World Investment Outlook - Chapter two: USA

It is hard to believe but President Donald J. Trump will be almost half way through his first term in office by November 2018, when he will face a test that may give a clue as to whether this will be his only four-year stint in the White House.

Americans in 36 states and three territories will be voting for their State Governors. More pertinently, 33 seats in the Senate will be contested, 23 of which are currently Democrat and eight Republican, alongside all 435 delegate for the House of Representatives. The winners will form the 116th United States Congress.

Just as Europe remains gripped by how the Brexit talks will ultimately pan out, the Americas must now watch President Trump’s attempts to renegotiate the North American Free Trade Agreement (NAFTA) as he seeks to “put America first.” He may be fighting the wrong war. Federal Reserve data shows that US industrial output is 152% higher than it was in 1975, yet the number of workers in industry has fallen by 25%. Robots may be the reason, rather than cheaper foreign labour.

It is to be hoped Trump fights no war of the real kind either, even if relations with North Korea remain very strained, and his key battle will be getting his tax reforms through Congress even as America bumps up against its latest debt ceiling. Markets still believe in the so-called Trump, or reflation, trade, judging by buoyant stock markets, although the Federal Reserve’s apparent determination to tighten monetary policy via Quantitative Tightening (QT) represents a potential challenge to stocks given how corporations and equity valuations have feasted on the cheap money served up by Quantitative Easing (QE).

Economics

The healthy increase in US stocks this year means that Trump is therefore on course to buck one historical quirk, namely the poor performance of US stocks in the first year of a Republican presidency, but he still has three years to go to tackle another one. Research from highly-respected strategist David Rosenberg, of the Canadian firm Gluskin Sheff, reveals that every Grand Old Party (GOP) President since 1869 has seen a recession in his first term of office.

That hardly fits with Wall Street’s preferred narrative, which is that Trump’s plan to reform taxes, deregulate and invest in infrastructure will lead to an economic boom, just as such a programme did during Ronald Reagan’s first term in office during 1981-1984. ‘The Gipper’ eventually stoked a furious recovery that briefly took US GDP growth to 8% on an annualised basis.

Tempting as comparisons with Reagan’s reforms are, Trump faces a different situation: Under Reagan, inflation, headline interest rates and mortgage rates were falling, debt-to-GDP was less than 40% and stocks had been beaten down by a bear market. Under Trump, the consensus view is that inflation and interest rates (and therefore mortgage rates) are going to rise from historic lows, while debt-to-GDP is already at record highs, while stocks (on some metrics) have only been as expensive as they are now two or three times before – 1929, 1999 and 2007. None of those episodes ended well, but even if Trump does fail it may well not be his fault, as America’s debts remain the elephant in the room.

Comparisons between Presidents Trump and Reagan may not be as straightforward as they seem

Source: FRED, St. Louis Federal Reserve database, Federal Reserve Bank of New York, www.econ.yale.edu/~shiller/data/ie_data.xls. *Excludes pension obligations.

For all of those doubts, the US economy is apparently ticking over quite nicely. The GDP growth rate exceeded the 3% year-on-year rate targeted by President Trump and Treasury Secretary Mnuchin.

US GDP annualised back to Q1 2009

Source: FRED, St. Louis Federal Reserve database

The International Monetary Fund (IMF) is forecasting a 2.3% rate of advance for 2018, perhaps because some of the data beneath the headlines is less benign:

• Growth in tax revenues for the Government has slowed to a crawl and the downward trend to a meagre 3.6% increase in the last quarter for which we have data mirrors trends that presaged the recessions of 1991-92, 2001 and 2007-09.
• Inventories are high (though declining) and stand at levels last seen during the 2007-09 recession on a finished-stocks-to-sales ratio basis.
  
• The US domestic savings rate has slumped to 3.2%, a figure last seen in 2007, not least because wage growth is weak, at just 2.4%, despite what look like low levels of unemployment. The American consumer may not be quite tapped out but he or she may be well on their way.

This mixed picture may be why the US Federal Reserve is proceeding very carefully when it comes to tightening monetary policy. New chair Jerome Powell will replace Janet Yellen at the head of the Fed in February and he and his colleagues on the Federal Open Markets Committee will have two decisions to make:

• Interest rates. The current consensus among economists is for a rate hike on 13 December and then two to three more in 2018. If all four come through that would take the Fed target rate to 2.00% to 2.25%. That is still low by historic standards but debt is so much higher that the economy is sensitive to smaller increases in borrowing costs. Moreover, history shows that it takes an average of eight to nine interest rate hikes (or 2.00% to 2.25% in total) to put the brakes on a bull stock market – and four more over the next 13 months would take the total to eight this time around.

