It is a very topical time to talk about US markets given the recent drawdowns. At the start of 2018 the consensus view was that US expansion was still delivering but moving into a later phase of the cycle, whereas emerging markets (EM), Japan and Europe were still in their infancy in terms of expansion and recovery.
Tax cuts introduced by President Trump at the end of last year were expected to widen the deficit in the US, but this stimulus would also be beneficial for global expansion, in particular in EM, energy and materials. Yield curves were predicted to steepen, which would likely encourage other central banks to rein in monetary easing. Meanwhile the US dollar was forecast to weaken and higher rates would mean value stocks, financials and EM would outperform, while technology and growth would underperform.
As ever, expectations do not always come to fruition. In reality, the trade war rhetoric coming from the Trump administration escalated rapidly, resulting in aggressive tactics against the rest of the world, not just China. This led to a significant depreciation in the renminbi in July, effectively destroying the consensus view outlined above.
For much of the period since August 2016, global markets have largely moved in tandem. However, in 2018 they have become more negatively correlated: US markets have continued to rise higher, while much of the rest of the world has dwelt in negative territory. In our view, this scenario is strange given the underlying dynamics of the US market.
We believe there are several key issues relating to valuations in the US market and the stimulus being applied to it. Firstly, the Citi Economic Surprise index appears to have completely disconnected from US equity trends; signs of worsening data have been ignored and the equity market has marched on regardless. In our view, this trend is not sustainable.
The US CAPE index, which shows the P/E ratio based on inflationary-adjusted earnings from the previous 10 years, is currently over the ‘warning’ level of 25 times for only the fourth time since the start of last century, indicating the market is overpriced. The reverse CAPE index, which compares earnings yields with the risk-free rates from Treasury bonds, suggests we are now in a situation where the rate on Treasuries is more attractive – another sign that US equities are not cheap.
The EBITDA multiple for the S&P 500 index is a further good measure to consider. This is currently at a peak of around 12 times. When one considers the rising import costs which will inevitably come from the tariff impositions, slowing overall Chinese demand for US goods, a strong US dollar eating away at foreign sales and rising interest rates, these all point to US earnings potential having peaked, which we believe has already been priced into the market. US equity buybacks are also at record levels, another potential warning signal that the market is reaching a peak.
For an even longer-term dynamic it is worth looking at US household net worth, which has grown enormously since the global financial crisis (GFC), and comparing it with GDP. There has been a significant divergence between the two over the last couple of decades; we are now in a position where almost everything is overvalued in our view. We find these big disconnects worrying because the resulting downdraught can be even more painful. Estimates of this overvaluation are in the region of USD 30 trillion. Again this is not sustainable.
The deficit also remains a major talking point. Predicted revenues will fall short of the spending which Trump has outlined and the deficit will likely be amplified by Trump’s planned tax cuts. Deficit increases of the current magnitude typically only occur in recessionary periods, therefore given the US is still in a period of growth this scale of debt is unnerving.
Moreover, it has not proven to be a good time to buy stocks when the rate of unemployment is at a cyclical low, as it is now. It could also be a bad time to buy stocks when the yield curve is at and on the verge of inverting.
Source: Bloomberg. Performance from 31 December 1946 to 31 March 2018.
For illustrative purposes only.
The upcoming mid-term elections may also provide ground for further market turbulence. While there are several possible outcomes, we believe the most likely scenario is that Trump will lose the House but retain the Senate. This outcome could be a negative for the stock market, given the potential for policy gridlock potentially slowing growth, but trade policy would likely remain aggressive. In our view, the market reaction would be muted but both the US dollar and equities would feel some selling pressure. Bond market stress would probably be contained as additional fiscal stimulus would be less likely.Ultimately, we are not overly surprised by the recent sell off given the variety of factors that suggest US equities are stretched after this year’s rally. We believe additional catalysts which could trigger further selling include US inflation rising significantly; the Federal Reserve making a policy error and tightening too quickly; and bond rates moving rapidly higher by pricing in full employment and imported tariff inflation. In our view there have been far better entry points into the US market than at present and there is better value to be found elsewhere.
You can hear more from Charles Hepworth on the topic of US Equity markets in this webinar of the same name, recorded last month.