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Marcuard's Market update by GaveKal Dragonomics
Data released on Friday (Aug. 7) reaffirmed the robust health of the US domestic sector. Paradoxically, this only strengthened our conviction that investors should underweight US equities in favour of other markets.
The July payroll report did not spring any surprises, but it did confirm the status quo—that the US labour market, while still growing, is looking increasingly tight. July payroll growth was stable at just over 200,000; unemployment was steady at just 5.3%; hours ticked up by a hair, and private hourly earnings growth inched up from 2.0% to 2.1% year-on-year. Following recent conflicting signals on wage growth, Friday’s data fit in with our expectations that tighter supplies of labor will lead to a rising trend in wage growth.
We also learned on Friday that US consumer credit grew at an annual rate of about 7% in June, with both the revolving and the non-revolving components growing at a similar pace. While non-revolving credit has been consistently strong in recent years thanks to government-provided student lending, over the last year we have also started to see a real pick-up in revolving credit, which is largely credit cards and auto loans.
Almost two years ago, we claimed that US households had largely repaired their balance sheets and that they were likely to start adding debt again, further encouraged by low interest rates. This renewed appetite is now showing up in credit card and auto loans. So far, household mortgage debt has only stabilised, but we expect growth there soon as well. Eventually, debt increases will lead to trouble, but for now they boost consumers’ power, which has also been juiced up by the fall in energy prices.
So, why does all this apparently positive news lead us to reiterate our underweight view on US equities relative to other equity markets? A few reasons:
1. So long as the largest consuming block in the world is showing strength, the chances of a global recession are limited. If we were to see a US recession in the making, we would not want to be overweight non-US equities, but instead overweight US long bonds. However, this is not (yet) the core scenario for some of our colleagues, such as Tan Kai Xian.
2. A stronger US consumer increases the odds of interest rate “lift-off” this year. The lack of any major deterioration in July’s labour data keeps the door open for the Federal Reserve to do as it wishes. And it wishes to start hiking rates—however timidly—before the end of 2015, and perhaps as soon as the September 17 meeting. Historically, rate hikes have weighed on equity multiples. And while it is possible that earnings growth could more than compensate for the multiple contraction, this could be difficult given our next factor…
3. Strong domestic data supports the US dollar at lofty levels. Considering that the US dollar is now clearly overvalued against almost every currency out there, except for the Chinese renminbi, we are negative on the US dollar over the long-term. However, it could be some time before the US dollar corrects. So long as domestic data is supportive of Fed rate hikes, while most other countries remain miles away from even thinking about raising rates, the US dollar is likely to remain strong. The US dollar’s rise has already hurt the profit numbers of multinationals, because of the translation effect. If the currency now stalls at these uncompetitive levels, future profit pains will be felt most keenly by US exporters, and by domestic producers who compete with foreign makers of tradable goods. So, while bad news for US producers, a strong US consumer and a strong US dollar are great news for foreign producers. Moreover, with the strong US dollar encouraging a widening of the US current account deficit, more US dollars will flow abroad—which usually leads to the outperformance of non-US markets.
This is not to say that the probability of a US and global recession in the next 12-18 months is zero. As Charles Gave has highlighted recently, there are some worrying signs that need to be assessed alongside all the positives (manufacturing is weak, profit growth is weak, and while corporate interest rates are still low, they have ticked up some recently). Appropriate portfolio protections should be in place. Charles says he is getting very close to calling for recession—and that he will do so if his indicators deteriorate any more. However, we do not yet see a recession in the making. As a result, we continue to expect superior returns from non-US markets, such as Japan and Europe.
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