Teflon-coated S&P 500

The US stock markets have crossed into a record territory, the longest bull market on record. They have just crossed the 1990 to 2000 bull market record of 3,452 days of consistently rising prices, with no correction of even 20 per cent. The markets have hit new highs and seem to show no sign of stopping. The US equity markets have been the place to be since the financial crisis, and have totally broken away from other regions since 2013. Just to give some context, if one were to rebase all equity markets to 100 (starting March 2009), then today US equities are near 450, while all the other regions, be they emerging markets (EM), Europe (EU), Japan or the UK, are between 200 and 225. The numbers are similar whether you look at large-cap indices or even indices for mid- and small-cap stocks. The US outperformance is not just about the FAANGs (Facebook, Amazon, Apple, Netflix and Google’s parent Alphabet stocks), or technology, it is much more broad-based.
 
The markets have also been remarkably resilient, refusing to buckle despite the trade wars/tariffs, signs of political difficulty for the Trump administration and the tightening of financial conditions in the US.
 
Why have US markets been so stable? Additionally, given the relative performance gap, especially in 2018, is it time to rotate away from US equities back into EM assets?
 
The best explanation for the resilience is that strong fundamentals are driving the US. Political risks are being swamped by earnings growing at 25 per cent, an acceleration in revenue and continued strong forward guidance. The US bull market is also being helped by an explosion in buybacks. In Q2 2018, US companies repurchased $433 billion of stock, nearly double the previous quarterly record of $242 billion set in the previous quarter. You can see where the tax cut windfall is going!
 
Elevated levels of private equity and mergers and acquisitions activity are also shrinking the universe of listed companies in the US. In 1996, there were 8,090 listed companies in America, which have now shrunk to about 4,300. As the potential universe shrinks, capital herds into the remaining stocks. Investors, for the time being, are ignoring the decoupling between reported earnings and the national income data on corporate profitability, which shows a more muted earnings trajectory.
 

Illustration by Ajaya Mohanty

An alternative explanation for the market’s stability is the implicit assumption that these political difficulties will force US President Donald Trump to shift focus and back away from more radical measures on trade and immigration. While he has delivered on deregulation and tax cuts, markets fret on his anti-globalisation instincts and obsession with the US trade deficit. The best case would be his toning down of protectionist tendencies, coupled with a continued focus on deregulation. Trump is likely to move more in this direction — the greater his political troubles.
 
As for moving money into EM assets, the arguments are clear. EM assets are in a bear market, and valuations are dramatically cheaper than the US. EM equities have been hit by a rising dollar, tightening liquidity, trade tensions and contagion risk.
 
The bulls argue that economic history shows that protectionism hurts the country closing its borders more than the countries supplying the goods. The US is at full employment, has hit its inflation target, has a massive fiscal stimulus underway and will not find it easy to replace Chinese imports. Even if it were to move away from Chinese goods, the alternative source for most of these products is other EM economies. The EM world taken together may not suffer. There is no way the US can stop importing these products, there simply isn’t enough manufacturing footprint to produce in the US. The trade wars will hurt EM less than the popular perception.
 
Even from a contagion risk perspective, the EM equity markets today are far more resilient. The four biggest EM markets today are China, South Korea, Taiwan and India — very different from the late 1990s when the biggest markets were Brazil, Mexico, South Korea and South Africa, all of whom had serious external imbalances. Today 75 per cent of the MSCI EM index is Asia, compared to 37 per cent in the late 1990s. The stability of growth and economic management is far better in Asia than in other geographies.
 
If you believe that the current bull run in the US still has some time and steam left, then a case to rotate into EM equities probably makes sense. However, if you feel that we are in the final innings of the US bull run, then caution is warranted. EM assets will not be able to decouple from a breakdown in US equities. In that case, cash remains the best bet.
 
India is now perceived as a safe haven within the EM universe. We are not a big exporter, nor do we have large foreign ownership of our debt markets. We benefit from falling commodity prices and the overvaluation of the rupee has been largely corrected. Continued weakness in EM equities will ironically lead to capital flows into India as global investors seek a hiding place from global turmoil. Already the outperformance delivered by India year-to-date is severely hurting those funds underweight the country. A few more months of this and despite falling markets, foreign portfolio investors (FPIs) may turn buyers after almost two years and ten billion dollars of non-stop selling. I hesitate to say it but Indian relative outperformance seems set to continue, till such time as other EM equity markets remain under pressure.

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The writer is with Amansa Capital