US equity leadership: relic of the past or status quo?
Investors are confronting a new market playbook amidst the 3D reset of deglobalization, decarbonization, and changing demographics. A lot of familiar investment rules are at risk, and we look at whether the US stock market’s post-GFC outperformance is one of them.
Can the post-Global Financial Crisis (GFC) outperformance of the US endure in the future? Earnings growth in the US has impressively outpaced international earnings growth since 2009. Now, in the gales of regime shift, investors are wondering what they can expect during the coming decade.
The next 10 years are unlikely to resemble the last 10 years given how much has changed since the dizzy era of low inflation and zero interest rates. Behind the significant changes unfolding worldwide are three key forces, which we name the 3Ds: deglobalization, decarbonization and demographics. We expect their impact to affect economies and markets for years to come. There is a “3D reset” of standards that existed for decades underway, changing the economic landscape for years to come.
The 3Ds are inflationary forces, and one implication is higher inflation and tighter economic policy for longer. Since the GFC, central banks intervened to bolster the economy and markets at the first sign of every downturn, slashing rates to record lows and employing trillions of dollars in quantitative easing to thwart the risk of deflation. Now amid mounting political pressure to stoke economic growth, central banks are actively trying to slow growth to lower inflation even at the cost of a recession.
While the winds of change sweep through global economies, we ask, Is the US’s exceptional stock market performance coming to an end? Perhaps it is time to analyze equity winners and losers beyond the US. A renewed focus on stock valuations rather than speculative growth may be necessary but is a broader geographic focus also required? In this paper we examine the 3Ds and how they may affect the US’s position of market leadership.
How have the 3Ds affected the US
In light of the powerful 3D effects, we think the US is in a position of strength but the rest of the world offers promise. Higher inflation for longer means higher rates for longer. In the equity world, there are three ways inflation can make an impact: valuations, slower economic activity (and therefore slower revenue growth) and higher borrowing costs. Given earnings growth primarily explains the US’s outperformance over the last decade, we focus our attention on borrowing costs.
Impact of higher borrowing costs
US companies are less sensitive to higher rates. In the US, companies have cleaned up their balance sheets and reduced their debt such that they are better capitalized and their interest coverage has improved. In contrast, international companies appear to be in a more challenging position. Markets such as Europe tend to carry more leverage and rely on bank loans, while other markets like Japan and EM tend to have a shorter duration on their debt (making them more exposed to central bank tightening).
Figure 1 Balance sheets are strong in the US, limiting the impact of short-term borrowing costs
Source: Thomson Reuters, Schroders. Economic indicators and related historical trends may not be accurate measures of market conditions and should not be relied upon to predict future results.
Figure 2 International markets are more sensitive to short-term borrowing costs
Source: Thomson Reuters, Schroders. Shown for illustrative purposes only and should not be interpreted as investment guidance
The effect of buybacks
Companies may look to mitigate rising borrowing costs via share buybacks. When the cost of debt rises, buying back shares becomes more expensive if companies use debt to fund their purchases. As Figure 3 illustrates, buybacks may be less of a tailwind than they previously were in the US, but international markets, most acutely EM, do not look better; they effectively ask investors for more money to maintain the same stake.
Figure 3 While the US buys back shares, emerging markets have diluted shareholders since 2006
Source: Bloomberg, Schroders.
Corporate profitability under pressure
Corporate profitability is under pressure: margins are peaking, labor costs are higher, and labor shortages are driving investment in technology. What does this mean for companies’ ability to grow profits? In Figures 4-6 we see a shift higher in post-GFC operating margins because labor and wages were steady. A structural decline in interest rates and taxes added further support to companies’ bottom-line. While that balance is unlikely to persist under the ‘3D reset’, we see two potential antidotes.
Figure 4 US companies’ margins took a step higher post-GFC
Source: Bloomberg, Schroders. Economic indicators and related historical trends may not be accurate measures of market conditions and should not be relied upon to predict future results
Figure 5 Effective interest rates have been on a decline
Source: Thomson Reuters, Bloomberg, Schroders. Economic indicators and related historical trends may not be accurate measures of market conditions and should not be relied upon to predict future results
Figure 6 Corporate tax rates have steadily fallen
Source: Thomson Reuters, Schroders. Economic indicators and related historical trends may not be accurate measures of market conditions and should not be relied upon to predict future results
Playing defense with pricing power
With last decade’s tailwinds reversing, how can companies compete? First, companies with more pricing power should feel less of a margin squeeze. Our framework for identifying these companies is to look for segments that enjoy high and stable margins. Here we find a mix of growth and defensive-value tend to dominate: Tech, Health Care, and Consumer Staples in particular. This mix of industries favors the US, where Tech in particular features prominently in the market cap of the S&P 500.
Figure 7 High and stable margins are indicative of pricing power
Source: Bloomberg, Schroders. Shown for illustrative purposes only and should not be viewed as investment guidance. Past performance is not a guide to future results and may not be repeated
Playing offense with asset efficiency
Increasing asset efficiency can also address pressure on margins. Margins are one factor that determine return on equity (ROE). They have been growing over the last 30 years and the ROE of the S&P 500 has improved. The Dupont formula says ROE is a function of taxes, margin, borrowing cost, leverage and asset turnover.
Prior to the pandemic, investors generally pushed companies to grow at all costs. Hence the large M&A and marketing spend that were designed to simply "buy revenue.” Companies could do this amid low bond yields and other secular tailwinds like globalization that supported margins. If there was a deficit in earnings-per-share figures, companies could boost them with share buybacks funded by cheap leverage. All of this came at the expense of operational efficiency.
While companies lack total control over their borrowing costs, tax rate or operating margin, they can control leverage and asset turnover. We see asset efficiency picking up because of higher interest rates. Companies are waking up to the fact that they haven’t been efficient with assets.
The headwinds of inflation, wage demands and government regulation appear likely to persist into the medium term. Thus, the winners in this environment will likely include companies that can generate more sales from existing assets.
Figure 8 US companies are finding ways to cope by improving asset efficiency
Source: Thomson Reuters, Schroders.
The US equity market’s 15-year streak of outperformance leaves us tempted to believe it will face it’s end amidst the 3D reset. However, upon closer analysis, we find there are several resilient qualities to the S&P 500 that puts it on a solid footing against the macroeconomic uncertainty ahead: strong balance sheets, pricing power, and attention to asset efficiency. While some of these qualities are shared by international markets, we find they are strongest in the US, suggesting it is too early to call the end of US exceptionalism.