In terms of our developed market equity exposure, it’s been America first for most of this economic cycle so far. The continuing primacy of the US economy and its consumers, allied to the breadth and quality of its stock market have been key factors in this persistent tactical tilt. While many have tangled themselves up in often poorly framed debates on valuation and the sustainability of corporate profit margins, US stock markets have soared, comfortably beating the returns available elsewhere in the global stock market.
In some senses, the backdrop looks more conducive for American stock market primacy now than at any other time in this cycle – The Republican tax cuts, alongside the recent bipartisan spending agreement represent a substantial dollop of fiscal stimulus to an economy that was already doing pretty nicely. Both, particularly the former, will materially lift corporate earnings for the next two years. The recent slide in the dollar and bump in oil prices will also help. Add all this, mostly temporary, earnings pep to the recent pull back in stocks and suddenly US stocks don’t appear so overvalued?
Even so, the US is no longer our top pick within the developed world - Continental European equities look to have the most near term upside to us. The pickup in corporate profitability is simply much younger, in keeping with a domestic economy that is finally breaking free from the grip of a rolling existential crisis that has plagued the euro for much of the last decade. For a given level of revenue growth, that should mean that European companies will generate a faster pace of earnings and dividend growth relative to their US peers over the next few years, driving higher relative returns. Admittedly the aforementioned temporary factors driving US corporate earnings make this a closer run thing than we expected a month or two ago.
Rates and valuation
We’ve noted before that the valuation debate around equities has focused too much on how the stock market looks relative to its distant ancestors and not enough on how it fits with the prevailing economic and capital markets backdrop. This remains the case. History contains no precise answers for how much we should pay for a dollar, euro or pound of forecast (or realised) corporate earnings today. The companies, and the accounting standards that govern them, are mostly too different, much like the world economy they operate in.
Whilst providing less clarity on what good value looks like today than some promise, history does tell us that valuation tends not to be a very important factor for investors to consider over 1, 3 and even 5 years. It is economic, and therefore profits, growth that matters most over these time frames. In spite of this, we may just be experiencing one of those moments when valuation comes into keener focus. The recent gyrations in stock markets could owe something to the potential ending of two eras. The trend of ever easier monetary policy around much of the developed world for the last 10 years looks to be at a definitive end - interest rates seem set to rise considerably in the US and the rest of the developed world over the next few years, while central bank balance sheets should retreat in tandem. This less indulgent central bank posture is perhaps coinciding with the end of a bull market in bonds that began in the 1980s with Fed Chair Paul Volcker’s war on inflation. Nominal yields have now bounced from the lows of last year, amidst a world economy that is no longer providing the scope for fixed income investors to drool over the prospect of deflation.
These ending eras provide important valuation context for equities of course. As bond yields rise, the relative call between stocks and bonds narrows. Bonds become more appealing just as corporate cashflows become worth a little less in present value terms. If stock market valuations are becoming a little more decisive with regards to prospective 12 month returns, then we are comfortable arguing that it is the US stock market which looks furthest away from fair value relative to both its developed and emerging world peer group. We expect this valuation headwind to be moderate, rather than definitive. However, alongside the likely ephemeral nature of the boost from the tax cuts, the dollar slide and oil’s resurgence, it is likely sufficient for us to put America second within our developed market equity allocation for now.