American Exceptionalism! Don’t Extrapolate

The Economist in April 2023:

• America’s economic outperformance is a marvel to behold
• The lessons from America’s astonishing economic record

Three quotes:

• America’s dominance of the rich world is startling. Today it accounts for 58% of the G7’s GDP, compared with 40% in 1990. Adjusted for purchasing power, only those in über-rich petrostates and financial hubs enjoy a higher income per person. Average incomes have grown much faster than in western Europe or Japan. Also adjusted for purchasing power, they exceed $50,000 in Mississippi, America’s poorest state—higher than in France.
• Investors who put $100 into the S&P 500 in 1990 would have more than $2,000 today, four times what they would have earned had they invested elsewhere in the rich world.
• On a whole range of measures American dominance remains striking. And relative to its rich-world peers its lead is increasing.

Nearly one year later, American exceptionalism is on everybody’s mind.

Ed Yardeni illustrates how U.S. equities have totally outperformed world markets over the past 15 years, both in local currencies and in dollar terms:

In dollar terms, U.S. MSCI revenues jumped 65% since 2008 while World-ex-US revenues declined 20% (+16% in local currencies).

Since the pandemic, U.S. MSCI: +30% vs World-ex-US: –5% (+5% in local currencies).

These next 2 charts compare U.S. revenues with developed countries-ex-US in dollar (left) and local currencies (right).

  

The Economist again: “The world’s biggest economy is leaving its peers ever further in the dust”.

Trends are not always our friends. After a while, we tend to take them for granted, they become “natural”, ingrained, widely expected. Without a complete understanding of how they happened, we may be surprised when they end and reverse.

This chart from J.P. Morgan Asset Management shows that

over the past 50 years, there have been different regimes of U.S. vs. international outperformance. In other words, outperformance comes in waves. After a long period of U.S. outperformance, it is worth considering whether we may be transitioning to a new wave.

Source: FactSet, MSCI, J.P. Morgan Asset Management

Growth arises from many sources. The American economy benefits from several advantages compared its world competitors. To list a few:

• population growth, including immigration
• education
• productivity, dynamism, flexibility
• innovations
• energy
• dollar

These attributes have long been mainstays of the American economy over time and cycles.

One additional source of growth has emerged since 2008: the U.S. government has significantly intervened in the economy, boosting its expenditures from 21% of GDP to its current 25.5%, doing so with borrowed capital as opposed to higher revenues.

In fact, every economic shock since 1981 was used to substantially boost the U.S. debt leverage, without subsequently restoring the debt ratio. The jump in leverage since the GFC has been nothing short of spectacular: the federal public debt exploded from 62% of GDP in 2007 to 120%, in 15 years!

Among G7 countries, only the U.K. boosted its debt leverage faster than the U.S. since 2010. For the average G7 countries ex-USA, debt to GDP increased by 14 percentage points (+18%). Meanwhile, debt leverage rose by 27 pp or 39% in the USA.

In effect, the U.S. government’s increased spending provided additional revenues to the private sector without any offsetting contribution extracted from corporations or citizens.

The budget space provided by the huge decline in interest rates since the mid-90s was entirely used to raise spending and debt.

As a result, interest expense now represents 15.4% of the government budget, up from 9.2% in 2010.

• The most recent projections from the Congressional Budget Office confirm once again that America’s fiscal outlook is on an unsustainable path — increasingly driven by higher interest costs. Growing debt, in addition to the rise in interest rates over the past couple of years, has significantly increased the cost of federal borrowing. In 2023, interest costs on the national debt totaled $659 billion — surpassing most other components of the federal budget. (Peterson Foundation)
• The debt is growing faster than the economy, so it is unsustainable. It’s time for us to get back to putting a priority on fiscal sustainability. And sooner’s better than later. (Jay Powell at 60-Minutes)

Keep in mind that the CBO projections naively assume that inflation, real growth and real Treasury yields will all average 2% over the forecast horizon.

About one third of Treasurys will be maturing during the next 12 months, very likely with a steep markup on renewals, taking even more budget space, crowding out more discretionary spending.

This means that the federal government is losing considerable leeway to adjust spending to economic needs and its discretionary expenditures are unlikely to provide the same economic impetus as they did since the GFC. The CBO’s baseline (and naive) projections have discretionary expenditures declining in 2024 and 2025 rising very modestly thereafter but actually declining in real terms.

The American stars (and stripes) neatly aligned themselves after the 2008-09 GFC. The federal budget exploded under both Democrat and Republican governments (R.I.P. the Tea Party) while interest rates were brought to zero. Corporate tax rates were drastically cut in 2018.

