At the recent Jackson Hole symposium, Federal Reserve chairman Jay Powell said he saw no “elevated risk” of the US economy overheating. Others would beg to differ, as US GDP growth shoots above 4%, the S&P 500 extends its longest-ever bull run, merger and acquisition activity takes off and buybacks accelerate.
President Trump’s current fiscal experiment is unusual, coming at a time when the US economy was already strong. Robert Love, head of research at Asset Intelligence, says: “The Trump administration’s tax cuts and spending increases represent a sizeable fiscal stimulus at a time when the economy is at full employment, so overheating risks could emerge on the horizon. This would put pressure on bond yields and interest rates to rise further, a risk which is already alive due to the Federal Reserve’s ambitious plans to reduce the scale of its balance sheet.”
The second quarter GDP growth figure of 4.1% - this week revised to 4.2% - seemed to support the ‘overheating’ thesis, along with President Trump’s bullish view that “we're going to go a lot higher than these numbers, and these are great numbers”.
The S&P 500 bull run is now the longest in history and continues to be fuelled by stronger earnings as companies reap the benefit of corporate tax cuts. Buybacks have also accelerated, leading some to suggest that share prices are being artificially supported. On most measures, the US stock market looks highly valued relative to its peers and its history.
US Inflation Benign
That said, investors have been worried about the US economy and stock market for some time and both have continued to surprise investors with their resilience. Perhaps most importantly, inflation has been relatively benign in spite of economic growth. Chairman Powell’s view was that while inflation has moved up near 2%, the central bank has seen no clear signs of an acceleration above 2%.
For all President Trump’s bravado, it is also possible that the 4.1% growth rate was an anomaly. Love says: “Drilling down into the data, it seems that some of the 4.1% annualised growth seen in the second quarter was in fact driven by Chinese firms speeding up their purchases of US imports in advance of any potential trade war. Therefore, the US economy may not be as overheated as this figure makes it appear at first glance.”
Hao Ran Wee, a strategist at Barclays Wealth Management, agrees: “The fiscal stimulus employed by the US government has already shown some signs of boosting growth in the short-term, but we think that its effects are likely temporary, and unlikely to change the long-term growth profile of the US economy.” This had been in the region of 2.5-3% in prior quarters.
There are mixed views on what this means for stock markets. While there may be few signs of overheating today, stock markets are forward-looking, and for that reason, Gavin Haynes, investment director at Whitechurch Securities, is cautious on the US markets: “While everything looks rosy and the market is likely to be supported in the short-term by strong corporate earnings and Trump’s tax reform bill could see one final push for the US market bull run, we are feeling a bit nervous.
“We are beginning to see a number of fund managers starting to question the sustainability of the US economic strength. On this basis the strong run of corporate earnings could begin to falter and high valuations, rising interest rates, and the political uncertainty over Trump are key reasons that make us cautious about the wider US market.”
He points out that US stock market valuations are trading significantly above both five year and 10-year averages and sectors such as technology particularly look stretched following an exceptional run. Given the potential clouds on the horizon, it wouldn’t take much bad news to destabilise markets. Volatility may have increased this year, but it remains low by historic standards, which suggests some complacency.
US Growth Story Intact
However, groups such as BlackRock are firmly of the view that investors should be directed to those parts of the global economy that show the strongest growth, which remains the US rather than Europe or the UK. The BlackRock Investment Institute says the US market has, “unmatched earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view.”
Ran Wee also believes the global growth cycle has further to run. US share prices are being driven by earnings, and the influence of buybacks has been exaggerated, he argues. In many cases earnings have also been driven by an increase in top-line revenue, with the S&P 500 delivering 9.9% revenue growth in Q2 2018, according to Factset.
Perhaps the biggest worry for investors should be the timing of any exit from US markets. While there may be further to run, the flattening yield curve – where yields on long-dated bonds compress to a similar level to short-dated bonds – has historically been a sign of more difficult times ahead. It may not be easy to judge the tipping point for the US economy.
