There is no life expectancy for the business cycle, but the current expansion in the US does appear somewhat extended. At 95 months in duration, this expansion is the third longest on record and significantly longer than the post-war average of 58 months.
In addition, the pace of economic growth during this current expansion is notably slower, with GDP growth averaging just 2.1 per cent – compared with the 3.6 per cent average rate of growth recorded during the 10-year expansion that occurred between 1991 and 2001, the longest on record. The average rate of growth in the nine-year up-cycle in the 1960s, the second longest on record, was 4.9 per cent.
For this reason, expansive fiscal policy is likely back in play, particularly given the promises of president Donald Trump. The initiatives Trump has proposed have largely been well received by financial markets thus far, but nevertheless present potential risks as well as rewards for investors and decision makers over the next four years.
Earnings facing numerous headwinds
As for the US equity market, stocks have performed strongly in recent months in an environment of continued expansion in the economy and the additional Trump boost – as the prospect of lower taxes and heightened levels of stimulus have been viewed as positives for domestic growth and corporate profitability.
However, looking ahead, with monetary policy tightening and market valuations at multi-year highs, we believe the upside in the US equity market will be closely linked to improving earnings delivery – rather than the significant multiple expansion witnessed during this cycle to date. We believe this is a dynamic facing numerous headwinds, given the heightened level of political risk, the strengthening of the US dollar and the outlook for higher rates.
Sales growth for the S&P 500 companies in aggregate averaged 0.1 per cent last year, a moderate improvement from the 0.6 per cent decline in the top-line in 2015. A combination of anaemic levels of global economic growth, significant weakness in core areas of the market, such as energy and financials, as well a strong dollar, have conspired to weigh on sales growth in recent years. Companies have responded to these dynamics by reducing costs, limiting investment and undertaking financial engineering to sustain profitability.
In the absence of a meaningful up-tick in economic activity, there are threats to US corporate margins. Further tightening in the labour market should drive wages higher, interest expense tailwinds should diminish as rates normalise and the strong dollar could dampen profitability from overseas operations, all of which would negatively impact overall profitability levels. Conversely, Trump’s potential corporate tax reform plan has the potential to partially offset these possible headwinds.
Shiller P/E at 65 per cent premium to 50-year average
In our view, the US equity market has not appropriately discounted the increased level of macro and microeconomic risks, given the forward price-to-earnings and EV/EBITDA multiples now stand at significant premiums to ten-year average levels. Both the P/E and EV/EBITDA ratios are now at or close to two standard deviations above the average.
In addition, the long-term cyclically adjusted price to earnings (CAPE) ratio, which adjusts for economic cycles, now stands at a 65 per cent premium to its 50-year average.
Shiller’s cyclically adjusted price-to-earnings ratio
Source: Yale University, S&P
The narrow base of US stocks leading the market higher is also a concern. While US equity indices trade at all-time high levels, this is driven by a relatively few number of very large companies, including the so-called ‘FANG’ stocks – Facebook, Amazon, Netflix and Google. The average stock is actually well below its highs, driven in large part by poor operating results – with an estimated one third of companies not operating profitably.
Tech and healthcare bucking the trend
In summary, the US equity market faces a business cycle that appears to be losing steam, a mounting risk the Federal Reserve may have to tighten monetary policy more rapidly than expected, as well as notable headwinds to margins and multi-year high market valuations. In addition, there is a significantly higher level of political uncertainty following the election of Trump.
We are maintaining a cautious outlook on the US equity market overall and continue to have underweight position in our global equity portfolio. However, in-line with our bottom-up fundamental approach, we continue to find compelling investment opportunities in particular areas of the US market, notably in technology and healthcare. We are witnessing many companies boasting strong business franchises – built around superior intellectual property, strong balance sheets and supported by long-term secular trends that should support earnings growth ahead of the market.
Robin Hepworth is chief investment officer at EdenTree Investment Management. The views expressed above are his own and should not be taken as investment advice.