The death of the US equity premium
What adjectives do you normally associate with the US government?
Ask that question across the political spectrum, and you might find the answers pretty paradoxical. However we’d wager most would agree that the US government is, by-and-large, pro-business. Particularly compared with other affluent nations.
Whether it’s under a Democrat or Republican administration, the US has long heralded enterprise as the driving force of growth, and policy has followed suit. Think of Trump’s 2017 corporate tax cuts as a recent example, or the Obama administration’s tacit decision not to chase criminal convictions in the aftermath of the financial crisis.
Putting business first has paid off for the past decade in the form of solid economic growth, record levels of employment and euphoric equity prices.
In particular, investors in US markets have seen their fortunes soar as the main market indexes have outgunned their global rivals over the past decade:
Accommodative government policy is, of course, not the only factor. Strong fundamentals in the form of higher margins, growth and a higher weighting towards tech have all contributed to the bonanza for investors.
Together it has led to what many market observers have referred to as an American equity premium -- a phenomenon where US assets command much higher multiples of earnings than their equivalent counterparts across the globe.
Here’s how the cyclically adjusted price-to-earnings ratio -- a popular measure that uses the average inflation-adjusted earnings of the past decade relative to price -- looked last summer for various global stock markets:
Not even the current administration, with its clear distaste for the formalities of government and America’s wider role in global geopolitics, could deter investors from parking their cash in US equities over the past five years.
It might now.
It’s easy for investors to ignore problematic governments when times are good. The market can paper over endless stories of administrative turnover, slashed departments and extended vacancies in key positions in the knowledge that it doesn’t matter much for the wheels of economic growth. As long as the government stays out of the way, the show should go on regardless.
The coronavirus pandemic has ended this. Equity markets, after a benign decade, are screaming for a co-ordinated, competent and concentrated response from the US government to stem what Wall Street analysts are beginning to pencil in as the fastest economic collapse in recorded history. Suddenly, the Trump administration’s comic approach to government has became a bad joke as a fiscal stimulus bill struggles to make it through the legislature.
Meanwhile in Europe and Asia, governments (some faster than others, admittedly) have responded with vast spending plans to cushion the blow of a twin demand and supply shock. Wage guarantees, small business loans, and quasi-nationalisations are just some of the policy measures being implemented which would have been unimaginable even a month ago.
America’s sluggish response, first in rhetoric and now in action, demonstrates to investors that they ignore the competency of the ruling-government at their peril. Particularly when every day that passes without a government response only deepens the costs -- both to humans and capital -- over the longer term.
But it may also a signal a sea-change in how investors think about pricing risk in the aftermath of the pandemic. For instance, what discount rate do you apply to cash flows if the US government proves to be far less resilient to exogenous shocks than its G20 counterparts? We’d argue: a much higher one than investors do now.
The death of the American century might have been exaggerated, but perhaps this crisis will signal the end of the American valuation premium. After all, what use is accommodative business policy on the way up, if it directly feeds back into the fact it can’t cushion you on the way down?