap fund.”

He points out that the Canadian dollar is typically a “risk-on” currency, while the U.S. dollar is “risk-off”, meaning that when investors are avoiding risk, they will head for the greenback.

“On days when the stock market is down, you have the U.S. dollar rising and the Canadian dollar falling,” MacMillan explains. “If you own U.S. equities, this acts as a governor and reduces your volatility.”