• The US stock market is historically expensive
  • The UK is a relative bargain by comparison
  • International investors seeking value should favour the UK

Last week, prior to a modest correction, the US Dow Jones Industrial Average was pushing 44,000. The Standard and Poor’s 500 index was closing in on 6,000 carrying a historically high P/E ratio of 28. While US stock markets have been doing well both outright and relative to other countries’ markets over the past year, Trump’s victory gave them another boost.

Source: Koyfin

Last week I wrote that the big Trump rally probably wasn’t justified given the state of the US and global economy. This week, I’m going to elaborate.

First off, as I’ve written on several occasions this year, headline economic data has often painted an overly optimistic picture of the US economy’s health. A closer examination reveals that the private sector has faced significant challenges, characterized by declining commercial bank lending and negative private-sector job growth.

If businesses aren’t borrowing and hiring, then chances are they’re not growing. This helps to explain why Trump’s recent victory was as large as it was. Government workers tend to vote disproportionately Democrat.

Private sector workers are more balanced between the parties. If things were better in the private sector, Trump’s margin would have been smaller and were the private sector strong he might well not have won.

If the private sector has been underperforming, which is where corporate profits are typically generated, how has the stock market managed to thrive over the past year? A major factor is the significant decrease in inflation and interest rates, which traditionally supports the stock market.

Another key element is public deficit spending, which can positively impact corporate profit margins. Funds borrowed and spent by the public sector eventually flow into the private sector, as that’s where the goods and services required by the public sector are sourced.

But how sustainable are either of these factors? Can inflation continue falling as it has? Almost certainly not. It has now settled back into a range not far off the average of the past quarter-century. The Federal Reserve is likely to want to keep it there as per their stated desire for inflation to be in the low single-digits.

As for the deficit, that is less clear. Trump might want to continue the US government’s bad habit of chronic borrowing. But this only makes it all the less likely that inflation can decline further. It could even begin to rise again if energy prices reverse their decline over the past year, for whatever reason.

None of the above is to say that there are not positive things that Trump could do for the US economy. Actions to lower taxes, reduce regulations and other pro-business and investment policies could be on the way. But while positive, the effects would only show up over the longer-term.

Trump does not have a magic wand that can make the US debt pile go away or less costly to service. Then there is the big elephant in the room: implied future debt issuance required to fund entitlement programmes, which is even greater.

If you think it would be difficult to fundamentally reform the NHS, try getting material entitlement reform through both Houses of Congress. Trump may give it a try, but that would be extremely difficult politically. More likely, he will leave that intractable problem for the next generation to solve.

So, Trump’s hands aren’t exactly tied but his room for manoeuvre is severely limited. Yet the stock market reaction to his victory has been to rise from historically high valuations to historically higher.

Trump’s proposed tariff policy is also a potential negative. He claims that it will rebalance trade in favour of domestic business. That may be true, but there’s no such thing as a free lunch. Tariffs are a tax. Consumers will feel the tariffs in their pocketbooks. And if other countries retaliate with tariffs of their own, the ensuing trade war will be a net negative for corporate profits overall.

My hope is that Trump’s tariff is used more as a negotiating tactic to extract better terms of trade from China and other big exporters. If he succeeds in that, we might find that global trade actually increases during his term, which would be a big positive for both US and global growth. But it is a risky strategy that should be discounted by the stock market.

Trump may be a good president for the economy and business. He may do most, if not all, of the right things. But even if he does, the stock market will struggle to maintain current lofty valuations.

Fortunately, there are sectors of the market that still trade at reasonable valuations: basic industrials, energy, chemicals and logistics, to name a few. That said, following years of relative outperformance, almost every US stock market sector trades at a valuation premium to its counterparts abroad.

At what point will relative US valuations become so high that international investors will begin to favour foreign companies instead? Could it be that the knee-jerk “just buy the US” reaction to Trump’s victory didn’t really take relative valuations into account?

Quite possibly. Due to my view that inflation is likely to remain structurally, stubbornly elevated in the coming years I do recommend that investors remain in the market, where corporate profits and dividends are able to at least keep up with inflation.

But the defensive strategy is to prioritize income and dividends over the growth associated with higher-valuation stocks. An even more defensive strategy is to seek better value beyond the US market, such as opportunities right here in the UK.

In sharp contrast to the US, the UK FTSE 100 index is not trading at a historically high valuation. The index P/E ratio is about 15, only about half that of the S&P 500. The FTSE 100 was also unable to participate in the Trump bounce and lies below where it was when elections were announced earlier this year.

Source: Koyfin

This disparity is largely driven by the exceptionally high valuations and market capitalizations of “big tech” companies. However, most S&P 500 sector P/E ratios also stand significantly higher than those of their FTSE 100 counterparts.

The FTSE 100, meanwhile, is notably international, with its companies generating 80% of their revenue from outside the UK, including 20% from the US.

In this context, the FTSE 100 represents a global revenue opportunity at a relative discount. It also offers a dividend yield of 3.7%, well above the S&P 500’s yield of just 1.2%.

The contrast between the two markets is stark no matter from what angle you choose to look at it. If you’re concerned about the high valuation of the US stock market and looking for a relatively defensive, global, diversified, income-oriented, low-valuation market as an alternative, the FTSE 100 ticks all those boxes. I suspect some major global investors are beginning to think this way.

If so, they are going to begin shifting out of the US and into the UK. Given the far smaller size of the UK market, that would disproportionately benefit the FTSE 100. The S&P 500 market cap is now about $46tn. The FTSE 100 is only at about $2.5tn.

If the valuation gap were to close only modestly, say by two or three points in the P/E spread, the FTSE 100 could outperform in price terms by 40-60%. Some of that performance could come via the exchange rate, in the event the pound rises versus the dollar. Regardless, the potential outperformance would be of the same magnitude in currency-adjusted terms.

While the FTSE 100 may well be attractive to global investors for all the above reasons, even better is the opportunity to outperform it. This is the mission of my Southbank Wealth Advantage service. It adjusts sector and company weightings based on the current macroeconomic environment and employs a risk-weighted optimization approach to maximize diversification benefits.

There is substantial potential to outperform the FTSE 100 using the Southbank Wealth Advantage investment strategy. And if I’m right that the FTSE 100 is likely to outperform the S&P 500 as global investors begin to shift some allocations between the two, there could be significant potential to exceed US market returns. To learn more about how Southbank Wealth Advantage can help you seize this opportunity, click here.

Until next time,

John Butler,
Investment Director, Fortune & Freedom