Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 51

The US recovery will surprise on the upside

Many commentators suggest that US economic growth will remain subdued. However, a number of indicators are suggesting it will surprise on the upside. If it does, there will be significant implications for policy, investment markets and portfolio construction.

In our opinion, a wide range of indicators point to a likely acceleration of US economic growth in 2014:

  • Improvement in the US labour market is real – Jobs are being created at a rate of 2.1 million p.a., the unemployment rate has fallen to 6.6% and average weekly earnings are rising. Although some economists believe that declining labour force participation indicates that unemployment is worse than headline figures suggest, it is important to note that participation has been naturally declining since 2000 as a result of the ageing of the US population, not just since the financial crisis.
  • Housing will help drive the economy - Recoveries in key indicators such as home prices, housing starts and mortgage debt are encouraging. We believe that private residential fixed investment remains depressed at around 1.5% of GDP, below its long run level (excluding multiplier effects) and will inevitably revert to more normal levels. Furthermore, the share of residential mortgages in negative equity has fallen considerably over the past couple of years which may encourage more households to draw down on home equity for consumption.
  • Credit conditions are favourable – Household debt has fallen considerably from its peak of 96% of GDP in 2009 to 77% today (the same as 2003), providing scope for rising consumption in the future. Furthermore, US banks are well positioned to deliver credit growth with common tangible equity to common tangible asset ratios having approximately doubled since 2008.
  • The competitive position of the US is improving – US manufacturing hourly labour costs have fallen significantly relative to other countries (in USD terms) over the past 10 years. The shale boom has also provided the US with a massive energy cost advantage, while also helping to reduce the trade deficit.
  • Fiscal drag is decreasing - The government expenditure component of GDP has been contracting in recent years following the large stimulus provided during the financial crisis. Economists estimate that expenditure cuts and payroll tax increases reduced GDP growth by 1.5-2.0% in 2013. However, a dramatic recovery in the federal budget deficit suggests there is declining pressure for further cuts, and the fiscal headwind is expected to be just 0.5% in 2014.

It is our view that, in the absence of a material negative shock, the US economy will experience accelerating economic growth over the next 12 to 24 months, and is likely to surprise on the upside.

What does a US upside surprise mean for markets?

A strengthening US economy will require the Federal Reserve to reduce the unprecedented monetary policy support it has provided since the global financial crisis in order to ward off excessive risk-taking in the financial system and to protect against future inflation. The Fed’s exit from QE poses risks for equity and other asset markets (particularly currency and bond/credit markets) as long term interest rates start to move closer to pre-crisis levels, potentially causing a dramatic redistribution of global money flows. We continue to view the Federal Reserve’s exit from QE as the major current investment risk.

A faster-than-expected US economic recovery, with strong demand for credit, could lead to high inflation as banks start to lend from their massive pool of excess reserves, currently USD2.4 trillion. While the Fed has a number of tools that could reduce the size of excess reserves or neutralise their impact, there is no reliable historical precedent that can guide investors (or the Fed itself) as to what will happen to markets as QE unwinds.

We continue to believe that there are two main scenarios that could play out:

  • An orderly unwinding of QE. This is our base case, predicated on a steady but not sharp US recovery, with a gradual increase in credit demand, and contained rises in short and longer term US yields. Under this scenario we would expect the US 10 year Treasury yield to rise to around 4.5-5.5% over the next one-and-a-half to two-and-a-half years. We would expect elevated market volatility and potentially some dramatic re-pricing of certain asset classes. This scenario does not overly concern us from an investment perspective.
  • A disorderly unwinding of QE. Under this scenario, longer dated bond yields could start increasing rapidly as investors lose confidence in the Fed’s ability to exit QE in an orderly manner (it is not unthinkable that US 10-Year Treasury yields could hit 8-10% over the next one-and-a-half to two-and-a-half years). This could lead to massive market dislocations, including large and rapid falls in asset prices, major moves in currency markets and the withdrawal of liquidity from certain emerging markets, as well as increase global systemic risk. A rapid rise in longer term US interest rates would also be highly likely to drive up longer term interest rates around the world, potentially re-igniting the European sovereign debt crisis.

We assess the risk of a disorderly unwinding of QE to be a ‘fat tail’, or low-probability, scenario. However, as we have repeated on many occasions, low probability does not mean zero probability.

Implications for portfolio construction

Although a rise in US economic growth presents a tailwind for businesses positively exposed to the US economy, it is important to recognise that economic growth is not the most important determinant of equity market returns. Indeed, we believe long term interest rates have historically been more important to aggregate stock market performance; higher interest rates will reduce valuations via the discount rate on companies’ expected future cash flows, leading to lower equity price-earnings multiples in aggregate. Investors should be asking themselves ‘what effect will higher interest rates have on markets?’ We are paying close attention to this critical question.

 

Hamish Douglass is CEO and Portfolio Manager at Magellan Asset Management. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.

 


 

Leave a Comment:

RELATED ARTICLES

Trump’s fiscal stimulus threatens stocks

Stock market winners 10 years on

Why China’s property market matters

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Overcoming the fear of running out of money in retirement

There’s an epidemic in Australia that has nothing to do with COVID-19, the flu, or the respiratory syncytial virus. This one is called FORO, or the fear of running out of money in retirement, and it's a growing problem.

Latest Updates

Investment strategies

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Economy

A pullback in Australian consumer spending could last years

Australian consumers have held up remarkably well amid rising interest rates and inflation. Yet, there are increasing signs that this is turning, and the weakness in consumer spending may last years, not months.

Investment strategies

The 9 most important things I've learned about investing over 40 years

The nine lessons include there is always a cycle, the crowd gets it wrong at extremes, what you pay for an investment matters a lot, markets don’t learn, and you need to know yourself to be a good investor.

Shares

Tax-loss selling creates opportunities in these 3 ASX stocks

It's that time of year when investors sell underperforming stocks at a loss to offset capital gains from profitable investments. This tax-loss selling is creating opportunities in three quality ASX stocks.

Economy

The global baby bust

Across the globe, leaders are concerned about the fallout from declining birth rates and shrinking populations. Australia, though attractive to migrants, mirrors global birth rate declines, and faces its own challenges.

Economy

Hidden card fees and why cash should make a comeback

Australians are paying almost two billion dollars in credit and debit card fees each year and the RBA wil now probe the whole payment system. What changes are needed to ensure the system is fair and transparent?

Investment strategies

Investment bonds should be considered for retirement planning

Many Australians neglect key retirement planning tools. Investment bonds are increasingly valuable as they facilitate intergenerational wealth transfer and offer strategic tax advantages, thereby enhancing financial security.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.