Briefing on the US economy and stock market
The US economy represents about 30% of the global economy and its stock market capitalisation accounts for about 50% of the world’s market capitalisation. Since the early 1980s, US consumer spending has been the driver of the global economy as its peaks and troughs have tended to lead trends in the rest of the world. It has been the most productive, large, developed economy in the world because it has been so successful at developing and applying new technology. The US stock market has been one of the best-performing markets over the last 25 years.
For many entrepreneurs, the US represents their ambitions and desires. It is an open and dynamic society that attracts talented people from all over the world, who wish to work in an environment of free enterprise, low taxation and light regulation where hard work and success can be very well rewarded.
Over the last 30 years, the trend of declining bond yields and enormous innovation in financial markets has led to a staggering increase in the indebtedness of the US consumer, the financial system as a whole and the US government, both in absolute terms and in relation to the size of the total economy. The debt within the financial system and the levels of consumer borrowing, have both, since the 2008 crisis, begun to fall back and the economy has started to “deleverage”. Government debt, however, has not yet reached this stage, with trillion dollar deficits recurring year by year, continuing to compound the problem.
US consumers have steadily reduced their savings rate from 1982 until 2008, and permitted their spending to grow faster than income. This trend has now been halted by the banking crisis, and as the consumer ages, there will be a trend towards reducing the debts that have built up.
The Government Debt to GDP ratio is now above 100%. Markets are not yet particularly concerned about this, but are assuming that action is taken over the next 6 to 12 months now that the US Presidential election is completed, to bring the annual trillion dollar deficits under control. As has been the case in Europe, this will constrain growth in the economy.
Monetary policy will remain very easy, which is the stated policy of the Federal Reserve whose leadership is not due to change until early 2014. Ben Bernanke is firmly of the conviction that deflation should be actively prevented from occurring and that the Central Bank has the capability to ensure that it is. He has however indicated (privately, according to reports) that he is unlikely to stay on for another term, and the next Chairman may adopt a different approach.
The US today
The Federal Reserve under Bernanke has acted very aggressively ever since the crisis to prevent the deflationary threat to the economy of consumer and banking system deleveraging. Interest rates fell rapidly from 5.25% to 0.25% followed by several phases of Quantitative Easing, with the latest iteration set at $40bn per month with no end-date. Monetary policy has been aimed at convincing consumers and businesses that there will be growth and some inflation and so they should have the confidence to spend now and help the economy to recover. Bernanke’s time as Chairman of the Federal Reserve ends in 2014 and he is likely to measure his success in the job by growth of the US economy at that point. Therefore, a continued very easy monetary policy should be expected until then.
US profits as a share of the economy are close to post-war highs, at almost 10%. The major factor behind this strength has been the decline in wages as a share of the economy over the last ten years. There has been an explosion in the global supply of labour over this period from the opening up of China and India as locations for both manufacturing and service businesses. This has held down wage growth in the Western world and is likely to continue to do so for the next few years as Western unemployment remains elevated.
Following the November elections, there is an expectation that the two parties will come together to take action to reduce the budget deficit over the long term. The political system in the US with its conflicting centres of power of the President, the Senate and Congress, is one designed to make achieving agreements on cutting government spending and increasing taxation very difficult to achieve. Nevertheless, the direction of travel must be towards lower budget deficits over time, which as Europe has discovered will tend to constrain economic growth.
The future for the US
US consumer spending will lose its place as the driver of demand in the global economy. This is because the US consumer has (i) reached a point of debt satiation, and (ii) seen little real disposable income growth in recent years, and is now approaching retirement with insufficient levels of savings. Where consumer spending growth ran ahead of overall economic growth in the past, spending will henceforward tend to grow at a slower rate than the overall economy. US exports to the emerging market consumers in Latin America and Asia will become a much more important economic driver.
The outlook for profit margins is reasonably good. Though these are historically high, the factors that could lead to lower margins appear to be weak at the current time. These are increases in (i) wages, (ii) commodity prices, (iii) taxation and (iv) interest charges. Higher wages are unlikely to occur given the global over-supply of labour described above. Higher commodity (especially oil) prices are possible if Chinese infrastructure demand continues to expand very quickly, but commodity inputs represent only a small part of the total US economy, which is increasingly services-based and online. Higher taxation must be a longer-term threat to US business since governments around the Western world are short of revenues and ample corporate profits are an obvious potential source to be tapped. Currently, however, governments are more focussed on stimulating growth and employment and are shying away from increasing the tax burden on companies who might then decide to relocate their operations to other nations. Higher interest charges are unlikely to occur in the next few years given the public pronouncements of Central Banks about their monetary policies. For the foreseeable future therefore, high margins should persist, and given low inflation, this translates into strong free cash flows for companies, which can be used to strengthen their competitive position or reward shareholders directly.
The valuation of US equities, unlike Europe, Asia and Japan, is currently a little more expensive than average in terms of P/E ratios and dividend yields. This reflects the outperformance of the US economy and company profits over other regions since the global financial crisis.
The US will remain a key part of the global economy, but its importance is declining as emerging economies grow in significance. It is likely to remain the leading technological innovator and its culture of free enterprise will continue to attract entrepreneurs from all over the world. Its stock market should continue to be a solid long term investment, but finding managers who can outperform its market indices will continue to prove a challenge, and cheaper index-tracking funds are likely to be the preferred method of gaining exposure to the US stock market.