US equities have outperformed global equities since the beginning of the recovery because the US economy was initially the sole engine of global growth, as European countries wrestled with the Eurozone crisis.
As the US economy recovered – driven by a recovery in the housing market, a shale renaissance, and a financially sound consumer – so did corporate earnings. Seven years into the recovery, the economy is still growing at a muted but steady pace with no exuberance to derail its path. Corporate earnings are now fuelled not only by a sound domestic backdrop, but also a synchronized global recovery fuelling demand for US goods internationally. With about 35% of earnings derived from overseas, the consensus therefore estimates US earnings will grow north of 10% in 2017 and 2018.
We often think of the US as one of the world’s most dynamic and innovative economies, so it is surprising that the US has one of the world’s highest federal rates of corporation tax at 35%. This is in part due to the increasingly partisan nature of US politics in recent decades, which made it difficult to pass corporation tax cuts through Congress at a time when other OECD members were reducing their rates. If handled well, the Trump administration may be able to build a consensus to improve the competitiveness to US corporation tax by cutting rates.
We would put the odds slightly over 50% that Congress is successful in passing tax reforms bringing corporate tax rates to 20%. In this case, many of the companies that are most domestically focussed – and which performed best immediately following the election – may lead the market. This includes domestically focused banks, industrials and material stocks and smaller companies that tend to pay higher tax rates.
We would also expect cash repatriation measures for tax “trapped” abroad. Taxing overseas cash at 12% as has been proposed by the House last week, could bring billions [of dollars] back to the US. Finally, we would stress that the fundamental backdrop for US equities is robust with and without the above as we have seen strong corporate profits growth in 2017 set to continue next year as global growth picks up. As the political process is difficult to predict and 2016 reminded us that it can deliver surprises, we believe a balanced approach to portfolio construction will be key for investors to navigate the coming market conditions.
Finally, on 17x consensus earnings for the next 12 months, the market seems fairly priced relative to long-term history and vis a vis the strong earnings growth it is set to generate. When looking at other asset classes such as Treasury Bonds, whose prices have been distorted by monetary policies, the equity market looks inexpensive.
Nadia Grant is head of US equities at Columbia Threadneedle Investments