So far this year a significant overweight exposure to US equities would have benefited portfolios. Charles Hepworth outlines why he is now taking a more global view, allocating away from the US, which he views as looking overvalued.
It is a very topical time to talk about US markets given the recent drawdowns. At the start of 2018 the consensus view was that US expansion was still delivering but moving into a later phase of the cycle, whereas emerging markets (EM), Japan and Europe were still in their infancy in terms of expansion and recovery.
Tax cuts introduced by President Trump at the end of last year were expected to widen the deficit in the US, but this stimulus would also be beneficial for global expansion, in particular in EM, energy and materials. Yield curves were predicted to steepen, which would likely encourage other central banks to rein in monetary easing. Meanwhile the US dollar was forecast to weaken and higher rates would mean value stocks, financials and EM would outperform, while technology and growth would underperform.
As ever, expectations do not always come to fruition. In reality, the trade war rhetoric coming from the Trump administration escalated rapidly, resulting in aggressive tactics against the rest of the world, not just China. This led to a significant depreciation in the renminbi in July, effectively destroying the consensus view outlined above.
For much of the period since August 2016, global markets have largely moved in tandem. However, in 2018 they have become more negatively correlated: US markets have continued to rise higher, while much of the rest of the world has dwelt in negative territory. In our view, this scenario is strange given the underlying dynamics of the US market.
We believe there are several key issues relating to valuations in the US market and the stimulus being applied to it. Firstly, the Citi Economic Surprise index appears to have completely disconnected from US equity trends; signs of worsening data have been ignored and the equity market has marched on regardless. In our view, this trend is not sustainable.
The US CAPE index, which shows the P/E ratio based on inflationary-adjusted earnings from the previous 10 years, is currently over the ‘warning’ level of 25 times for only the fourth time since the start of last century, indicating the market is overpriced. The reverse CAPE index, which compares earnings yields with the risk-free rates from Treasury bonds, suggests we are now in a situation where the rate on Treasuries is more attractive – another sign that US equities are not cheap.