Look up
Look up
As we come to the end of the year, with US equities having risen 27% through the year it is worth noting that very few people, whether ‘professional’ or ‘non-professional’, had such an upbeat view of the potential for US equities at the start of the year. Just like now, most commentators appear to hold US equities with some element of caution.
We accept that the elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. However, whilst they continue to deliver robust earnings growth, the valuation risk may not materialise. In contrast, non-US equities struggle to generate profits growth (when denominated in US Dollars) in part due to US Dollar strength, which explains the continued outperformance of US equities.
The US Dollar strength is driven by the relative change in bond yields as the economic growth paths of the US and Europe diverge, with strength in the former and weakness in the latter. The strength in US economic growth is having an impact on interest rate expectations for 2025, with only two to three interest rate cuts expected in the US. Whilst in Europe, which is beset by recessionary conditions and political turbulence in France and Germany, interest rates are expected to fall further and faster in 2025. This has caused bond yields in the US to rise while those in Europe have fallen, leading to strength in the US Dollar.
Interest rates in the US may not fall by as much as had previously been expected but rate cuts are still on the cards. Whilst rates are being cut and if economic and profits growth remain upbeat, US equities are likely to rise further through 2025 despite the valuation hurdle. However, as readers will know, a Trump presidency may contain shocks both positive and negative that will shape investor appetite in coming months. A known risk is the inflationary impact of his tariff and immigration policies, which may in turn limit the extent to which the Federal Reserve can cut interest rates. If rates stop falling due to higher inflation rather than stronger economic growth the support for US equities may fade, but for the time being that isn't being forecast.
Beware of forecasts
It is the time of year when investment commentators peer into the future and make forecasts. They really shouldn’t. 2024 has once again proved that forecasters are prone to error. At the start of 2024 when the US equity market in the shape of the S&P 500 (the largest 500 listed companies in the US) was at 4769, the average forecast was for the S&P 500 to end 2024 at 4835, a 1.4% increase. The current level of 6090 is a staggering 27% higher than the start of the year. For what it’s worth, the very same forecasters now expect the S&P 500 to trade at 6614 at the end of 2025, a rise of 8.6%.
Even in the UK, forecasters had expected the UK equity market to increase by 2.1% in 2024 and it has risen by 6.1%. For 2025, forecasters anticipate a 5.5% increase from current levels. In Germany, despite the economic gloom, the DAX has risen a robust 21% compared to expectations of a 1.7% rise, and for 2025 strategist expect a 1.4% increase.
US equities: 2024 outcome versus forecasts at the start of 2024 for the S&P 500
US profits continue to drive returns
The key reason for the drive higher in equities has been the climb in US profits. At the start of the year expectations were for 12-month forward Earnings per Share (EPS) to be at $240. For the next 12 months this measure is now at $269, a 12% increase. Over the same period, profits for non-US global equities have stagnated at $163.
The chart below shows how the returns and profits (as shown by EPS) of US equities and non-US equities compare over the past few years. After a period of weakness in late 2022, US profits have grown by 18% and non-US equities have seen growth of 3%. So the outperformance of US equities over the past 2 years is grounded on the relative strength of US corporate profitability.
US equities v non-US equities: relative returns appear to be linked to underlying profits
The chart below shows the relationship between the US and non-US profits when denominated in US Dollars. Since the start of 2023, when the US Dollar strengthens the US Dollar value of profits of non-US equities fall. The strength of the US Dollar in the past few months has eroded the profitability backdrop.
Non-US equities: profits struggle to grow in periods of US Dollar strength
US Dollar strength can be explained by looking at the path of relative interest rates. The chart below shows the 2 year bond yield (interest rate) difference between the US and Germany. Currently, the US bond yield is about 2.5%. Back in 2020-21 this gap was under 1%. Through 2021 bond yields rose more quickly in the US compared to Germany and the US Dollar rose from 1.20 to 1.00 versus the Euro. In recent months, bond yields have risen in the US and the US Dollar has risen. As we can see from the above relationship this appears to be a driver of earnings and returns for non-US equities.
US Dollar versus the Euro appear to be linked to the difference in the respective bond yield
And the reason for the higher interest rate in the US is based on the better than expected growth outcome in 2024, which is shown on the chart below, where growth is measure by Gross Domestic Product (GDP).
