No man is an island, John Donne wrote, but the U.S. stock market’s performance is increasingly separated from the rest of the world. That divergence has widened in recent months, coincident with the escalation of tariffs and trade tiffs between America and its trading partners, notably China. But Wall Street’s outperformance stretches back far further, almost to the beginning of the bull market.
The important questions for investors are: What has accounted for U.S. stocks’ stellar showing and, more important, will it continue?
The divergence has been especially acute recently. In the 12 months through last Tuesday, the S&P 500 was up 15.68%, while the MSCI Asia Pacific index was down 2.41%. Until early June, the two had been roughly in sync, according to a chart distributed by Peter Boockvar, chief strategist for Bleakley Advisory Group, to his firm’s clients. “This is not a sustainable trend, and something has to give in one direction or another as the Asian region is one-third of global [gross domestic product], greater than North America and Europe,” he comments. Specifically, Japan has the biggest weighting in the MSCI Asia Pacific index, some 38%, followed by China with 18%, Australia, 11%, South Korea, 8%, and Taiwan, 7%, with others accounting for the rest.
Looking back to the end of 2010, Bespoke Investment Group finds that the relatively more robust performance of the MSCI U.S. index versus the MSCI World ex-U.S. index has been driven “consistently by stronger earnings,” although higher valuations also played a part.
BCA Research reaches the same conclusion, although it notes that profits in Japan have kept pace with those in the U.S. in recent years, but only after a long stretch of weak growth. BCA also sees investors responding to better American profits by awarding higher price/earnings multiples to U.S. shares.
The stronger earnings growth and higher valuations attest to the strength of the U.S. economy, which recovered much sooner and more strongly than those elsewhere, owing to Washington’s relatively rapid policy response. Fiscal stimulus was provided in the wake of the financial crisis; the government further helped by putting capital into the banks (which was repaid to the taxpayers at a profit). Most particularly, the Federal Reserve quintupled the size of its balance sheet from its precrisis level. In contrast, the European Central Bank actually raised interest rates in 2011 to fight phantom inflation, while forcing fiscal austerity in the euro zone, especially in Greece.
But the U.S. market’s outperformance also is tilted by technical factors. Notably, its indexes are more heavily weighted toward sectors with faster profit growth. For instance, 12-month forward earnings in the technology sector have jumped by almost 160% globally since 2010, while those for materials companies have increased by just 25%, according to BCA. But the dominance of Big Tech in the American economy means that the sector’s weighting is 15 percentage points higher in the U.S. index than in the global one. Conversely, the U.S. weighting in weak materials stocks is five percentage points below that in the global average.
Bespoke Investment Group concludes that, if the weights were equal in both indexes, the performance of the non-U.S. index would more than double.
But profits still are the main factor. The bad news is that BCA sees corporate profit growth slowing in 2019. Earnings per share also are likely to get less of boost from stock repurchases, in light of high valuations and rising interest rates.
Profit margins are apt to be squeezed by increased wage growth brought about by the tight labor market, a welcome change on Main Street, if not Wall Street. BCA also looks for a stronger dollar to eat into earnings. The firm estimates that a 5% appreciation in the trade-weighted greenback reduces S&P 500 earnings by 1% over the subsequent 12-18 months. This year, the buck has risen by 6.2%, on a trade-weighted basis, and BCA expects further increases.
Global growth is likely to weaken, in part because the U.S. is running out of excess capacity. Emerging markets, meanwhile, are struggling. BCA also thinks “the policy environment will become more challenging.” The EU is limiting internet companies’ ability to collect personal data, while the Trump administration is targeting social-media companies for allegedly curtailing conservative viewpoints, it notes. Then there are the U.S.-China trade tensions.
BCA thus sees potential for disappointment in investors’ “wildly optimistic” earnings expectations. The average S&P 500 company is forecast to increase earnings at an annual rate of 16.5% over the next three to five years, according to the forecasting firm. That’s six percentage points higher than estimates just three years ago, and only exceeded by the “euphoric projection” of 18.7% earnings gains in the giddy dot-com days of 2000.
Strong earnings have fueled U.S. stocks’ outperformance throughout this bull market. That fuel might start running low next year.
Write to Randall W. Forsyth at email@example.com