US Markets and Fundamentals

Posted: 31st July 2016

By: Stuart Lucy

US Markets and Fundamentals

IS the current bull market in the United States justified by the underlying health of the American economy?

Post GFC Recovery Snapshot

Since 2008, a broad based recovery has taken hold and ushered in a period of slow but relatively stable economic growth. This has been picked up by investors, resulting in a long running bull market on S&P 500 that culminated in the value of the index nearly tripling since it’s GFC low. However, while the growth has been relatively stable, this has also been the slowest recovery which the US has had since the Great Depression. Most economists attribute this factor to the fact that the GFC took a large toll on corporate balance sheets, particularly in the financial sector, and it will thus take many years of rebuilding companies before investment and business confidence fully recovers. As such, economic growth remains subdued and, while recent US corporate earnings have in most cases exceeded expectations, they have nonetheless suffered from a volatile global economy. Nevertheless, over the post GFC period, modest growth in GDP and corporate earnings points to an improving US economy.

US labour force fundamentals

The impact of post GFC US economic policy can also be analysed through the lenz of labour resource utilisation. Initially the picture is overwhelmingly positive: while the US employment rate took 3 years to fall 2 percentage points (crossing below the 8% level), unemployment has now halved since the GFC to reach a level that is close to pre crisis lows. However, official data should be treated with some suspicion. It is worth recognising that the UK government for instance made over 12 changes to the way unemployment was calculated in the space of a decade, with all of them reducing the rate and painting a more positive picture of the underlying economic fundamentals. Similar, but somewhat more complicated, objections are often raised about the methodology by which US data is calculated.

The participation rate brings the true nature of the recent economic recovery to light. While policy makers still appear to have succeeded in reducing the unemployment rate, the 3% fall in workforce participation since the GFC points to a far deeper problem: the emergence of a substantially larger underclass of potential workers who have dropped out of the labour market and are no longer looking for a job. Should the fall in workforce participation be added back to the fall in unemployment, the fall in unemployment would be closer to 2% since the GFC. As such, labour force data indicates that the US economy is mid-cycle, should congress be successful at designing policy to combat long term unemployment. The recent uptick in the participation rate over the past few months appears promising – we will wait to see how this pans out over the next few years.

Causes of the current rally

Despite a US recovery which is sub-optimal at best, the S&P500 has enjoyed one of its longest and most profitable bull markets in history. There are a number of reasons for this trend:

  1. Quantitative Easing – QE, particularly QE3 which occurred against the backdrop of an established bull market, complemented record low interest rates to provide a strong backdrop for an ongoing rally in US equities markets. QE3 involved the US Federal Reserve buying assets, mostly US Government bonds, at a rate of US$85bn a month. Increased demand for bonds results in falling yields, thus reducing the relative attractiveness of investing in bonds over stocks, increasing the amount of capital flowing into equity markets and driving the stock exchange up. This program increased both financial and economic investment in the US economy, thus providing a basis for current growth levels in the United States.
  2. Corporate earnings – While corporate earnings have been somewhat lacklustre in the past quarter, they have grown substantially over the past few years. It is worth noting here that, over the short term, economic factors affect both how markets value future earnings of companies (through the market PE ratio) and the profitability of companies (through the earnings themselves). While increased the increased confidence brought about by QE was successful in bringing about the former, the slow but steady US recovery has contributed to that latter. Corporate earnings have therefore contributed much needed fundamental support to the current rally, necessary in a world of market participants who are far more cautious after the GFC.
  3. The GFC bear market is, in hindsight, widely regarded as an overcorrection which markets resolved over the long term. This was primarily caused by panic amongst market participants who were either not able or not willing to buy securities and wait for a US recovery. This can be seen by reflecting on the thousands of investment firms, particularly hedge funds, which were forced to file for bankruptcy due to excessive use of leverage. This compounded the effect of deteriorating economic fundamentals on US markets, leaving the S&P500 at an unjustifiably low level which was, at the same time, a great starting point for the recent rally.