  US stocks have tended to hit peak after around eight rate hikes in a cycle
  

  

  Source: US Federal Reserve, Thomson Reuters Datastream

• Quantitative Tightening (QT). After Quantitative Easing (QE) comes Quantitative Tightening (QT). From October, the Fed began to withdraw monetary stimulus by letting its bond holdings mature and not reinvest the coupons on new paper. The initial withdrawal rate is $10 billion a month, but that ratchets higher in $10 billion increments every three months, so that by October 2018 the rate will be $50 billion a month. At that rate it will take the Fed until early 2024 to reduce its balance sheet to pre-crisis, pre-QE levels. The impact of QT could be a key challenge for US stocks given the apparent correlation between monetary stimulus and the S&P 500 during the QE years. At the very least, the economy and corporate earnings growth will need to accelerate to provide additional support to valuations.

  QT could be a big challenge for US stocks, given how helpful QE has been
  

  

  Source: US Federal Reserve, Thomson Reuters Datastream. Based on the plan to shrink its balance sheet outlined by the Fed in June 2016 and new chair Powell's comment he sees the programme ending in the $2.5-3.0 trillion range

Markets

Although the US stock market set a series of new all-time highs in 2017, the S&P 500 was a relatively modest performer in a global context in 2017. In total return, sterling terms, America ranked fifth out of the eight major global regions, its worst showing since 2012, although it was probably held back by lofty valuations rather any lack of optimism.

US equity markets ranked fifth out of eight in 2017

Source: Thomson Reuters Datastream, based on S&P 500 index. Total returns in sterling terms, 1 January to 30 November 2017.

Lofty valuations rather any lack of optimism probably worked against US stocks on the global stage.

After all, company earnings as a percentage of GDP stand at a near-record high of 9.3%, compared to a post-1951 average of 6.4%. Moreover, estimates from Standard & Poor’s put aggregate earnings per share (EPS) for the S&P 500’s constituents at $145. That is a record high and compares to the $40 trough reached in 2009.

But a market-cap-to-GDP ratio of 132% stands above the 2007 peak and very near the 1999 one. Neither of those dates offers an encouraging precedents and Professor Robert Shiller’s cyclically adjusted price earnings (CAPE) ratio offers equally little comfort when it comes to fathoming whether US valuations offer any margin of safety on the downside, in the event that something unforeseen does happen. A 30.5 CAPE multiple has only been exceeded twice in history, in 1929 and 1999, and disaster followed on both of those occasions.

The Shiller CAPE valuation metric has been a decent guide to ten-year returns from the S&P 500

Source: www.econ.yale.edu/~shiller/data/ie.xls, Thomson Reuters Datastream

But investors may be able to use a more prosaic indicator to see if the US stock market is staying firmly on the rails or not. Richard Russell may have died in 2015 but the legacy of the expert writer on financial markets lives on, in the form of Dow Theory.

According to Dow Theory the Transport index’s move to lead the Industrials higher is a bullish sign

Source: Thomson Reuters Datastream

The idea is a simple one. If the Dow Jones Transportation index continues to lead the Dow Jones Industrials higher, then all should be well. This is because if goods are being shipped, then they are being sold and more will be made. But if the Transports falter (and the Industrials keep rising) then there could be trouble ahead.

As 2017 draws to a close, the mixed news is that the Dow Jones Transportation index has been lagging and not leading of late. That said, the benchmark has also just set a new all-time high, helped by a powerful gain on Wednesday 29 November. Bulls will be pleased if the Transports take the lead once more, as they did after two other periods of torpid performance earlier this year.

Russ Mould, AJ Bell Investment Director

Next chapter

Read more from our World Investment Outlook 2018 series:

World Investment Outlook - Chapter one: UK

World Investment Outlook - Chapter two: USA

World Investment Outlook - Chapter three: Japan

World Investment Outlook - Chapter four: Asia

World Investment Outlook - Chapter five: Western Europe

World Investment Outlook - Chapter six: Emerging Markets