The current US economic expansion ranks as the third longest on record and markets seem content to assume it will continue indefinitely. We see scope for growing inflationary forces to surprise markets and precipitate disruption.
The status of the US as the world’s most dynamic and important single country economy remains well intact, not least among investors. Its strengths are now very much reflected in financial market valuations. This is evident in stocks, with the US having been at the vanguard of a multi-year bull run, while bond yields have reached extended levels.
One key support for this has been economic strength. The economy has been in an expansion phase since 2009, 101 months. This is the third longest expansion on record after the 120 months ending with the dot-com crash in March 2001 and a 106 month phase in the 1960s.
Economic expansions do not usually die of old age, but it is hard to refute the idea that the US upswing may now be entering its last leg. This is if nothing else by virtue of its own strength and the reality of economic cycles. Current valuations in markets and the very low levels of volatility suggest markets do not foresee any disruption to the status quo. Should economic and growth conditions persist as they are, however, inflationary pressures will start to become a problem potentially necessitating a response from the Federal Reserve (Fed).
A number of measures point to the maturity of the US cycle. The household wealth/income ratio is at an all-time high of 670%, compared to previous highs of 657% in 2007 and 613% in 2000. This measure reflects the level of financial assets versus income of individual households, indicating a high level of participation in financial markets by individual investors. Consumer and business sentiment are strong. According to the Chicago Federal Reserve, financial conditions are the easiest since 2004 even after four interest rate hikes.
The unemployment rate is near an all-time low at 4.4%. Over the past year the number of jobs added has exceeded growth in the labour force by 100,000 a month. If this rate is maintained unemployment would reach 3.5% over the next 12 months. In certain metropolitan areas of the country where unemployment has already reached this level, wages are rising at 4%. If that were to become more widespread, the below-target headline inflation, which has puzzled even Fed Chair Janet Yellen, would soon disappear.
Added to this, President Trump continues to laud plans for grand fiscal reform. Even if the economy doesn’t reach the point of problematic inflation of its own accord, fiscal stimulus might do it.
This scenario could precipitate a significant overhaul of the current market consensus, according to Robin McDonald, Fund Manager, Cazenove Multi-Manager. “We have depression-level interest rates with boom-level equities. The market is assuming growth without inflation and no threat from the bond market,” said McDonald. “I do not think the bond market or the equity market have priced anywhere near what the Fed might have to do if wages start rising at 4%,” he said. “There would be a big hit for bonds, a big headwind for a lot of the leadership assets in the equity market, and a big tailwind for things like value stocks.”
Nick Kirrage, Fund Manager, Equity Value, said the hitherto highly constructive opportunity set for value investors in the US has dried up with a handful of opportunities remaining in retail.
Kirrage highlighted the elevated tangible book value per share (TBV) of the S&P 500, currently 24x, which is high by historical standards and compared to other regions. The TBV of Japan’s Topix, ex-financials, currently stands at 1.9x.
Kirrage sees a number of “anecdotal” warning signs, for example a 30-year low in cash held in Charles Schwab retail accounts and the low level of the Vix volatility index.
“Look at the FAANGs ( Facebook , Apple , Amazon.com , Netflix, Alphabet ) and Tesla; people are willing to back concept stocks with very large amounts of money,” Kirrage said. “Cryptocurrencies is another thing which suggests people are speculating and speculating quite aggressively.”
“One thing that is always a huge lag and is very late cycle is wholesale merger and acquisition activity, which we are yet to see,” he continued. “We have seen some big deals and I’ve thought ‘this is it’ a couple of times…but we have not seen tonnes and tonnes of it.”
“It’s this context where various little things, none of which they teach you in CFA, together feel unnerving.”
Hugo Machin, Co-Head of Global Real Estate Securities, said that four of the five strongest cities worldwide are in the US. This is in particular because US cities have been better placed to take advantage of the rise of technology companies and the “knowledge-based economy”.
“If you look at why the west coast of the US ranks so highly, it goes back to that knowledge base. It is very obvious to us that universities have become a real magnet in terms of where companies have to be to meet the almost insatiable demand for developers and programmers,” said Machin.
“ Amazon.com is looking for a location for its second headquarters. They need 50,000 people at an average of $100,000 salary. There are not that many places they can go. They need mass transport and a lot of smart people. It has never been more important to pick the right locations.” The Global Cities team is optimistic about this development, but caution that the ability to deliver sustainable returns will increasingly depend on investing in the right location, sub-sector and companies.
There is significant bifurcation between sub-sectors and the traditional approach of buying and holding office or retail bricks and mortar seems increasingly obsolete. This is showing up in the relative performance of property securities with warehouse owners and operators outperforming retail real estate. Underpinning this is ecommerce and the resulting increased demand for warehouse space. Online retail is now about 16% of $2.5 trillion of annual retail sales in the US. This leaves a lot of room for growth, Machin says. “For the next generation it’s second nature to buy things on your smartphone,” Machin said.
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