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US equities outperformance to continue
INVESTORS have taken note that US equities are making new highs, with the S&P 500 index breaking through the 2,900 level at the end of August. As if on cue, much of the market commentary since then has focused on the prospects of a market correction, sidestepping many of the fundamental factors that arguably brought the US market to its lofty peak in the first place. The divergence in performance between US equities and the rest of the world is stark; hence it is worthwhile to re-examine the case for this market and by extension, the US dollar.
To start, in our view, it is hard to find an economy that can boast the same rude health as the US today. Unemployment, at below 4 per cent, is widely expected to keep falling, and may reach 3.4-3.5 per cent (by end 2019), which would be levels of joblessness not seen since the late 1960's. The all-time low for US unemployment in the post-war era occurred in June 1953, at 2.6 per cent, based on Bloomberg data. While we may not trace back to this golden age of US growth and job creation, we can argue that by most accounts, the American economy today is growing well above its natural (or trend) rate. Therefore, GDP growth near 3 per cent for 2018 (and only a moderate slow down to 2.5 per cent in 2019) implies that the demand for labour should stay robust over the coming five quarters, at a minimum.
Ample jobs mean that US consumers are in buoyant mood and happy to spend. While there are a great number of retail spending statistics to look at, one stands out: According to JP Morgan, consumer spending at restaurant and bars surged to a three-month moving average rate of 25 per cent year-on-year in July; a staggering surge given that this number normally fluctuates between -5 per cent and +15 per cent.
Intuitively, spending on eating and drinking out is a very discretionary part of any household's outlay, hence the +25 per cent increase demonstrates Americans' confidence in their current and future outlooks.
The spending is backed up by another telling statistic: According to US Federal Reserve, household wealth in the US has now exceeded US$100 trillion - it is very likely that this is the largest pool of wealth in recorded human economic history. For further context, the pre-Global Financial Crisis peak in US wealth (in 2007) was close to US$70 trillion.
As with households, the US corporate sector is in good stead. Here too the US is well ahead of the pack. On an aggregated basis, for the preceding quarter, US company profits grew by +25 per cent yoy, relative to Europe at 12 per cent and Japan at 8 per cent, according to JP Morgan.
For the full year, US firms' earnings are forecast to grow at 23 per cent, which again is well ahead of European peers at 9 per cent. In terms of valuations, with 12 month forward price to earnings ratio of 17x (according to the I/B/E/S consensus), some investors maintain that the US is simply expensive.
This is a matter for debate, but on the surface, it is undeniable that there are "cheaper" equity markets to be found. We would argue, however, that given uniquely strong US economic momentum, investors can expect to pay more to own these fundamentals; and if political noise and trade-related uncertainty were to worsen over the coming months, paradoxically, we believe that US stocks will become even more "expensive".
On US politics, financial markets are squarely focused on the outcome of the US mid-term elections that take place in November. Polls (and historical experience) indicate that the party opposite to the sitting president (in this case, the Democrats) will gain seats in the lower house of Congress, at the expense of the current Republican majority.
In terms of the upper chamber (Senate), the Republicans are currently expected to hold on to their slim, two-seat majority. While it is conceivable that this possible electoral outcome raises the temperature on President Donald Trump, investors may note that successful passage of impeachment proceedings requires a super-majority of 2/3 of the votes in the Senate.
As this appears very unlikely, US assets are largely discounting these political risks to zero, in our view. Flaring up of rhetoric seems inevitable, but given that with the exception of Nixon, no US president has left office early in the modern era; hence crafting an investment strategy around the prospect of President Trump facing this scenario does not seem worthwhile.
Would political noise impact the US dollar, perhaps more so than equities? The appreciation of the greenback this year has confounded many investment strategists, ourselves included. This is because conventional currency metrics that drive Purchasing Power Parity based calculations point to a weaker US dollar. Inflation is higher in the US than most of its trading partners and the economy has widening twin deficits.
Indeed, the combination of December 2017 tax reform and the 2018-19 Budget Act means that, according to the non-partisan Congressional Budget Office (CBO), the US fiscal deficit will run at -5 per cent of GDP, all the way out to 2028.
By contrast, the White House forecasts that the deficit will narrow to only -1 per cent of GDP over the same time horizon. While it remains to be seen which forecast ends up being the more accurate over time, if investors are inclined to agree with the CBO, then a weaker US dollar could be an eventual outcome.
The fact is, however, that the US dollar has remained strong in 2018, irrespective of competing forecasts on the fiscal deficit. Our own view is that, over the coming 12 months, the door remains open for the euro to gently appreciate against the US dollar, assuming that the US-EU trade relationship remains on a solid footing and tariffs are not applied to US auto imports. This is because we assume the growth differential between the US and Europe can narrow, but only if trade relations continue to normalise.
Should they worsen, then investors can expect the US dollar to rally further, paradoxically as the greenback has defensive, safe haven characteristics, even if the US is seen as the driver in raising political risks. Even under this scenario, we expect US stocks to continue their outperformance. W
The writer is Chief Investment Strategist at LGT Private Banking Asia