The pandemic prompted the U.S. government to further boost spending and the Fed to flood the economy with liquidity. Americans merrily spent their pandemic bounty. Meanwhile, broken trade channels and the trade dispute with China are inciting businesses to reshore production, encouraged by significant government subsidies and increased protectionism.

Manufacturing construction doubled (+$110B) since mid-2022, ten times faster than GDP, while manufacturing shipments and new orders stagnated. Actually, manufacturers spent twice more building plants in 2022-23 than during all previous 20 years.

Manufacturing capacity utilization peaked at 80% in April 2022, highest in 22 years, from 76% pre-pandemic. It has since dropped to 76.5% and is likely to get lower as the more recent projects get completed.

Most of this new capacity is not to meet new demand, creating overcapacity, mainly in China, that is now fighting for new orders, likely displacing other production in a deflationary domino effect.

The war in Ukraine also benefitted defense spending in the U.S..

Industrial production in the U.S. defense and space sector has increased 17.5% since Russia launched its full-scale invasion of Ukraine two years ago. Business is coming from European allies trying to build out their military capabilities as well as from the Pentagon, which is both buying new equipment from defense manufacturers and replenishing military stocks depleted by deliveries to Ukraine. (WSJ)

Looking ahead, many important changes are likely:

• Consumer spending will normalize, with increased volatility. Since 1959, the personal savings rate has only been lower than the current 3.7% during the 2005-08 period when Americans splurged on housing, and briefly in 2022, in total only 7% of the time. Before the pandemic, the savings rate ranged between 5.0% and 8.5%.
• Construction spending will also normalize. Since 2010, total construction spending grew 50% faster than GDP, carrying a high economic multiplier.
• Government spending ex-interest expense will measurably slow down.
• The unemployment rate is at a historical low. Employment growth will slow.
• American politics are getting increasingly toxic and inefficient.

Investors are paying top valuations for large cap stocks, clearly extrapolating the past without appreciating that the true American exceptionalism actually is all the exceptional factors that boosted its economy since 2009 and oblivious to the rising risk from its indebtedness as interest rates normalize.

We may well be in a melt-up fueled by Goldilocks sentiment and passive investing mechanically boosting the Magnificent 7 stocks, but the risk/reward ratio has reached a mined no-man’s land area.

J.P. Morgan Asset Management agrees:

Indeed, the stars do seem to be aligning for international to take the baton from the U.S. over the next decade, including: cheaper equity valuations, cheaper currencies and a combination of cyclical and structural investment themes than can help boost long-term returns.

The panel below shows valuation measures for international equity markets. The left-hand side shows the price-to-earnings discount of international vs. U.S. equities. On the right-hand side, we show the difference in dividend yields between international and U.S. stocks.

We can see that international equities are trading at a significant discount right now and that they offer an attractive yield pickup relative to U.S. equities on average.

Ed Yardeni offers these absolute P/E charts:

(MacroMicro)

Another way to contextualize current valuation ratios from JPMAM:

Since 2009, this blog has been discouraging country diversification: in single words, Europe was seen as unmanageable, Japan as unscrutable and China as uninvestable. By comparison, the U.S. was very likable, and mostly reasonably valued.

Nobody knows how long the U.S. will remain such a magnet for capital and what will trigger the change in sentiment. But alternatives are now more interesting, allowing for at least some diversification.

Back in 2009, U.S equities were selling at a discount to the world as the GFC made it “uninvestable” to many (one reader called me a “bloody fool” after I wrote a very bullish post in March 2009). The current premium is the largest ever as the U.S market has become “the only one”.

According to Bank of America’s latest fund manager survey, institutional investors are overweight US stocks, but even more worrisome may be the concentration in smaller investor portfolios. According to a recent Wall Street Journal article citing Vanda Research, the average individual’s stock portfolio has 40% of its value tied up in just three tech stocks! (…)

Eventually, high valuations and unattainable growth expectations lead to disappointments and significant devaluations. The subsequent period of deteriorating fundamentals and weak returns causes the pendulum to swing to opposite extremes.

As a result, periods of significant outperformance tend to be followed by periods of significant underperformance, reversing much of the previously earned extraordinary gains, even for the biggest of secular themes. Positioning and valuation suggest that investors expect the US equity dominance of the past 15 years will last indefinitely, but history seems to suggest otherwise. (…)

When coupled with the prevailing bifurcation of sentiment and record market concentration, the current juncture may offer investors a once-in-a-generation opportunity to rebalance portfolios. Just as in the wake of the Internet bubble, what part of the market you own could mean the difference between another lost decade of returns for crowded and expensive assets or very attractive returns or assets where capital is truly scarce. (RBA)

To be sure, many alternatives carry their own stigmas: the Eurozone is still largely disfunctional and China is still China. But big opportunities generally hide in plain sight, particularly when nobody wants to look.