US equity valuations are reflecting fears of a recession despite conditions for one seeming unlikely, according to research from JP Morgan Asset Management (JPMAM). 
Christian Preussner, head of US equity client portfolio management team, says the spread between the highest valuations and lowest valuations in the market have reached near all-time highs.
“We have reached an extreme level that has only been seen in the Lehmann crisis and in the TMT bubble before in terms of spread,” he said.
Over the last three years the US market has far outperformed the other major regions of the world, returning 69.84 per cent to investors, mainly due to the rise of defensive growth companies.
Performance of indices over 3yrs
Source: FE Analytics
Even this year, with much uncertainty surrounding the political situation in America and the Federal Reserve’s apparent caution in lifting interest rates, the market has been the second best performer behind the resurgent emerging markets.
But this prolonged period of success has led to questions over whether the US could be facing the prospect of a recession sooner than many investors have priced in.
Maria Paola Toschi, global market strategist at JPMAM, said: “The recession has become rarer compared to the past. Now we are living in an expansionary cycle, that has lasted 84 months and this is the fourth in terms of duration since the beginning of the last century.
“Since the beginning of the 1980s we have seen only three recessions out of 134 quarters, meaning the probability ratio is something like 2.2 per cent.”
While this makes a recession unlikely, there are some factors, she says, that could suggest a downturn in the US economy.
“When we talk about the US economy I think it is very important to consider that the manufacturing sector is not in a very exciting shape,” she said.
“Investment is still high but real capital goods orders are still declining and the business spending is probably still missing in many developed economies including the US.”
While this is leading to slower growth, with this period of recovery the slowest dating back to 1948, it is unlikely to be recessionary, according to Toschi.
She says that a decline in investment, of skilled workers, and of improvement in the efficiency of production, have all meant this recovery has taken longer than usual.
The main reason, however, the US will likely not fall into recession is consumption, which remains “very satisfying”.
“We must consider that this consumption is really the focus in terms of the driver of the economy because consumption weighs something like 70 per cent of the GDP of this country, compared to something like 16 per cent of the business investment,” Toschi said.
She adds there is a “favourable environment for households and in our opinion these are conditions that means in the third and the fourth quarter of this year we could see a more robust environment and an increase in the trend of the GDP thanks to a labour market that is still supporting this trend of positive consumption”.
Looking at the trends of prolonged bear markets, Toschi says it is also unlikely that the US market will slip back, with drivers of previous cycles not yet visible.
Most bear markets come about on the back of a recession, such as the tech bubble in 2000 and the 2008 financial crisis, which can be seen in the below graph.
Performance of index over 20yrs
Source: FE Analytics
Other drivers, she says, include commodity spikes, something unlikely to occur with the depressed price of oil and an aggressive Federal Reserve, the opposite of the dovish Fed currently in place.
The only other factor is stretched valuations, which were big problems in the two bear markets so far this century. And while the other factors are not prevalent in the US, valuations are reflecting the possibility of a recession.
“From an equity valuation point of view we are in a recession,” Christian Preussner said adding that it is reflecting “no growth in terms of earnings,” and that “we won’t be selling anything outside of the US”.
He says this is a “complete collapse of sentiment” which “turned around slightly between February and May [this year] but got another hit with Brexit and is now down to the levels seen in the credit crisis”.
“We are not in a recession, we are not in a crisis, but still equity valuations are extremely wide with the very defensive companies very expensive but anything with a cyclical element trading very cheaply.”
David Coombs, head of multi-asset investments at Rathbones, agrees that valuations have become too stretched, noting: “Valuations cannot be ignored, however wide the qualitative difference between stocks or markets appears to be.”
Performance of indices over 5yrs
Source: FE Analytics
Indeed, as the graph above shows, the gap between growth and value has been widening in the US since 2015, having previously been traded in almost parallel.
“Given their higher-quality earnings, the US stocks could be described as ‘reassuringly expensive’. In a low growth environment, high-quality companies justifiably command premium valuations,” Coombs said.
The MSCI USA Growth index is now 16.13 percentage points ahead of the MSCI USA Value index, among the highest spreads seen in recent years.
Preussner said: “For 2017 we forecast a small double-digit earnings per share growth for the S&P 500 index mostly centred around three big sectors.”
The first is financial services, he says, “because it is on nobody’s radar”. While many believe there is too much risk and volatility, Preussner believes much of this is already priced in, meaning there is less downside risk to the sector.
Next is consumer discretionary, as wages have increased more than 2 percentage points over the last 12 months.
“That’s something whereby the US consumer will be spending more and on the flip side hopefully saving less. After thanksgiving ‘Black Friday’ and ‘Cyber Monday’ is coming up and just before the elections this will give proof if there is that much consumer spending going on,” he said.
Finally, he says healthcare could benefit in 2017, despite controversial statements from presidential candidate Hillary Clinton on reforms for the sector.
“It’s one of the paths that we’re still seeing quite positively for 2017, however you have to divide healthcare into the pharma companies and biotech.
“We are much more positive pharma than we are biotech where earnings haven’t come in as strongly as you would expect.
“While pharma companies have always had very high cash flow, they pay a dividend and they have invested so much into R&D over the last three years that they are now seeing the benefits of it.”