SustainAbility: Is the US becoming less equity friendly?

As Lenin said, ‘There are decades where nothing happens and there are weeks where decades happen’. The momentous events of the last week, in the White House and beyond, have the potential to rewrite some of the fundamental underpinnings of investment markets.

While no one has privileged access to the future, here are a few thoughts on the potential implications of the fall out between the US and the rest of the world.

Geographic exposure

Investing has been a relatively simple game over the last decade: overweight the US and ignore everything else. This has manifested itself in huge flows into global funds and the US stock market. In many ways this has been entirely rational. After all the US is managed to the benefit of the stock market, whereas Europe and Asia have been managed to the benefit of the debt markets. This is self-evident in the relative returns of these markets. Is this changing?

When Trump was elected, our belief and the belief of many was that the S&P 500, the US stock market, would be his key indicator of success. This may ultimately be the case, but he and his Treasury secretary have been much more focused on the debt market, and many of their actions have been suggestive of their priority to get the cost of debt down, rather than equity prices up.

This makes sense. Back in 2020, during the pandemic, interest rates were cut to levels which allowed governments and corporates to borrow at near zero cost. With the average length of debt being around five years, this will now need to be refinanced. Many entities, including the US government, may struggle to absorb higher interest rates which will be more like 5% than 0%. Getting the cost of debt down is, for now, more important than getting equity markets up.

At the same time Europe is enacting a growth agenda. Admittedly, this is in relation to having to re-arm itself, but the Achillies heel of Europe, its reluctance to run deficits to fund growth, is being removed at speed. This is negative for European bonds, but positive for European equities. China too is re-embracing the corporate sector. Jack Ma, founder of Alibaba, who was banished after criticising the Chinese government has now reappeared with the Chinese president. China is, at the margin, becoming more equity friendly.

In totality, this is an inversion of the trends of the last decade. US equities are becoming less attractive at a time when European (including the UK) and Asia markets are becoming more so. Most investors are positioned the opposite way and were this to become a more permanent feature of markets, significant amounts of capital would need to move.

In totality, this is an inversion of the trends of the last decade. US equities are becoming less attractive at a time when European (including the UK) and Asia markets are becoming more so.

Of course, we are not predicting this. There are arguments that are strong counterpoints, such as the plans to deregulate and reduce taxation in the US, which should increase its attractiveness relative to Europe. Any bullishness about Europe also does depend on a peaceful outcome to the Ukraine conflict. Markets are made at the margin however, and the US is becoming less equity friendly whilst Europe and China are becoming more so.

Recession or not?

One of our messages in recent years is that investors have been overestimating the probability of a recession in the US. This was due to a general bearishness in investor mentality (recessions are quite rare at about 15% of the time since 1935, whereas investors constantly fear one is around the corner), deficit spending supporting economic activity, and the wealth effect of record house and investment prices.

There is no doubt however that daily policy changes in the form of tariffs and deficit reductions are hitting US corporate and consumer confidence. Where should a company build its next factory? Will Elon Musk fire me this weekend? This is reflected in some lead indicators for the US economy weakening in recent weeks. It is one reason why the US equity market has fallen.

On balance, it is not our central case that we will see a recession this year in the US. The banking sector, the origin of most credit creation, is in a healthy condition and there is lots of potential to cut interest rates in the face of a slowdown. That said, investing is a game of probabilities, not certainties, and the chances of an economic air pocket are higher than a few weeks ago.

Sector exposures

Another consequence of recent events is the changing shape of sector performance. Unsurprisingly, defence stocks have performed exceptionally well as countries commit to increase expenditure on armaments. Oil stocks have been weak however, as many of the bridges Trump is trying to build are to major oil producers such as Russia and Saudi Arabia. If ‘the art of the deal’, the book which Trump wrote about his approach to business is correct, lower oil prices out of Russia will be attractive to the Trump administration in return for intervening in geopolitical situations.

The banking sector continues to perform strongly. If European growth and yields increase, as they should do if Europe spends more, banking profitability will be a key beneficiary. European banks have outperformed for each of the last four years, and this still under owned and unloved sector would continue to do so.

What will happen to the magnificent seven, the US technology companies which have led global markets and portfolios for so long at the expense of almost everything else? In the short term they will be a source of funding for evolving portfolios away from the US, and they have already been weak for this reason. In the long run it is more nuanced. If AI is for real, and in our view it is more likely than not that it is, then these stocks will be key beneficiaries. Equally some of them remain reasonably priced after recent moves. This leaves the case for them balanced, but perhaps not as universally positive as it once was.

Conclusions

Investors have been left wondering if the investment environment has structurally changed in the last week. Will investment performance come from different regions and sectors than in the past? If the US is increasingly being run for debt investors at the same time as its economy is slowing, and Europe is being run for equity investors at the same time its economy is accelerating, that is a big change. Add in a more favourable market in China and it is possible to see a very different future than what we’ve experienced in the past.

Investors, of course, do not need to be binary. It is possible to have exposure to all the areas noted above in a portfolio. That may be lesson of the last week. Sources of investment performance are becoming broader, by geography and sector, and that will require some degree of change from the narrow, US tech-led portfolios which have been successful in recent years. This view is of course subject to change based on the next social media post from the President of the United States!

For professional investors only.  This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.