Why has US equities outperformed so strongly?
The simplest explanation for US equity outperformance this year is economic divergence that has translated into equally divergent corporate earnings profiles.
The synchronized global growth of 2017 ended abruptly earlier this year, with economic data disappointing in much of the rest of the world, in part driven by the lagged effects of Chinese deleveraging.
Meanwhile, US economic growth accelerated on late-cycle fiscal stimulus.
Against this backdrop US company profits have grown strongly – beating even upbeat expectations over the past few quarters – while corporate earnings outside of the US have stuttered and in the case of Europe, disappointed.
Escalating trade tensions also played a key role
Increased trade tensions have also played a role, with the market judging that tit-for-tat escalation of tariffs will disproportionately affect more trade-dependent nations than the US.
China is now engaging in monetary and fiscal stimulus to cushion its economy against the effects of prior de-leveraging and trade tensions, which could help offset some of the recent US-rest of the world growth imbalance.
The outlook from here
At the moment we think the US is in the midst of a positive feedback loop between a robust economy and still accommodative financial conditions. Strong economic performance has boosted confidence to borrow and invest while broad financial conditions remain easy even amid Fed hikes.
While we recognize that plenty of good news is in the price, and the economy is later cycle, we do not want to stand in the way of this ‘positive reflexivity’ until we see clear signs of a breakdown in leading indicators including business and consumer confidence.
Perhaps this will be the case if the US business community more fully takes into account the impact of recent trade escalation and slows investment and employment plans, evidence of which we have yet to see.
And while we recognize relative valuations between value and growth are extreme, we are not confident there is a powerful enough catalyst (such as materially higher rates or a spike in tech regulation) to reverse these trends in the near term.
Note as well that despite another strong year of outperformance, US equities are now more attractive than they were after profits have grown faster than share prices have risen (as measured by the twelve month forward P/E ratio). This suggests that US equities can continue to perform, even if recent momentum moderates somewhat.
What’s the bottom line for asset allocation?
On a global basis, we remain constructive on equities given above-trend global growth, still easy financial conditions, and limited recession risks over the next year. But despite strong US outperformance year to date and less attractive valuations compared to other regions, we are not looking to be actively underweight the US versus Europe, EM or Japan at the moment.
Our focus remains on economic data: If we see genuine signs of stabilization in China and ex-US developed markets, or perhaps a greater appreciation of tariff risks in the US economy, we would be more inclined to shift relative preferences. Likewise, a durable pickup in inflation in Europe and Japan would give us more conviction in entering bond convergence trades, to take advantage of historically wide spreads.
Ultimately we expect the time for convergence to come, but we are not convinced it has arrived just yet.