United States: Secondhand growth

Cyclical strength in Europe and the emerging markets has rippled back into the U.S. market, helping large-cap businesses beat earnings expectations for two consecutive quarters. However, domestic fundamentals still look mediocre.

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Global strength and the asymmetry problem

The global business cycle has strengthened considerably since the middle of 2016. By most measures, continental Europe and the emerging markets were the engines of this growth acceleration, and the U.S. was a passive beneficiary, at best. For example, the Citi U.S. Economic Surprise Index — which tracks incoming economic data relative to expectations — has been in negative territory for five consecutive months through September 2017. Meanwhile, the Trump Administration’s original timetable for comprehensive tax reform by August has come and gone, and details are still lacking. Policy uncertainty is driving a wedge between plans for elevated business capital expenditure (capex) and actual capex, which is currently subdued. Our broader assessment of domestic economic trends remains mediocre. Nevertheless, we are cautiously optimistic that Congressional Republicans will want to demonstrate a significant legislative accomplishment (taxes) before the 2018 mid-term elections. But progress has been frustratingly slow, and market expectations have been ratcheted lower.

So why is the S&P 500 Index up 11.4% year-to-date through September 15, 2017? The one fundamental factor that we can point to, convincingly, is that the global cycle has rippled back into the U.S. in a positive way. This “secondhand growth” was a big tailwind for U.S. earnings, given large-cap businesses source almost half of their revenues from overseas. Indeed, the S&P 500 Index delivered double-digit earnings growth in the first half of 2017 – a result that was ahead of our forecasts. While the U.S. has been a beneficiary of these developments, fundamentals support tilting equity allocations towards international markets, which have been the engine of growth and trade at more attractive valuations.

Prices for U.S. equities, as measured by the S&P 500 as of September 2017, are trading at 30 times cyclically adjusted earnings, which is the most expensive level ever outside of 1929 and the late 1990s. This creates asymmetry in the expected return profile. Equities can keep grinding higher with positive momentum. But at current valuations, our analysis suggests the upside potential is limited, and the drawdown potential could be significant.

Disinflated Fed plans, deflated bond market expectations

In our mid-year report, we titled our U.S. outlook “strike three on inflation” and warned there could be some persistence to the softness in pricing. That forecast proved accurate through the July consumer price index (CPI) report which delivered the fifth consecutive month of disappointment. Recent inflation data has been a bit firmer, but the Fed is still not following through on its price-stability mandate and has understandably become much more conflicted about the need for a third hike in 2017. At the time of this writing (before the September meeting), our assessment of public Fed statements suggests that half of the Committee wants to pause the tightening cycle. Fed Chair Janet Yellen’s position is unclear, but the current level of disagreement is likely sufficient for her to take a more patient approach. We expect the Fed to remain on hold for the remainder of 2017.

Our forecast does not mean that U.S. Treasury yields are likely to fall. Fixed income markets have priced-in a much slower path for the Fed (only one more hike through the end of 2018) than we think is warranted by fundamentals. There are four key reasons to expect a faster pace on rates in 2018:

  1. Even though the Fed has already hiked the overnight interest rate four times in this expansion, they haven’t engendered any real tightening from an economic perspective. The 10-year U.S. Treasury yield is lower today than it was in December 2015, the U.S. dollar is weaker, credit spreads are tighter and the U.S. equity market is stronger.

  2. Medium-term inflation risks are slowly building, and we believe the unemployment rate is likely to fall to 4% or lower in 2018.

  3. The U.S. dollar, which had been a big disinflationary force on the U.S. economy in 2015 and 2016, has fallen off a cliff this year and we believe this is likely to start boosting import prices and the inflation numbers in early 2018 (see chart below).

  4. A prolonged period of low rates is a risk to financial stability. As such, we think the Fed is on track for two or three federal funds rate increases in 2018, which is more aggressive than current pricing, and this should exert upward pressure on yields. The Fed also looks committed to announcing the start of their balance sheet normalization plans in September. This is basically a form of quantitative tightening. Given the predictability of the program, we don’t expect a large market impact, but directionally it should also exert upward pressure on long-term interest rates (in the same way that quantitative easing lowered them). Taken together, we look for the U.S. 10-year Treasury yield to increase to 2.5% over the next 12 months.

USD appears more likely to boost inflation in 2018
Estimated impact of the broad USD on U.S. core personal consumption expenditure (PCE) inflation.

Source: Russell Investments as of September 15, 2017.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Strategy outlook

  • Business cycle: Corporate profits have come in ahead of schedule as a stronger global cycle helped U.S. businesses deliver 14% earnings growth in Q1 and 10% in Q2. We expect a moderation in the quarters ahead and forecast earnings growth of roughly 8% in 2017. We don’t see enough cyclical support to generate strong returns at current valuation levels.

  • Valuation: U.S. equities are very expensive. The Shiller P/E ratio for the S&P 500 stands at 30 times — its highest level ever outside of 1929 and the late 1990s.

  • Sentiment: Price momentum is firmly positive and a tailwind for the U.S. market. We continue to have an underweight preference for U.S. equities in global portfolios primarily on the back of their expensive valuations.

  • Conclusion: We continue to have an underweight preference for U.S. equities in global portfolios.

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