At a time when US equities continue to outperform other global markets, we are often asked why the US has been such a strong market over the past few years. It is true that equities have had a good run, but we believe that there is more to come. Two major ingredients in this are consumer confidence and business confidence.
First, US consumer activity represents 70% of the US economy. As the US consumer goes, so goes the US economy. Americans like to spend money. And when we look at consumer spending, it is not just traditional retail goods and services. It is travel, events and experiences. And we think the US consumer will continue to spend.
Second; whether you agree with his politics or not, business confidence has risen sharply in the US since Trump’s election victory in November 2016, with the shift particularly visible at the smaller end of the market cap scale (see chart 1). The NFIB Small Business Optimism Index reached a record high of 108.8 in August 2018.
Chart 1: Small business optimism at a record high
Source: Bloomberg, NFIB data, as at 31 August 2018. The NFIB Small Business Optimism Index is a composite of seasonally adjusted components that indicates the trends in optimism among small US businesses.
When we talk to business leaders and chief executives, what they tell us is the biggest difference between this administration and the previous one, is that there is greater certainty of a positive environment for taxes, regulation and the overall business environment. This certainty gives chief executives more confidence to invest in their businesses, and to grow. We have also seen a fair amount of merger and acquisition activity as business confidence has risen. These two factors – consumer and business confidence – have led to a stronger economy and a better-performing market.
Are valuations too high?
US fundamentals are still positive, but many people think that valuations are now too high, and that it cannot be a good time to invest. Looking at 12-month forward price/earnings ratios (chart 2), valuations vary across sectors, but broadly they remain at a similar level to where they were last year – and in many cases lower. Even though equity prices have gone up, corporate earnings, profits and cash flow have gone up more. So in our eyes, valuations do not look unreasonable.
Chart 2: Valuations have largely come down since 2017
Current interest rates in the US provide a lot of fundamental support for these valuations and – in our view – the risk of a dramatic increase from here is quite low. The US is ahead of the rest of the world in the interest rate cycle, largely because the US economy has outperformed other global economies. We do not believe that the US Federal Reserve (Fed) is increasing rates because it has to, in order to contain inflation. Rather, by raising them now, when the US economy is in good shape, it provides the Fed with the ability to reduce rates in future, should we face any future financial crisis.
When reviewing markets, we look at the relative opportunities between equities and bonds, to help guide our decisions on where best to allocate capital. We believe that equities remain a better choice at present than either investment grade or high yield bonds, given the mismatch between risk and return on fixed income assets. Our investment strategy takes a dynamic approach to asset allocation, leveraging bottom-up, fundamental equity and fixed income research to guide our investment decisions. Over time, we believe that this can help us to achieve an optimal balance of asset class exposure for the prevailing market conditions.