The idea of American Exceptionalism has been a favourite rhetorical device of US presidents since the days of John F. Kennedy. It goes beyond conveying the sense that the country is richer and more powerful than other countries, but also that its unique culture and historical path render its destiny superior.
Ironically, it appears the phrase itself was coined by Joseph Stalin (or someone in his inner circle). The Soviet dictator was weighing in on the debate in communist circles that American capitalism was not fertile soil for the Marxist revolution they deemed inevitable everywhere else.
Investors are familiar with America’s financial exceptionalism. The saying ‘when America sneezes, the world catches a cold’ is one of those trusty market aphorisms commentators like to trot out, along with any number of Warren Buffett quotes.
The biggest by far
America is the biggest national economy in the world, responsible for around a fifth of global economic output (though China is quickly catching up).
However, American-listed companies represent more than half of global equity market capitalisation, while the American bond market (government and corporate) also accounts for around half of global outstanding traded debt.
To that one can add the US dollar’s reserve currency status, and its disproportionate share of global foreign exchange markets (around 80%) and use in global trade invoicing and funding, and of course the fact that most commodities are priced in dollars.
America plays an out-sized role on global financial markets, which is why we all pay such close attention to developments there, especially monetary policy (which sets dollar interest rates). More on this below.
This does not mean, of course, that American financial assets always outperform the rest of the world. Markets are cyclical in the US and elsewhere.
For instance, since becoming a free-floating currency when President Nixon broke the gold peg in 1971, the US dollar has experienced three big multi-year bull markets. The third such bull market started in 2011, and therefore we are probably closer to its end than the beginning.
Chart 1 – US dollar index
Source: Refinitiv Datastream
Similarly, US equities don’t always outperform. However, they have done so spectacularly over the past decade.
Last week, the benchmark S&P 500 Index reached a new all-time high of 3,508, exactly six months after the previous peak. In other words, the coronavirus-related losses have been recovered.
In contrast, other notable national indices are well off previous records. As we are all too aware, the FTSE/JSE All Share’s record of 61,684 set in January 2018 still seems distant.
The UK’s FTSE 100 peaked a few months later at 7 859 points in May 2018. However, its current level of 6,115 was first breached in 1999. That is two decades of going nowhere.
Similarly, the French CAC 40 Index, currently around 5,000 index points, peaked in 2000. Australia’s S&P/ASX 200 Index finally surpassed its 2007 peak in mid-2019 year and set a new record in January of this year. But it is still 14% below this point.
MSCI’s Emerging Markets Equity Index is still below the 2007 record when measured in dollars. The biggest laggard by far is Japan’s Nikkei 225, which might never retest its 1990 record of 38,915 points, currently languishing at 22,985 points.
All the above numbers refer to the index price level, excluding dividends. The picture would look better for the individual countries if dividends were reinvested (i.e. on a total return basis), but it wouldn’t close the gap with the US.
Chart 2 – Ratio of US to non-US equity performance in dollars
Source: Refinitiv Datastream
MSCI produces an index of non-US global equities stretching back to 1987. Chart 1 earlier shows how the ratio of US against non-US equities since then.
When the line rises, as in the 1990s and the 2010s, US equities were outperforming, while in the late 1980s and early 2000s global shares outperformed. Chart 2 above shows the trend since the end of the Global Financial Crisis in 2009.
The dollar performance of South African equities is also included as a comparison. Our market has mostly performed in line with non-US equities over this period. The US, not SA, has been the outlier since 2009.
Chart 3 – US, non-US and South African equities since 2009
Source: Refinitiv Datastream
Clearly the dollar plays a role. Since returns from many different countries are translated into a single currency, a strong dollar will make US performance look better and vice versa.
There is also a deeper reason at work. Periods of dollar strength are associated with tightening global liquidity conditions. Dollars grease the wheels of global commerce, and when they are expensive, it has a range of knock-on effects.
One of these is to make it more costly to service dollar-denominated debt. While the dollar is at no risk of losing its reserve currency status (there is simply no other currency that can currently fulfil that role), that does not mean it cannot have periods of cyclical weakness.
If a period of dollar weakness lies ahead, as many expect with US interest rates no longer significantly higher than anywhere else, this should support the non-US equity returns, particularly emerging markets.
What lies ahead?
That is ultimately the proverbial million-dollar question: over the next decade, is it the US or the rest that outperforms?