US economic growth expectations for 2024 have risen while other regions have fallen
The strangeness of people
The customer is always right. A mantra that many young people get told repeatedly in their early working lives, and to some degree is etched on the brains of many workers. Wisdom of crowds is another adage that seeps into folklore as ‘truth’. The recent US election is testing these ‘truths’. Since the US election the expectations of the US consumer have changed depending on political affiliation. Republican voters feel better and conversely Democrats are less optimistic. To some degree, we can believe that people may feel more/less upbeat given the electoral outcome.
US consumer confidence: split along partisan lines with Republicans feeling more confident about the US economy now that Trump has been elected
Oddly this reversal of sentiment is showing up in inflation expectations. Republican voters feel better and think that inflation will be lower in the future, and, conversely, Democrats think inflation will be higher, purely on the back of the election result. We struggle to see how expectations or inflation outcomes can have changed so much along partisan lines based on electoral outcomes.
Inflation expectations: oddly partisan political divide appears apparent in inflation expectations. Republicans expecting lower inflation given the change in President
So much for the consumer always being right. The National Federation of Independent Business (NFIB) is seen as the small business survey in the US. The survey data has changed and repeats the 2016 pattern, where business owners became more upbeat post the Trump election victory. However, we note that the 2016 surge in business optimism didn’t appear to result in faster economic growth. Opinions matter… but only when they shape the outcome and in this case the uptick in optimism may not be an economic event.
National Federation of Independent Business (NFIB) has registered heightened optimism amongst small business owners since the election, but we should remember that this happened in 2016 without any subsequent economic pickup (yoy = year on year)
Shock stock sentiment
After the returns from US equities over the past two years, US consumers are at last feeling optimistic about equity markets. When asked, 56.4% of consumers expected stock prices to increase over the next 12 months, another record high for this measure. Somewhat oddly, since the monthly survey started in 1987, apart from a brief period in 2018, US consumers on average have not believed that the US equity market would rise over the subsequent 12 months. And we know from history that on average US equities have risen, despite two prolonged bear markets (2000-02 and 2007-09). So together with the oddities of political partisanship influencing inflation expectations, it seems that the US consumer has held oddly negative views on the potential returns from US equities.
Expectations of the US consumer about the potential return of US equities over the next 12 months have reached record highs
In extremis the use of surveys may tell us when consumers are too confident or depressed about the potential outcome for markets, but in general the survey has limited (if any) ability to correctly predict the direction of the market. Arguably not much more unreliable than the professional forecasters reviewed in the previous pages.
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Conclusion
It has been another year of strong outperformance of the US equity market and overall economy.
We accept that the elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. However, whilst they continue to deliver robust earnings growth, the valuation risk may not materialise. In contrast, non-US equities struggle to generate profits growth (when denominated in US Dollars) in part due to US Dollar strength, which explains the continued outperformance of US equities.
The US Dollar strength is driven by the relative change in bond yields as the economic growth paths of the US and Europe diverge, with strength in the former and weakness in the latter. The strength in US economic growth is having an impact on interest rate expectations, with only two to three interest rate cuts expected in the US in 2025. Whilst in Europe, which is beset by recessionary conditions and political turbulence in France and Germany, interest rates are expected to fall further and faster in 2025. This has caused bond yields in the US to rise while those in Europe have fallen, leading to strength in the US Dollar.
Interest rates in the US may not fall by as much as had previously been expected but rate cuts are still on the cards. Whilst rates are being cut and if economic and profits growth remain upbeat, US equities are likely to rise further through 2025 despite the valuation hurdle. However, as readers will know, a Trump presidency may contain shocks both positive and negative that will shape investor appetite in coming months. A known risk is the inflationary impact of his tariff and immigration policies, which may in turn limit the extent to which the Federal Reserve can cut interest rates. If rates stop falling due to higher inflation rather than stronger economic growth, the support for US equities may fade, but for the time being that’s not being forecast.
Important Information
Artorius provides this document in good faith and for information purposes only. All expressions of opinion reflect the judgment of Artorius at 20th December 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results.
Nothing in this document is intended to be, or should be construed as, regulated advice. Reliance should not be placed on the information contained within this document when taking individual investment or strategic decisions.
Any advisory services we provide will be subject to a formal Engagement Letter signed by both parties. Any Investment Management services we provide will be subject to a formal Investment Management Agreement, which will include an agreed mandate.
Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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