Why look beyond the US for equity returns?

Wed 15 Aug 2018

The US stock market has made some impressive gains year-to-date. In January the S&P 500 reached a record high of 2872.87, with the exchange falling just 10 points short of this figure two weeks ago. Apple also recently made headlines worldwide when it became the first US company to be valued at a staggering $1tn. The US equity market has so far defied expectations of a significant market correction and continues to be the best performing equity market year-to-date, returning double that of the next highest performer. However, US stocks have certainly not had it easy this year. One notable example being Facebook, one of the S&P 500’s largest companies, whose revenues recently missed expectations by 1% and lost more than $100bn in market value. This comes shortly after a widely publicised data scandal tainted its reputation earlier this year. Nonetheless, the US stock market has shrugged off any weakness along with potential implications from mounting trade tensions in favour of focussing on stronger corporate earnings.

Elsewhere, emerging markets are dealing with the fallout from a stronger dollar, possible trade wars, as well as sanctions imposed on Turkey and Russia, which threatens to cause contagion across all developing regions. Additionally, China’s stock market is the worst-performing index year-to-date, having lost over $2tn in value and therefore relinquishing its title as the world’s second-largest stock market to Japan. In Europe the future of the Eurozone following recent Italian elections continues to trouble investors, while foreign investment in the UK remains subdued as Brexit negotiations and uncertainty persist. As such, with its recent resilience, as well as apparent corporate and economic strength, is the US the only place to be?

Just last week the S&P 500 closed 0.5% short of its January record, surging as more recent worries around Iranian supplies of oil have driven the commodity even higher, despite gains of 17.7% (in GBP) already this year. Additionally, the Nasdaq, which is very technology oriented has been buoyed by Elon Musk’s recent announcement of the potential privatisation of Tesla. The US stock market is booming, and come 22^nd August the US stock market will officially have enjoyed its longest-ever bull run. The backdrop is promising with average earnings increasing over 23% in Q2 and 78.9% (of the 90% of companies that have reported so far this season) having exceeded earnings estimates, according to Thomson Reuters. The US also recently reported an annualized 4.1% quarter on quarter GDP growth in the same period. With data like this, it is hard to ignore the current strength of both the US economy and the corporate sector, and fund managers have understandably taken note. The most recent edition of BAML’s Fund Manager Survey, which polled 243 investment managers, saw global fund managers name the US as the world’s top equity market region for the first time in five years, with allocations increasing to the highest levels since January 2015[1].

As long term investors it is important to try to discern what is simply market noise and where the inherent risks lie. While there is no doubt that fundamentals look supportive, we should remember that earnings have largely been affected by the Trump tax cuts, which are estimated to have added an extra 7-8% to earnings. This trajectory can’t last forever and soon the benefits of this new law will wane. Additionally, there are a number of technical factors external to any company that influences the supply of and demand for its stock and some of these factors will indirectly affect fundamentals. For instance, the way in which economic growth indirectly contributes to earnings growth. While GDP growth currently looks robust, despite the optimism, the US is moving towards a “demographic cliff”.

The term coined by US economist Harry Dent refers to a country where the percentage of people of working age declines considerably due to decreasing fertility rates. This means less people joining the workforce in the future, leading to less demand in the economy and less innovation. Hardly promising for GDP growth. According to the World Economic Forum, the US fertility rate has dropped to the lowest in 30 years. Conversely, regions like Asia generally have young populations and strong economic growth rates. Most recently, the IMF reported that India now contributes, in purchasing power parity measures, 15% of the growth in the global economy, which is next to only China and the US. For the advanced economies, the IMF project growth this year of 2.4% and 2.2% for 2019. On the other hand, estimates for emerging market economies of 4.9% and 5.1% for 2018 and 2019 respectively look much more attractive. We believe that there is still a case for long term investment in developing regions, despite current headwinds from possible trade wars, sanctions and a stronger US dollar.

With a $1tn technology company in its index, it is no surprise that the US has a very strong technology bias. With a 25.96% tech weighting as at the end of June, the sector risk that you are exposed to from the S&P 500 is significant. Since November 2016, the total market capitalization of the stocks in the S&P 500 has increased $6tn, with 50% of that increase being in tech, and more than $1.4tn being in the five FAANG stocks alone. As such, should US equities, or even just the technology sector, take a turn for the worse, having exposure to different economies and markets will undoubtedly better protect your portfolio.

The investment case is there, but it is not without risk. Yes, the US is a force to be reckoned with at present, however for those taking a longer term view, the important question is how long can it last?

[1] https://www.thestreet.com/markets/us-stocks-top-global-fund-managers-list-amid-best-eps-forecast-in-17-years-baml-14682077