To answer that, we first need to get into some of the other reasons behind the performance gap, and then consider valuations.
The 800-pound gorilla is America’s world-beating technology sector. In particular, the famous five of Facebook, Apple, Amazon, Microsoft and Google are simply in a different league.
Since the COVID-19 pandemic, they appear to be on a different planet. They’ve pulled the US market higher even while other companies and sectors that rely on the movement and physical interaction of people languish.
In the process, these five shares now account for almost 25% of the S&P 500, making the index the most concentrated in decades. Apple became the first company valued at $2 trillion dollars last week. That is almost five times more than the total market cap of the FTSE/JSE All Share Index.
Why these so-called growth stocks can do so well in a world of low growth is puzzling to many?
It is not just that these companies make more money as more people shop, work and play at home. They are certainly profitable now (which is the big difference from the 2000 tech bubble) but in a world of near-zero interest rates, the present value of the profits they are set to make far into the future become so much more valuable.
In contrast, European and emerging markets are largely dominated by ‘value’ shares that are cheaper but need a strong economy for the discount to be unlocked (a notable exception being Chinese technology companies like Tencent).
In other words, it would take stronger economic growth and rising interest rate expectations for the decade-long out-performance of growth stocks (and by implication, the US market) to end.
Two other supports for US markets might fade in the meantime. US companies have been much more aggressive in buying back their own shares than in other parts of the world in recent years.
More broadly, US company executives have been much more faithful to the creed of maximising shareholder value than the principle of acting in the interest of a broader set of stakeholders, including labour.
However, the political mood around this is changing and late last year a group of top US business leaders announced that companies’ narrow focus on shareholder primacy needed to be expanded.
One can expect that the COVID-19 shock will further change the way people view this. Share buybacks have indeed declined sharply since the pandemic hit, though that is probably more due to companies conserving cash.
The 2017 corporate tax cuts also delivered a one-off boost to the profitability of US companies relative to other countries.
A Democrat sweep in the November elections will almost certainly lead to a reversal of those tax changes and usher in more of the policies that force companies to look beyond simple profitability. (This might include higher minimum wages, stricter environmental regulations, paid parental leave and so on.) If Joe Biden wins the White House but not the Senate, a period of policy gridlock might loom.
We’ve had a taste of stalemate in recent weeks, with a failure of Republicans and Democrats in Congress to extend key emergency pandemic unemployment benefits.
Still, between the Federal Reserve and the CARES Act passed by Congress in March, the financial response to the pandemic has added up to trillions of dollars, and as a percentage of total US national income, was one of the strongest in the world. This is in contrast to the public health response, which was remarkably (some would say predictably) uncoordinated and chaotic.
The Fed is likely to err on the side of extreme caution. The bond market wobbled a bit last week when the minutes from the most recent policy meeting showed that polices targeting a specific level of long bond yields (as the Bank of Japan does) are not under serious consideration at the moment. But the minutes do show that Fed officials are willing to step up the policy response if needed, particularly by committing to keeping rates low-for-longer, even if inflation rises.
This gets us to valuations. Relative to its own history, the US market was last this expensive in the throes of the dotcom bubble, though valuations moved even higher then. Interest rates were also much higher though.
Valuations are not market timing tools, and US equities can continue rallying for some time.
However, the current valuations do tell us not to get too excited about the long-term return prospects from US equities. It is hardly worth talking about the long-term return prospects of US government bonds, or those of any other developed country for that matter, since only persisted deflation can generate long-term real returns from the current record low yields.
There is no question that the US market is more expensive than non-US markets. It currently trades at 22 times the expected earnings over the next 12 months, compared to 16 times for the MSCI All Country World ex US index. That does not necessarily tell us much, since the US usually trades at a premium, but the gap has grown wider and wider.
Chart 4 – US and non-US 12-month forward price: earnings ratios
Source: Refinitiv Datastream
South Africans tend to look at investing as a binary choice of local versus offshore, and recently the attitude seems to have been to get money out of the country as fast as possible with little consideration for where it is going.
Clearly, global investing in general and global equities in particular have their own complexities that investors need to consider. The out-performance of US equities has gotten rather extreme, and extremes tend not to last in markets.
While it almost never pays to bet against America (another famous Buffett quote), it looks like it will pay to have substantial non-US equity exposure in a diversified portfolio in future.