How Do I Not Love Thee US Stocks, Let Credit Suisse Count The Ways

Credit Suisse is out with a new Global Equities Strategy update.

Now who’s excited?!

No, but seriously, there’s a lot to like about this latest installment from Andrew Garthwaite and team.

Specifically, there’s a lot about the eurozone and the French elections that’s definitely worth a read and the section on Japan isn’t a complete waste of time either.

Of course US investors are a myopic bunch and if most retail investors had their way, there wouldn’t be any markets other than those that are open from 9:30 a.m. EST to 4:00 p.m. EST Monday through Friday.

So because I aim to please, I wanted to highlight the bank’s comprehensive look across US equity markets. And because I also aim to disappoint by raining on the “buy every dip in US stocks” parade, I think all of what you’ll read below is worth noting for what it says about how things are likely to turn out for anyone buying into a market the bank describes as “scoring at the bottom of the scorecard.”

Via Credit Suisse

What are the challenges?

US equity underperformance has been rare in recent years, but year-to-date, US equities have underperformed global equities by around 0.7% in USD terms. We reiterate our underweight stance, and view the challenges for US equities in a global context as the following:

1) The US scores at the bottom of our scorecards. The US scores at the bottom of our composite scorecard, as shown in the overview of this regional update (see Figure 1). This is primarily a result of high relative valuations and low earnings momentum, with the US now at the bottom of our earnings momentum scorecard, as shown below.

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2) Relative valuation is unattractive. US equities account for 53% of the MSCI AC World thanks to the relative rally in the underlying equity index, combined with the move higher in the US dollar since 2011. As a result, US equities as a share of market cap are above their late-1990s peak when compared with the DM-centric MSCI World, or just a couple of percentage points below their peak when compared with AC World.

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This period of outperformance has, however, left US equities at historically high valuations relative to the rest of the world, which we show below in terms of Credit Suisse HOLT P/B relative (now around 2 standard deviations extended), as well as a simple 12-month forward P/E.

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3) The current phase of the global economic cycle does not suit the US. The defensiveness of US equities in a global context stems from the following features:

  • The US has relatively low operational leverage. As we illustrate in other country sections, US equities have the lowest beta of EPS to global IP of any major region, as one would expect for the region with the highest profit margins;
  • The superior ability of US corporates to cut costs in downturns, particularly in contrast to Japan and Europe, where labour laws are much more restrictive;

Hence, as the first chart below illustrates, US equities tend outperform when global PMIs fall and when global GDP growth decelerates. Crudely, the US market appears to be discounting a slight fall in global PMIs from current levels, at a time when we think the risk for PMIs, and indeed global growth momentum more broadly, is to the upside for 2017.

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4) Rising bond yields are bad for the relative performance of the US. To some extent, the US market is long of ‘growth’ stocks (technology and biotech are 20% of market cap compared with 12% globally) and short of financials (banks are 6% of US market cap compared with 12% in Europe and 11% globally). As a result, rising US yields tend to be associated with US equity underperformance. There is an investment style element to this too: when yields rise, growth as a style, which tends to be of longer duration, tends to underperform. To some extent, growth stocks are discounting a 1.5% US bond yield. We would still agree with our house view that US bond yields will trend back towards 3% by year-end.

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5) The US economy is late cycle. With the exception of Japan, we think the US is the major economy closest to full employment. To us this represents a dual negative for equities:

  • First, a tighter labour market increases labour’s pricing power, which increases the wage share of GDP and compresses the corporate share of GDP. Four out of the last five times unemployment has fallen below the level consistent with full employment, the profit share of GDP has fallen. We now think the unemployment rate consistent with full employment is closer to 4.2% rather than the 4.8% we initially believed
  • Second, if wage growth rises above 3%, then the Fed may well feel obliged to return to a ‘tight’, as opposed to a neutral, policy; 3% wage growth would, we think, threaten to push the core PCE deflator above 2%.

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6) US corporate leverage is at the previous peak. With buybacks accounting for almost half of total cash returns to shareholders, the rise in leverage limits the ability of the US companies to boost EPS, as well as limiting the buying power of what has been the critical buyer of equity in recent years. Recently buybacks as a style have started to underperform once again, suggesting that investors currently are not rewarding those corporates pursuing buyback strategies.

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7) The US has the lowest exposure to GEM. The US has the lowest exposure to GEM and China. While this helped the relative performance of US equities through the taper tantrum and beyond, this we think should now be considered a negative given our more constructive view on emerging markets.

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8) An unraveling of the Trump trade. There are now some significant question marks over aspects of the Trump policy package that were considered to be of benefit to US corporates, including:

  • Fewer funds available for corporate tax cuts: Passing a budget with a simple majority, i.e. via a budget resolution process, requires that any announced plans be revenue-neutral over a 10-year period. The Tax Policy Center has estimated that President Trump’s proposed corporate tax cut plans would cost around $2trn, and thus funding them would require significant new revenues or savings from elsewhere. According to the CBO, the initial version of the repeal of the Affordable Care Act would have saved $340bn through to 2026, while the implementation of Border Adjustment Tax (BAT) is estimated by the Tax Policy Center to raise $1.2trn over 10 years. These two policy proposals therefore represented a significant contribution to the cost of funding corporate tax cuts. With the first of these plans now pulled, and significant question marks hanging over the second (at least 10 Republican Senators have come out against a BAT), the funds available to cut corporate taxes now appear to be at risk. Mark Meadows, the Chairman of the House Freedom Caucus, has suggested corporate tax cuts need not be revenue-neutral, but finding broad-based support for that stance might be difficult.
  • Significant reform takes time: Tax reform appears very unlikely until next fiscal year, in our view, with the recent failure to pass the healthcare bill highlighting the difficulties of passing significant legislation in the current political environment. That said, 61% of respondents to our US equity strategy team’s recent survey thought tax reform would still occur by the end of 2018. The challenge to that view is that it took Ronald Reagan two years to implement corporate tax reform despite broader bipartisan support and a near clean sweep in his second term as President. A poll conducted by ABC found that less than 30% of Americans support a tax cut for corporates.
  • The outlook for de-regulation: De-regulation could be a positive for US equities (particularly for the telecoms, energy and pharma sectors), but there have been some signals recently that de-regulation may not be as far-reaching as initially thought. As reported by Reuters (6 April 2017), the director of the National Economic Council, Gary Cohn, has indicated that he supports the restoration of Glass-Steagall, which would separate banks’ consumer-lending businesses from their investment banks.

9) More cyclical optimism priced into the US equity market. The valuation of US cyclicals relative to defensives is much more extended than in Europe, despite the fact that (as noted above), the euro area economy could well out-grow the US this year.

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10) US ex tech is underperforming global equities. The biggest support for the US is its overweight of tech. One of our biggest sector overweights from a European, US and global stance has been technology, and thus we would characterise our stance as being underweight the US excluding technology. Yearto-date, US equities have underperformed global equities in aggregate, and non-tech has underperformed even more.

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11) Flows are only middling. Equity outflows from the US have recovered from extreme levels in 2015, and are now close to their strongest pace as a share of AuM observed over the past five years. However, EPFR positioning data continue to suggest that asset managers remain slightly underweight the US compared to their historical average.

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