FYI | Jan 29 2015
By Louis Gave of GavekalDragonomics
Investment decisions are typically driven by the costs of five factors: land, labor, capital, energy and government. One of the key theses of Too Different for Comfort, the book I wrote a couple of years ago (available for free download here), was that in the years following the Asian Crisis of the late 1990s, Asia boasted one massive comparative advantage: a much cheaper cost of labor than anyone else. So for ten years, any new factory, petrochemical plant or call center was far more likely to spring up in Asia than anywhere else. The fact that during that period the marginal investment dollar tended to flow to Asia meant the region experienced a triple merit scenario of appreciating currencies, falling interest rates and rising asset prices.
However, as the book argued, the collapse in prices for DRAM modules, optics, and software coding meant we moved into a world in which low-end labor was increasingly replaced by machinery and software programs (which is why the book’s cover pictured a robot). In this brave new world, Asia’s cheap labor was no longer a killer comparative advantage. Instead, the new comparative advantage lay with the US which, thanks to the shale revolution and the knuckle-headed energy policies of Japan and Germany (which turned off their nukes following Fukushima), enjoyed a far cheaper cost of energy than anyone else. And, as the book also argued, cheaper energy costs meant that the marginal dollar of investment began to flow not to Asia but to the US, making for a stronger US dollar and the outperformance of US assets.
This theory looked good until energy prices started to collapse. Now, however, everyone has a cheap cost of energy, which begs the question: where is the US comparative advantage today? One thing is for sure: it is not a low equity market valuation. Indeed, with the P/E ratio on the MSCI US flirting with 20, one has to ask what will drive a continued bull market in US equities (see chart in web version). With the Federal Reserve no longer pumping liquidity into the system, global bond yields unlikely to fall much from here, and corporate spreads widening, it seems unlikely that US P/E ratios will be able to climb much further from their currrently elevated levels. This means that if it is to continue, the bull market in US stocks will have to rest on solid earnings.
On this front, the recent news is lackluster. First, energy companies are having to cut their estimates drastically to bring their outlook into line with the new oil price reality (according to Bloomberg, the S&P 500 energy sector is trading at 13x 2014 earnings, but 22x 2015 estimates). Meanwhile, the latest results from JP Morgan, Goldman Sachs and others show that bank earnings are getting squeezed by higher compliance costs on one side, and the challenge of making money in a world of flatter yield curves on the other. Possibly the single biggest question mark hovering over US earnings, however, is the impact that the rapid rise of the US dollar will have on bottom lines. After all, as much as a third of S&P 500 earnings is reported to come directly or indirectly from abroad, so a strong US dollar is likely to be a stiff headwind for margins and profits going forward. In recent days, releases from the likes of Caterpillar, DuPont, 3M, Procter & Gamble and Microsoft all seem to indicate that the US dollar’s strength is biting hard. In short, the ‘foreign’ earnings component of the US earnings per share equation is very likely to disappoint over the coming years.
So, if betting on a further expansion in P/E ratios expansion makes little sense, and if betting on solid foreign earnings for US corporates is imprudent, then US equity bulls will have to pin their hopes on a massive boom in domestic US earnings. This may well materialize, thanks in part to the likely pick-up in US consumption and investment triggered by the lower oil price. But then, given the relative valuations, wouldn’t it be wiser to play the US consumer by buying European or Asian exporters than to overweight US equities today? Indeed, why overweight US equities when Asia benefits more from falling oil prices than the US? Or why overweight US equities when the combination of low oil, low interest rates and a weak currency will surely boost Europe from its currently depressed state? (Or to put it another way, if euroland cannot grow with a cheaper currency, cheap oil and record low interest rates, then it will never be able grow at all, and the whole region can be written off for good.)
To put it all together, it seems that, at the margin, overall fundamentals no longer argue for US outperformance (we would argue that fundamentals are once again smiling on Asia). Nor do valuations (valuations are much more favorable in Asia and, to a lesser extent, Europe). Nor does excess liquidity creation (the Fed is now one of the few central banks not aggressively printing money). The one thing that does remain strong, however, is the US equity market’s momentum. But is strong momentum alone a good enough reason to overweight US equities? We doubt it. We may soon reach the point at which underweighting US equities in a global portfolio starts to reap returns.
The information contained herein is provided for informational purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy the securities or products mentioned. This document is a private publication intended for private distribution. The value of all investments and any income generated can decrease as well as increase. Performance numbers shown are records of past performance and as such do not guarantee future performance. No representation is made that any one investor achieved any of the results shown herein. This information is subject to change without notice. The securities and products mentioned may not be eligible for sale in some states or countries, nor suitable for all types of investors. Gavekal Research Limited does not warrant the accuracy, completeness, reliability, fitness for a particular purpose or merchantability of this information, and expressly disclaim liability for errors or omissions in this information and data. Gavekal Research Limited shall have no liability for the use, misuse, or distribution of this information to unauthorized recipients.
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