US exceptionalism is not enough for investors

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management

Ongoing American exceptionalism, as it is often termed, appears to have garnered strong consensus among clients, and understandably so. The US economy and markets have had an extraordinary run over the past decade.

Since 2010, the total return on the S&P 500 has been 590 per cent, far outpacing the 150 per cent delivered by MSCI Europe or the 120 per cent from the FTSE 100. And that outperformance has not been limited to the equity market. Higher interest rates on bonds have also served to attract capital from savers in regions mired by low or even negative interest rates.

As global capital flowed to take advantage of these opportunities, it put continued upward pressure on the dollar’s value. Many asset allocators are firmly committed to a structural overweight in US assets, even though their valuations compared with the rest of the world are now at rarely seen levels. But will a large overweight in US assets hold up for the coming decade? Is it simply that corporate America is better than corporate Europe?

It is true that fantastic US earnings growth has supported this rally. The companies that constitute the S&P 500 have seen earnings per share rise 290 per cent since 2010. This contrasts with 60 per cent for MSCI Europe.

Mario Draghi’s recent report on Europe’s competitiveness highlighted some of the structural problems Europe faces, particularly when it comes to innovation and the ability of companies to scale up. There are, however, reasons to challenge the “they’re just better” narrative that widely underpins the rationale for an overweight position in US stocks.

First, if US companies are more profitable or faster growing and markets are efficient, then that should already be reflected in the price and not create further excess returns.

Second, the US has also been “exceptional” in arguably less compelling ways. Government debt has exploded during this period of outperformance and far more than in Europe. In fact, since the US Treasury first started reporting borrowing in 1783, it has accrued $33tn of debt. Almost two-thirds of this, $21tn, has been accrued since 2010. Unsurprisingly, this debt increase boosted spending and corporate earnings. But this surely cannot be repeated.

Third, the US has seen an expansion of profit margins which I would argue cannot be repeated. Corporate America has done a very good job of grabbing an ever-larger slice of the US income pie. However, workers will become increasingly agitated if this continues. We would see more strikes and more demands for higher pay.

Finally, we must acknowledge the role of technology stocks in driving performance. The spectacular rise in the value of US tech stocks accounts for 40 per cent of the returns that the S&P 500 has generated since 2010. Excitement about artificial intelligence and other technologies has pushed the valuation of the top 10 US companies to 30 times their expected earnings for the coming year. This compares with a valuation of 14 times for MSCI Europe.

This valuation premium of “tech versus the rest” will inevitably have to close at some point. I believe it will close in one of two ways. Either the valuations of non-tech companies will rise as it becomes clear that AI will boost their efficiency and profits. Or the AI products that have been developed will not be in demand from the broader corporate universe, and the tech companies will struggle to make the expected return on their enormous investments.

Historically, the market has tended to overestimate the future returns of innovators and underestimate the future returns of adaptors. Think of telecommunications, where the returns have been unspectacular compared with the shopping and convenience platforms that have utilised the underlying phone networks.

Given the US’s concentration in tech stocks, a rotation of performance away from tech is likely to coincide with a rotation in geographical stock performance. As capital flows to new opportunities elsewhere, this could also weaken the dollar.

To be clear, I am not suggesting the US is about to experience a decade of stunning underperformance. However, we should question some of the underpinnings of American exceptionalism and be cautious about being too overweight on last decade’s story.

Investors who have not rebalanced will naturally find themselves with a large overweight. If you allocated 50 per cent of your wealth to US stocks in 2010 and the other half to stocks in the rest of the world, that has now become a 75 per cent weighting to the US. At the very least, it is time for some rebalancing.