INDUSTRY VOICE: Lyxor's Cross Asset team looks at the economic backdrop for US assets - can the market hold up under recent strains?
US economic growth still looks firm - consumption remains the strongest driver, backed by continued consumer optimism and substantial wage gains. The current expansionary phase should soon become the joint second-longest in the country's history. Should it endure to next spring, it would be the longest ever. However, it could be showing signs of wear and tear.
Inflation is on the rise, so real consumption is outstripping income. The household savings rate has halved over the last couple of years, while rising delinquency rates for auto loans suggest early signs of consumer stress. Slower job growth and lower rates of savings means the recent tax cuts could be crucial - without them Trump's bid to sustain the current growth trend may be doomed to failure. The question is whether they have gone far enough.
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Fiscal push or fiscal nudge?
Last December's tax reforms included a new corporate tax rate of 21%, the repeal of the corporate alternative minimum tax and full expensing of equipment for the next five years. The recent budget deal added further stimulus through federal spending. The amount likely to be injected into the US economy should exceed 1% of GDP each year. Yet, at this late stage of the cycle, the measures may not be entirely reflected in real activity. Overall, the fiscal push should add around 0.5% to growth this year - meaning a rate of around 2.75% by year end.
Whatever its real effects, it's still an unprecedentedly large stimulus package at such a late stage of the cycle and it will, in our view, undoubtedly spur on inflation in all its forms. A tight labour market should push wage inflation past the 3% mark within months. This would eventually pass through inflation prints and benefit US breakevens.
The fear of four
The exceptional conditions that have artificially suppressed yields since the Global Financial Crisis should continue to fade. We've long expected at least three hikes from the Fed in 2018, and now believe the possibility of four 25 basis point hikes is greater. Tighter policy normalisation cannot be ruled out. We suspect ten-year Treasury yields will push some way past 3%, so we are underweight over the long term. Shorter-term however, they retain their safe haven appeal should risk aversion spike.
How far from here?
The firmer wage growth at this late stage of the expansion is likely to dent corporate profitability. Margins could compress by about 0.5% per year, although the positive effects of tax reform will help to mitigate this to some degree. All told we expect solid earnings-per-share growth of around 9% this year but rather more sedate results next year as the cycle totters into its dotage. There may therefore only be limited upside for the mainstream indices like the S&P 500 Index from here - only products offering the lowest cost access, or the very best performance merit consideration.
Trading insults, rather than ideas
Greater consumer spending may encourage more imports as the US is hitting its capacity constraints. Any widening of the trade deficit could add further political pressure to Trump's tightwire trade agenda. The heady rhetoric and recent bout of brinkmanship seem more of negotiating tactic than they are a declaration of trade war or a U-turn on globalisation, not least because of looming mid-term elections. In our view, Trump won't risk blowing up a bull market - one of few feelgood factors at his disposal - at such a time.
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Q2 positioning
So we still expect US equities to outperform bonds in Q2, albeit by a lesser margin than before. That said, the President's taste for battle may rattle some of the country's more risk-averse trading partners. Expect outward-looking international firms to suffer more than their domestic-focused counterparts. As a result, we're neutral on the outlook for the broader indices and our preference for selected themes, like favouring growth over value, and sectors.
Take capex for example; tax reform should help accelerate spending on non-residential investments and in technology, a sector representing 30% of current capex and around 35% of the S&P 500 Growth Index. Despite all the talk of a new tech bubble, valuations look merely stretched in places rather than speculative or bubbly.
Our one value-based call remains banks because of the sector's cyclicality. Commercial and industrial loans look likely to rebound, which will boost profitability. Higher inflation expectations also tend to translate into better prospects. The Fed's continued willingness to simplify regulation is the last of a powerful trio of clearly positive catalysts.
S&P 500 margins look vulnerable as the cycle matures
Source: Bloomberg, Macrobond, Lyxor AM
S&P500 Growth versus Value
Source: Bloomberg, Macrobond, Lyxor AM
In fixed income, away from our views on breakevens and treasuries, we've yet to really touch on credit. In our view, the picture is fairly bleak - especially for high yield because valuations appear high and the sector appears to be pricing in a growth rate far in excess of what's likely to eventuate in 2018.
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