US market exceptionalism

A bet on US outperformance is a bet on tech, which is near the end of its own hype cycle

For any global investor, the US has been the place to be since the global financial crisis (GFC). Ironically, for a crisis initially concentrated in the US, and which brought the American financial system to its knees, it also marked a turning point in US relative equity returns. Since 2008 —over the past 13 years— US equity markets have outperformed both developed markets (DMs) excluding the US, and emerging markets (EMs) by 7 per cent annually. So, $100 invested in the US in the beginning of 2008 is worth $385 today, compared to $165, if invested in the rest of the world.

The US today accounts for 58 per cent weightage in global equity indices, compared to 29 per cent for DM, excluding US, and 13 per cent for EM. This is despite the US being only 25 per cent of global gross domestic product (GDP). Given the dominance of the American markets, the strength and durability of their outperformance, combined with their liquidity, one can be forgiven for thinking, why bother with global diversification? Why venture outside the US? Combine this with the fact that all global markets are strongly correlated with the US. In any major drawdown or episode of risk aversion, correlations rapidly approach one anyway. Diversification has not really helped in moments of financial market stress.

An equally relevant question for EM investors is the attractiveness of the asset class itself. Since 1988, from the beginnings of the asset class, till today, US equity markets over this entire 33-year period have outperformed EM equities in USD terms. This EM underperformance was despite the fact that over the majority of this time period the EM countries grew real GDP by 3.5 per cent per annum faster than the US. This macro outperformance, however, did not translate into earnings, as the EM indices delivered slower earnings per share growth.

EM relative performance seems to follow a seven-year feast and famine, with alternating periods of significant outperformance/underperformance, and the current 10-year run of underperformance seems a late stage/cycle. There seems to be at the minimum a tactical argument to overweight EM equities.

While the US has been the clear leader in equity performance over the last decade, it was not always so. Through the 1970s and most of the ‘80s, as an example, the US significantly underperformed global markets. Looking at data over the past 50 years, 75 per cent of the 10-year relative outperformance/ underperformance for US equity markets were reversed in the subsequent 10 years (source:JPM). Classic reversion to the mean. This reversion was driven by reversals in earnings growth and tech sector performance. Over the entire 50 years, the US has delivered total returns of 10.5 per cent per annum, compared to 9.7 per cent for Europe, with Japan being the drag on non-US returns and laggard at 7.2 per cent. The US has outperformed, but by no means near as much as the last decade, there has been mean reversion in the returns.

If there is clear mean reversion in the long-term relative regional returns, then an obvious question is, what drives the outperformance and how predictable is it? Straight away, from an even cursory glance at the data, it becomes obvious that valuation is not an effective predictive tool of regional long-term performance. There is very little value in using relative valuation or multiples gap analysis in trying to predict prospective 10-year returns. JPM tried to do this in a recent paper and their correlations were non-existent and statistically insignificant.

Illustration: Binay Sinha

Relative return mean reversion is coming from reversion in earnings growth and not from normalisation of multiples.

Over the last 12-13 years, US relative strength has been driven by relative earnings outperformance. This earnings outperformance has been driven both by rising margins, and the higher weightage of technology at 27 per cent in US indices, compared to 12 per cent weightage in non-US benchmarks.

US margins and earnings have accelerated due to a combination of falling effective tax rates, reduced cost of leverage and globalisation. Another factor has been increased concentration across industries, falling new company formation and reduced listings. Over the past 20 years, the number of listed companies in the US has fallen from 6,000, to just over 3,000. Over the past 13 years of outperformance, US corporate margins have expanded by 400 basis points versus EM and Europe.

Given that both rates and taxes have bottomed and corporate concentration has also likely peaked, given the noises coming out of the Biden administration, combined with the beginnings of wage pressures, it is fair to assume that margins can only decline in the US. As margins normalise, relative earnings outperformance will cease.

The other issue to consider is the greater technology weightage in US indices. While tech has been critical in driving US outperformance, it has not been the only factor. Absent technology, US equity markets would still have outperformed non-US equities by 5 per cent per annum. So the story of relative outperformance is not all technology. What is true however, is that over the last 50 years, whenever tech is in fashion and outperforming in its own market, US equities tend to outperform global markets. So in a way, a bet on US outperformance is a bet on tech. Given where the technology sector is in its own hype cycle, weightage and market capitalisation of the tech titans and the frenzy in IPO markets, one cannot expect the huge outperformance of tech to continue. We also have winds of change blowing in antitrust policy and global taxation, both of which effect and impact technology Titans head on.

Given the history, it is fair to assume that over the coming years this current period of exceptionalism in US equity returns will come to an end. Driven by headwinds to both profit margins and thus relative earnings growth, as well as the exaggerated outperformance of technology, US returns over the coming years should mean revert. EM equities and global stocks, which have consistently disappointed over the last decade will also have their time in the sun. It is inevitable and worth betting on. Just when mean reversion seems outdated as a concept, it normally snaps back. Having called for a reversal of US outperformance for years, and been proven wrong, most consultants and allocators have given up on this trade. Being significantly underweight US equities constitutes career risk for many. When the reversal of relative outperformance commences, it will last years.

The writer is with Amansa Capital