US equities have outperformed global equities since the
beginning of the recovery because the US economy was initially the
sole engine of global growth, as European countries wrestled with
the Eurozone crisis. As the US economy recovered - driven by a
recovery in the housing market, a shale renaissance, and a
financially sound consumer - so did corporate earnings. Seven years
into the recovery, the economy is still growing at a muted but
steady pace with no exuberance to derail its path. Corporate
earnings are now fuelled not only by a sound domestic backdrop, but
also a synchronized global recovery fuelling demand for US goods
internationally. With about 35% of earnings derived from overseas,
the consensus therefore estimates US earnings will grow north of
10% in both 2017 and 2018.
Mega-trends
Greater earnings growth will be supported by secular mega-trends
in technology. The $350bn semiconductor industry, for example, is
poised to grow by 2x-3x global GDP (versus 1x historically), as
chipmakers shape and benefit from multiple megatrends in technology
and society. The cloud economy is creating enormous need for
cost-effective acquisition, storage, communications and analysis of
data, and its conversion into insights and actions. Semiconductors
are aligned to lead these changes, driven by Moore's law of a
virtuous cycle of cheaper, faster, and smaller. Trends in cloud
computing, artificial intelligence, connected cars, gaming, 'always
on' unlimited mobile broadband, 5G wireless, and the 'internet of
trillions of things' that could collectively add nearly $100bn in
addressable opportunity over the next five years. The technology
sector is outgrowing the S&P500 by 5% per annum, but while the
US technology sector is mainly exposed to these trends, the whole
ecosystem will benefit: for example, REITs exposed to data centres,
that will grow and expand with demand.
Valuations
Valuations of the technology sector are not extreme. The US IT
sector still looks reasonably valued on a forward P/E multiple
basis relative to the market. On a price-to-book measure the sector
is looking more expensive, but one could argue whether historical
P/E is a relevant metric given that the sector is becoming more
software and services oriented in the US. Moreover, on an equity
risk premium basis, the US looks compelling. While the last 10
years has seen the historical US equity risk premium exceed that of
other developed markets, this likely justifies the higher valuation
premium of the US. Over the long term, the risk premia of the US
and Europe ex-UK is about equal and exceeds that of Japan and the
UK.
Tax reform
The US has one of the world's highest federal rates of
corporation tax at 35%. This is in part due to the increasingly
partisan nature of US politics in recent decades, which made it
difficult to pass corporation tax cuts through Congress at a time
when other OECD members were reducing their rates. If handled well,
the Trump administration will be able to build a consensus to
improve the competitiveness to US corporation tax by cutting rates.
In this case and as observed recently, many of the companies that
are most domestically focused and which performed best immediately
following the election - will lead the market. This includes
domestically-focused banks, industrials and material stocks and
smaller companies that tend to pay higher tax rates. From a style
viewpoint, we would have a rotation out of Growth and Momentum
stocks into Value.
We estimate the earnings accretion from tax reforms of + 6% to
10% leading to earnings growth of +18% at the midpoint for S&P
companies (if reforms occur in 2018). GDP would see a 0.2% to 0.3%
uplift.
Summary
Finally, we would stress that the fundamental backdrop for US
equities is robust with and without the above as we have seen
strong corporate profits growth in 2017 set to continue next year
as global growth picks up and we see valuation as fair in the light
of very strong earnings prospects.
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