In the words of Clint Eastwood’s character ‘Blondie’ in the famous Western ‘The Good, the Bad and the Ugly’: “there’s two kinds of people in this world, those with loaded guns and those who dig”. Within the current economic power dynamic, US has a loaded gun, while the rest of the world digs.
Amid a softer global growth dynamic, the US still displays strong economic momentum. Yet the US’ strength may this time be a poisoned chalice. The combination of an improving job market, investment spending, tax cuts and rising short-term rates is at odds with economic dynamics across the rest of the globe – and this divergence has already wreaked havoc, especially in the emerging world.
Protectionism and the prospect of a US withdrawal from the global trade arena risk amplifying this trend and could possibly Make America Great Again – at the expense of the rest of the world. The US may be, at the same time, the Good, the Bad and the Ugly of the global economy, depending on whether you look at its positive growth dynamic, its damaging monetary policy spillovers impacting emerging markets, or its uncooperative trade policies.
The Good: an attractive buying opportunity
There is no rest for the US economy: it is firing on all cylinders in terms of household consumption, business investment and public spending. The central bank revised upwards its GDP growth projection, expects the unemployment rate to reach a multi-decade low and sees inflation finally settling just above its 2% target. Moreover, the possibility of another round of tax cuts before November’s midterm elections counterbalances any potential loss of momentum in H2 after the H1 ‘sugar rush’.
With this in mind, the recent market weakness was a buying opportunity. We upgraded our stance on US equities to harvest the equity risk premium and create a better-balanced asset allocation; this was based on the relative resilience of the US economy compared to other parts of the world. However, making the US our single most favoured equity market requires further explanation – as valuations are higher than the rest of the world.
Looking at FactSet data, the US trades on a more than three-point premium to the rest of the world in terms of 12-month leading PE ratios. Yet when looking at the PE-to-growth ratio, the valuation difference between the US and the rest of the world has narrowed substantially over the last few months and is now almost at the same level. This can be attributed to differences in relative expectations for earnings growth. While the world ex-US has broadly gone sideways in terms of earnings revisions, the US has seen a sharp increase, comparable to 2009-2010 after the global financial crisis. A big part of this has to do with the corporate tax reform, as well as ongoing deregulation, which will in our view continue to provide a favourable backdrop for corporate earnings going forward. Hence, the US has once more taken on the role of a defensive market for portfolio construction.
The Bad: Fed policy impacts EMs
The Federal Reserve’s monetary policy tightening has impacted economies reliant on US dollar funding. This has triggered a change in the emerging market macroeconomic backdrop, evidenced by rate hikes in Turkey, Indonesia, Mexico and India and by the end of the easing cycle in South Africa, Brazil and Russia. The general monetary policy trend across emerging markets is now directed toward tighter credit conditions, in order to contain currency depreciation and resulting imported inflationary pressures.
At a time when the Fed is firmly set on normalising its monetary policy, softer business cycle and inflation dynamics in Europe have led to the ECB playing down concerns of a rapid monetary policy tightening in the Eurozone, while the Bank of Japan shows no sign of appetite for altering its existing accommodative stance. Nevertheless, such desynchronisation from the Fed rate cycle, even if the fruit of disappointing economic data, may paradoxically act as a welcome tailwind for the global growth outlook in the coming months.
The Ugly: toxic trade tensions
In Europe, global trade tensions and tariff threats will continue to weigh on export-sensitive industrial sectors. Although growth stabilisation is expected in the coming months, based on resilient domestic demand, growth momentum in the Eurozone has constantly slowed in the first half of the year and underlying inflationary pressures remain subdued at best.
Faced with this environment of a positive but softer growth dynamic and rising downside risks, Mario Draghi is having to perform another balancing act. While the ECB is formally still on the monetary policy normalisation path, downside risks and uncertainties – due to trade tensions – led it to set an extremely cautious timeframe for normalisation. The underlying idea is clear: the ECB wants to maintain ultra accommodative financial conditions until it has more confidence nothing will derail the ongoing Eurozone expansion.
In China, concerns around the impact of US trade tariffs on export-related industries also come on top of a softer domestic growth environment. However, Chinese authorities have the tools to manage such headwinds – up to a certain point – by pulling monetary policy levers – which has become decidedly accommodative recently – and FX policy – with a 5% depreciation of the yuan versus the US dollar in the last two months.
Adrien Pichoud, chief economist, and Hartwig Kos, co-head of multi-asset at SYZ Asset Management