US equities: will the bull market continue or run out of steam?

June 8, 2017
With the US Federal Reserve intent on tightening policy further despite recent economic data having underwhelmed, Daniel Masters, Investment Director at Brooks Macdonald, explores the risks and opportunities associated with US equities.

A succession of weaker-than-expected economic data has raised some questions over the US economy. However, we believe these disappointments are representative of high expectations, rather than the struggles of the economy; the absolute level of most US economic data remains encouraging.

The US labour market continues to go from strength to strength. Labour-force participation has stabilised, the number of people claiming unemployment benefits has reached cyclical lows and the economy is adding jobs at a robust rate.

Alongside strong consumer sentiment, the strength of the labour market is supporting consumption. It has also helped boost the household savings rate, which has improved debt sustainability in the economy.

Some investors are worried about a lack of inflationary pressure, with members of the Federal Open Market Committee (FOMC) having also admitted surprise at the low level of wage growth.

However, we see three structural trends that help explain the failure of wage growth to accelerate in recent years, and do not believe they provide reason for longer-term concern:

  1. Shifting population demographics. The ageing of the workforce has meant that fewer people are moving jobs and, generally, younger people have greater propensity to change jobs to increase their pay, while older people place more value on job security.
  2. Changes in labour force participation. Older, higher-earning workers are retiring, while lower earners have continued in employment.
  3. . Increasing automation. Businesses’ increasing ability to automate tasks has meant workers’ leverage in seeking pay increases has diminished in certain lines of employment.

Together, these factors have kept wage growth low and justified the Fed’s decision to maintain its highly accommodative monetary-policy stance level in recent years.

However, inflation will not be contained indefinitely. The fundamentals underpinning the progress of the economy remain strong and the Fed expects inflation to stabilise around its 2 per cent mandate target over the medium term, justifying its current interest rate projections. But these remain slightly higher than those of the market, which is why some investors are concerned that the Fed may make a policy error by raising US interest rates too quickly.

The Trump effect

The recent bout of weaker-than-expected US survey data can partly be explained by expectations having been raised too far following Trump’s election, as well as some transitory cyclical factors. The president has been anticipated to enact pro-growth, inflationary and business-friendly policies, but so far his progress has been limited.

A lack of support forced him to withdraw a bill designed to repeal and replace the Affordable Care Act (Obamacare). The release of his much-anticipated tax plan also underwhelmed, as has a lack of newsflow surrounding infrastructure spending plans.

These developments are indicative of infighting within the Republican Party and raise questions over his ability to implement the reforms he has promised.

Nevertheless, there are areas of encouragement; the risk of trade protectionism appears to have diminished following the president’s meetings with global counterparts, including Chinese premier Xi Jinping.

Likewise, the trend of decreasing regulation seems to have gathered steam, with proposed amendments to the Clean Air and Dodd Frank acts appearing more achievable. Indeed, changes to the latter have become a key element of our financials theme.

Overall, optimism over Trump’s reforms has been tempered since his inauguration. The market impact appears to have been limited, with equity indices continuing to reach new highs, but this has been against a backdrop of supportive newsflow elsewhere in the world. Given the recent tempering of expectations, there is now room for sentiment to improve as traction on any major reforms is gained.

The corporate backdrop

US businesses are currently operating within a ‘goldilocks’ environment, characterised by supportive monetary policy, low but rising inflation and contained wage growth. Capital expenditure is increasing as corporate earnings growth has moved back into positive territory, while accelerating global growth and the recent weakening of the dollar will also provide support.

Nevertheless, the Fed’s rate-hiking cycle is now well under way and rates are set to rise further. As such, the corporate backdrop may become more difficult in the medium term as tighter monetary policy begins to weigh on the economy.

Overall the US economy is performing well, but its strengths are well known and the recent bout of weaker-than-expected data has shown that expectations are already high. US equity valuations are by no means stretched, although they are trading at the higher end of their range relative to their global peers.

This situation is somewhat justified by the strength of corporate earnings, but we believe the case for US equities has become less compelling given opportunity elsewhere in the world. Nevertheless, we continue to favour certain thematic investments in the region, in sectors such as technology, financials and healthcare.

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