Peak US Exceptionalism?

‘The right thing for the Fed to do is to maximize economic performance. The right thing for the president and Congress to do is to adjust the tax system to make a fairer economy. We should have higher corporate tax rates, full taxation of carried interest and capital gains, close loopholes that allow capital gains to escape taxation, tax penalties on leveraged buybacks and limit corporate interest deductibility.’ Former Treasury Secretary, Larry Summers interviewed recently

The points made in a note entitled ‘Fed Firepower Overwhelms Fundamentals and IB Consensus…’ back in early April are now widely accepted and remain key. Policymakers were attempting to make everyone ‘whole’ on their pandemic losses, from furloughed workers to mismanaged hedge funds and until bond markets stage a mutiny, will continue to do so – there was no point overthinking it. The past couple of months is a reminder that the intuitive notion that markets and economies track together is hugely misleading and gives economists a deluded claim to be able to help (rather than usually hinder) the investment process.

There is almost no correlation between US stock returns and real GDP growth contemporaneously, and it remains modest even a year ahead. Unlike say last summer, when PMI inventory/sales data etc. were giving a lead to a growth reacceleration and risk on signal, in the current situation, there has been little practical gain in poring over diffusion indices – granular data on consumer activity and corporate outlook statements have been more useful guides.

There has been too much ‘the pandemic changes everything’ analysis, but we’ve highlighted the underlying strength in the US economy coming into this crisis e.g. in housing, with its household formation as well as mortgage cost underpinnings. The MBA Purchase Applications Index is another ‘V’, soaring from 180 in April to 325 in June, up 20% y/y, while median home listing prices have jumped from -1% in April to +8% on Redfin data.  Whether the pandemic has boosted per capita housing demand on a sustained basis (urban apartments to suburban houses with dual work from home space) remains to be seen, but regardless Millennials who have married and started families later than previous generations for a variety of reasons (not least student debt) will be buying houses at a faster pace. Starts should rebound strongly in H2, and resurgent lumber prices bear watching as a signal – it would also add support to the copper rally. On Google trends data, new vehicle related search traffic has turned positive y/y for the first time since February, confirmed by the Mannheim used car index rebound since May.

Often the headline numbers have been misleading in any case e.g in relation to US unemployment and the perverse incentives of workers and businesses to game the system. That macro data will become relevant again as the ‘bungee jump’ distortions abate and economies reopen further to confirm or refute investor assumptions on the speed of the potential earnings recovery, as in China right now. The cross asset return expectations distribution curve is still skewed to deflationary outcomes, which looks dangerous as redistribution and reshoring become dominant political themes, against the backdrop of fiscal and monetary policy convergence. Assuming there is no ‘fiscal cliff’ in July and most support measures are extended (adding another 4-5% of GDP in stimulus), bond investors risk a shock by mid-late 2021 if the labour market re-tightens surprisingly fast in a post vaccine world and inflationary pressures accordingly return.

The consensus has capitulated since May on views including that we were likely to see a retest of the March lows, that this was ‘just a bear market rally’, that negative US rates were even a possibility worth discounting etc. The ‘Great Depression’ economic analogues and technicians overlaying 1930 price charts on 2020 ones have been shelved. Aside from the historic scale of global stimulus, three factors have been pivotal to sparking the risk-on frenzy: firstly, the rapid rebound in Chinese industrial activity, reflected in mainland oil, copper and iron ore demand, to feed resurgent infrastructure spending and housing starts. Excavator sales have also jumped in Q2, and the GPS tracked utilisation rate for Komatsu excavators in China has hit the highest since late 2018. Secondly the reduction in Eurozone tail risk via breakthrough debt mutualisation proposals, aggressive German fiscal reflation and expanded ECB peripheral buying and thirdly the unemployment insurance/PPP transfer windfall in the US which has offset the household earned income impact of the lockdown, and exaggerated the scale of the (still severe) employment downturn.

So far, reopening in Europe and Asia is proceeding remarkably well despite inevitable regional/city level clusters, the US clearly less so as sensible public health advice gets politicised and dragged into the culture wars. Consensus expected 2021 EPS is about $164, putting the 2021 forward PER at 20x, versus 18x at the February high – the Fed trillions are surely worth a couple of points of multiple expansion, but now as the data improves, things get more nuanced from a policy perspective. An optimistic forecast at this point might be 2021 EPS of $175 (i.e. the 2020 EPS expectation pre lockdown) but a growing risk for US equities after record outperformance relative to ROW is that the Democrats sweep to power and push through a progressive agenda, from tech regulation to tougher ‘gig economy’ labour legislation.

The partial rollback of the 2017 tax cuts Biden has endorsed would take $20 or so off whatever EPS number you project for next year. The other key issue for relative US performance into next year is belated anti-trust scrutiny of the tech sector. So far, fitful attempts at a pro-cyclical value rotation have faltered on Covid headlines, despite the overextension of tech growth/the quality factor and the risk that we have seen a ‘front loading’ in Q2 of secular online transition trends. At historic EV/sales and FCF multiple software sector valuations, any disappointment would trigger a deep selloff given crowded positioning. Fifty state attorneys general are probing Google’s digital advertising business practices, alongside a similar probe being led by the Department of Justice, which marks the first serious attempt (with bipartisan support) to overhaul anti-trust law and curtail the inherently winner takes all dynamic of web platforms. In the EU, Apple faces new investigations extending from its app download duopoly with Google to NFC payments.

The systematic tax arbitrage of digital IP (notably via Ireland) which has suppressed effective tax rates for US tech (and pharma) over the past decade faces OECD scrutiny and an inevitable move to some form of local revenue based inferred minimum tax. While the Trump administration is willing to risk a transatlantic trade war on the issue, a Biden one seeking multilateral consensus almost certainly won’t. That earnings tailwind would likely drive a rotation out of large cap tech, which dominates most portfolios (including fast growing ESG ones) and has reached a record share of US and global indices. Meanwhile, a successful vaccine this autumn would clearly be a game changer for the economic outlook beyond 2021 and justify a more procyclical, value oriented portfolio stance. Among several promising candidates, Astra Zeneca’s vaccine partnership with the Oxford Jenner Institute and the Gates Foundation bears close watching, which is heading into Phase 3 trials in Brazil and is scaling production capacity to 2bn doses, succeeds this autumn.

We’ll know in September…what will that do, after the astonishing monetary/fiscal stimulus seen globally, to the growth and inflation outlook beyond next year? We would enter a classic end of cycle blow off phase, because the fiscal and capex spending drags which had delayed it are gone – politics now matters more than anything, and tacking inequality and climate change in the wake of the pandemic implies a generational regime shift for asset markets. Rather that worrying about ‘V’ shapes and trying to second guess epidemiologists, the bigger questions right now for asset allocators are whether the US is approaching a peak share of MSCI AC and if we are beginning a shift to a structurally inflationary environment. Both look reasonable bets to us…