America the possibly beautiful

Good morning. The biggest two questions on Wall Street lately have been: how far will the Federal Reserve lower rates, and how soon with it start? The market’s reply has been: six rate cuts (or about 1.5 percentage points), starting in March. Investors still expect six cuts, but have become slightly less sure about how soon they’ll begin:

Some Fed officials have tried to talk the market down. But with six Fed speeches scheduled for this week, the market might listen selectively. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

American exceptionalism

My personal stock portfolio, which is made up entirely of index products, is 75 per cent US equities. I wish it were 100 per cent. Or rather, I wish that it had been 100 per cent 10 years ago. If it were, I’d be a significantly wealthier man now. American stocks have clobbered almost everything else over the decade. Ten years ago, I was a huge believer in international diversification. Subsequent experience has drained a lot of that confidence away.

The excellent relative performance of US stocks has led to a big valuation gap with the rest of the world. Here, for example, is the S&P 500 against the MSCI world ex-US and MSCI emerging market indices:

This divergence has made “this is the year that international stocks catch up with the US” a perennial January pitch from brokers and fund managers alike. Fair enough: why pay 50 per cent more for a dollar of earnings in the US versus a dollar of earnings in Germany or Taiwan?

Goldman Sachs Wealth Management has consistently swum against this current. In a report released late last week, it acknowledges US stocks look expensive relative to other geographies and their own history, but argues investors should not cut their US allocation in response.

Its argument can be summed up as “pricey, but worth it”. The US, GSWM notes, is a unique combination: it is the only very large country with high gross domestic product per person and deep, liquid capital markets. It has a huge internal market that insulates it against global turbulence. It has the best demographic outlook of any large economy save India. It has the highest labour productivity in the world. It is the largest producer of oil and gas in the world. It exports more agricultural commodities than any other country. It is the undisputed technological and research leader globally.

There are lots of reasons, then, that the earnings of US companies have, over the long term, outpaced the rest of the world, and to expect them to continue doing so. And GSWM argues that while US stocks are expensive, they are not as expensive as they look. For one thing, if you remove the impact of the Magnificent Seven Big Tech stocks and Netflix, price earnings multiples look less inflated:

For another, if you adjust the multiples of other global indices for sector mix — adjusting, essentially, for the US’s overweight position in technology stocks — the valuation difference shrinks:

The other side of debate over US dominance has been taken up by the big factor-investing fund AQR. They think emerging market equities, in particular, are better positioned than their US counterparts. The view was laid on in a Bloomberg article yesterday:

“Emerging markets are almost certain to outperform the US over the longer term, according to Dan Villalon, head of AQR’s portfolio solutions group, who made a similar call in June of last year. “Emerging markets have the highest expected return over the next five to 10 years,” he said in an interview earlier this month . ..

For US stocks to continue beating the developing-world counterparts, “valuations of US equities would have to increase into tech-bubble land”, he said. “We think this is a risky proposition to say the least. We still think that there’s a case to be made for diversification outside the US.”

AQRs argument is laid out in detail in two white papers. First, the great performance of the US over the past 10 years — beating cash returns by 11.9 per cent a year — is simply unlikely to repeat. They show this by decomposing those great returns into real earnings growth (which contributed 4.5 per cent annually), dividend yield (2.1) and valuation expansion as measured by cyclically adjusted price/earnings ratios (3.6). Subtracting the real returns on cash adds 1.7 per cent to the excess-of-cash return (that is, real cash returns were negative). 

If you take the current dividend yield (1.5) and use the Fed projection for the long-term neutral rate as a proxy for cash returns (positive 0.5), then you need 10.9 percentage points of return from earnings growth and multiple expansion. So assume you get 6 percentage points a year from earnings growth — that is, a 90th percentile result relative to history. Even then you need valuations to reach absolute all-time highs over the next 10 years to get returns like the last 10. In sum,

to forecast a repeat performance from equity markets, you must forecast earnings growth at levels unprecedented [starting from a] non-recession economy and the market to trade at its richest level ever at the end of the decade . . . For the market to deliver even average performance [about 7 per cent a year] over the next ten years requires both strong earnings growth and richening valuations

The situation in emerging markets is almost the opposite. In theory, emerging markets should offer investors higher average returns than US markets, to compensate for the higher volatility. That happened in the first decade of this century, but not since, leaving EM shares with low valuations. Meanwhile, EM fundamentals have improved, as their economies have grown and their exposure to financial shocks has fallen:

Where does Unhedged land on this debate? Even the watered-down version of the efficient markets hypothesis to which we adhere suggests that all the advantages the US enjoys should be broadly reflected in prices. America’s tremendous advantages and strengths are well understood by everyone except a few declinist nitwits. The idea that the US’s ample resources, technological leadership and favourable demographics should be a persistent source of equity outperformance is therefore a bit odd.

What might be less well understood, and which might at least keep US valuations high, is the fact that the world is awash in savings and the US is the place most of those savings desperately want to go, because of our combination rule of law and deep, open capital markets. This, as I understand it, is one upshot of the work of people such as Atif Mian, Ludwig Straub and Amir Sufi; and Michael Pettis and Matthew Klein. If the world is becoming less stable, then the flow of capital into US stocks might only increase (even if some of the sources of that instability have their origin in the US).

The ultimate test for me is whether I am ready to rebalance away from US stocks. And I find myself hesitating. I’ve been hoping for and/or expecting mean-reversion of returns across my portfolio for years, and it hasn’t happened. Geographic diversification has been a huge loser for me for years, making it hard to keep the faith.

One good read

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