Factors to watch

  1. US Tech earnings – US companies are at the cutting edge of the latest innovations and are likely to disrupt the market over the coming years. Of particular interest are companies operating in fintech, robotics and medical research. The exponential growth in technology in any of these areas could structurally transform the global economy and turbocharge economic growth in the same way that personal computers did last century. It is worth mentioning that the 20 year post war market rally was also on the back of a technological revolution based on innovations which were developed in WWII.
  2. China – the recent market stock market crash in China’s notoriously volatile bourses has worried both Chinese policy makers and the US Fed. A hard landing in China is likely to also derail the US economy and potentially cause a global recession, given that the nation is responsible for around half of global growth. Nevertheless, the willingness of current policy makers to address issues in the economy has resulted in the economy consistently disappointing bears – especially in recent times. While policy makers, no matter how good, are unlikely to be able to fend off a recession forever, it is futile for most of us to aim to predict a recession. This view is supported by the fact that most China bears, including George Soros, are not ahead even after the last 50% drop in Chinese markets (the largest in Chinese history by volume), due to the fact that they were underweight in Chinese equities well before the recent crash and stock markets have risen over the course of their bearish positions. While the bears are likely to be right at some point, so is a broken clock once every 12 hours. As such, while a recession in China could derail US markets, be mindful of the fact that the chance of an imminent hard landing in the country still remains low.
  3. US elections – Research reveals that the stock market generally performs better under Democrats than it does under Republicans. One theory which has been advanced to explain this is that Democrats, being more likely than Republicans to support increased regulation, create the side effect of higher barriers to entry in industries and thus serve to protect the position of America’s largest companies. This benefits equity markets which are disproportionally skewed towards big business, thus driving up bourses such as the S&P500. Although a “big business” image may sound contrary to the perception of the Democratic Party as one sceptical of the top 1%, it is worth noting that the wealthiest people in the United States actually donate far more money to the Democratic Party than they do to the GOP. Furthermore, Republicans have been more likely to believe that America has a role as a “global policeman” and thus increase expenditure on military pursuits abroad – although this benefits the defence sector, it is a net withdrawal from the US economy which is likely to be a drag on markets. Please note: we maintain an unbiased position and do not believe that voters should vote for, or otherwise endorse, a candidate purely based on their impact on equity markets; consider that the debt fuelled boom in the Athens stock exchange up to 2007 was most certainly not a good omen for the Greek economy.

Does the oil price matter?

It is worth noting that, despite the strong correlation between the performance of financial markets and that of the economies in which they are based, markets contain companies which only form a part share of the US economy. Such was the case in Q1 of this year, when a collapse in oil prices wreaked havoc on Wall St, despite oil and gas making up a relatively small percentage of the US economy (keep in mind that the percentage change of the Dow Jones on the day during which it fell by 1000 points in a matter of minutes is greater than the percentage share of O&G in the US economy). As such, a collapsing oil price adversely affected financial markets in the short term, we expect this trend to be repeated in the event of another oil price shock. Nevertheless, if sustained over the long term, lower oil prices are likely to help other sectors of the US economy such as aviation, manufacturing and construction. The effect of these changes are likely to wipe out any effect caused by a lower oil price, thus contributing to higher US corporate earnings.

Conclusion

While both financial markets and the US economy have performed well since the GFC, there are a number of structural factors which have the potential to drive US markets higher over the coming decade. Although there could be a small recession in the interim, a repeat of the GFC is highly unlikely and US economic fundamentals will provide the backdrop for a strong rally in American stocks over the next few years. Despite volatility, US markets will almost certainly be trading at higher levels in 10 years’ time. We thus hold a strongly bullish long term buy recommendation on US markets; to this end we endorse a line from Warren Buffett: “Our favourite holding period is forever”.