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Fortress America

12 September 2019

The US economy, currency and equity markets are notably robust due to structural inheritance factors as well as the unique way its economic institutions and boardrooms are run. GAM Investments’ Julian Howard examines how these advantages allow the US to navigate periods of economic and geopolitical uncertainty.

The trade war instigated by the current US administration is affecting economic growth and corporate earnings around the world. Both Europe’s and the developing world’s economies and stock markets have proven especially vulnerable due to their dependence on the global manufacturing supply chain. But investors seeking diversification and stability should look to the eye of the storm – the US. The US economy, the US dollar and the US equity market all enjoy unique characteristics which make them a vital part of any investment portfolio even though it is the US political system itself which has produced today’s heightened economic uncertainty.

The US economy lends itself to robust insulation from external forces. With a population of 372 million, an estimated 80% of the economy is based on consumption. Second quarter GDP numbers showed just how important this was: amid an intensifying trade war and business investment slumping by -5.5% on the previous year, US GDP was still able to post a 2.1% gain ahead of Wall Street expectations thanks to robust consumer expenditure. Such is consumer confidence that mortgage applications for house purchases (as opposed to refinancing) have also been steadily rising. As consumption and services become an ever larger part of the US economy, an industrial or manufacturing slowdown is becoming an increasingly unlikely source of any future recession. In today’s fraught global trading environment, that is a highly attractive feature enjoyed by few other economies.

Chart 1: Consumed by optimism – wages, mortgage applications recover to pre-GFC levels

Source: Bloomberg (July 2009- July 2018)

For international investors, the US dollar’s stability is also vitally important in order to preserve the value of their investments in local currency terms. Again, the US finds itself in an exceptional position on this score. The US dollar is strong and stable thanks to its status as a de facto reserve currency which shows little sign of changing. Global trade is increasingly carried out in dollars while US dollar-denominated debt owed by firms and governments is approaching USD 10 trillion. The global economy has literally bought into the US dollar’s status, encouraged by its ability to act as a store of value (via its highly liquid capital markets), as well as its high levels of liquidity and safety. The last point is crucial, with the US Federal Reserve (Fed) clearly demonstrating it is prepared to act as a lender of last resort. During the 2008 global financial crisis, the US central bank instituted currency swap lines with no fewer than 14 other central banks in order to ensure a steady supply of dollar liquidity. The US dollar is not immune to depreciation of course, as seen in the first decade of the 21st century when the economy struggled to recover from a recession. And the US administration recently mooted the possibility of devaluing the US dollar by 10% in order to support export manufacturing. But the ‘dollarisation’ process of the last decade or so, combined with the intrinsic features described above, suggest that the US dollar will remain an attractive currency amid on-going global – rather than US-specific – economic turbulence.

Turning to the capital markets, and in particular US equities, American exceptionalism again applies. While some internationally-focused US firms such as Nike have exhorted the US administration to tone down the trade war rhetoric, US corporate profitability remains robust. Median profit growth expectations for the second quarter corporate earnings season are +4% on the previous year, while many firms are demonstrating managerial flexibility by shifting their supply chains away from China instead of waiting for uncertain political outcomes. In practical terms, this means moving factories to ‘second tier’ manufacturing bases such as Mexico, Thailand and Indonesia among others. Support is also coming from an increasingly ‘on-side’ Fed which has become more open to interest rate cuts as the global economic storm clouds gather. But the US also offers something intrinsically superior to other markets which transcends prevailing conditions: a consistently higher Return on Equity (RoE) than other markets.

Chart 2: More bang for your buck – US enjoys higher RoE than other markets over time

Source: Bloomberg (December 1999- June 2019)

What might account for this? Put simply, a higher quality of corporate management. This is not just a hunch that ‘American firms are simply better run’ than others, rather a scientifically observed phenomenon. In a seminal 2010 study by Nicholas Bloom and John Van Reenen1 , US firms achieved the top management score globally based on criteria such as adoption of modern manufacturing techniques, performance monitoring, internal target achievement, peer review processes, incentive structures and talent management. While a strong business education infrastructure is probably part of the reason for this high score, America’s Darwinian approach to individual success and failure in the corporate world is likely to play the bigger role. Interestingly, the UK scored ninth in the world, with the authors highlighting a fatalistic culture of leadership mediocrity personified in popular culture by characters such as Basil Fawlty, David Brent and Alan Partridge. In the US, such caricatures are harder to relate to due to their relative absence. This superiority of management combines with the sheer depth of the US equity market, where nearly six and a half billion shares were traded daily on average in 2017. The result is that the S&P 500 tends to demonstrate ‘skewness’ over time, performing well in a rising global equity environment but also defending robustly in a falling global equity environment, reflecting a prized ‘all-weather’ characteristic.

Chart 3: No ‘Fawlty’ management here – US comes top in measured management quality

Source: Bloom, Van Reenen 2010

Fortress America is a well-observed economic and investment phenomenon. Other regions and investment styles may demonstrate higher growth, such as emerging markets with their blossoming middle classes, while others may appear to offer better outright value, for example much-derided European equities. But the US economy, currency and equity markets enjoy a resilience which derives in part from structural inheritance but also owes much to a consistently high quality of leadership across its economic institutions and boardrooms. These unique advantages leave the US well placed to weather a prolonged period of global geopolitical and economic uncertainty, even when its roots are home-grown. While some would argue the US administration is trying to make the country more insular, the good news is that US capital markets remain easily accessible to international investors.

1Why Do Management Practices Differ Across Firms and Countries? Bloom & Van Reenen, 2010

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.