The risks of the US exceptionalism narrative - Angles & Perspectives Q4 2024

The risks of the US exceptionalism narrative

US markets continue to outperform, which has sent US exposure in global indices soaring to new highs. The belief in a compelling narrative drives market participant behaviour and leads to periods of exceptional performance. The ‘US exceptionalism’ narrative seeks to explain the surging valuations placed on US stocks as being driven by fundamentals following from the US’s recent economic performance. However, this narrative tends to overlook macroeconomic vulnerabilities and accumulating imbalances. When the current market trend runs out of steam, we may well see markets reach a ‘Minsky moment’, which could hold significant risks for global risk asset prices.

The compelling narrative of US exceptionalism
Market extremes are built on narratives. At the core of every good narrative is a kernel of truth. The US economy has grown significantly faster than other developed countries over the past five years. The US dollar (USD), shown in the chart below, has strengthened to a level last seen 40 years ago. The US’s largest technology companies, the Magnificent 7 (‘Mag 7’), have had a period of strong growth, much of it related to the developing artificial intelligence (AI) industry. The Mag 7’s share price performance has been spectacular. They have grown to massive weights in the S&P 500 and Nasdaq Indices, which has also driven good returns in these broader indices. US stocks now make up some 74% of the MSCI World index.

US domestic investors now have the highest equity ownership in recent history, and a river of foreign capital has entered the US financial markets chasing these returns. As US assets start to dominate global indices, benchmark-cognisant investors are forced to buy them – not that they need to be forced. The Bank of America Global Fund Manager December 2024 publication shows investors are the most overweight to US equities they have ever been (the survey covers about 25 years). So, US equities have grown to dominate benchmarks, and investors are at record overweight positions to that elevated benchmark level as well!

To most global investors, this overweight US positioning has been validated by the strong 2023 and 2024 equity returns, and today, the US exceptionalism narrative is totally dominant in determining positioning. Those questioning what the risks may be of the overwhelmingly US-centric positioning in the years to come tend to be viewed as Luddites who just ‘don’t get it’. This is strongly reminiscent of attitudes we personally experienced in late 2021 and during the 1998 to 2000 ‘TMT’ bubble, and have read about in regard to the ‘Nifty 50’ US stocks in the lead-up to the 1973 bear market.

With so much of global portfolios at risk, we believe it is crucially important for investors to examine the fundamental foundation to the US exceptionalism narrative on a forward-looking basis, and with some impartiality. The key underpinnings to the narrative are:

• attractive assets
• a strong USD
• superior growth

Let’s dive in and factually examine these underpinnings.

‘Attractive assets’
US equity indices are very, very expensive relative to history, on almost any measure. The Shiller price-earnings (PE) ratio uses through-the-cycle earnings and adjusts them for inflation. The current level of the S&P 500 Index implies a Shiller PE ratio of over 35x (charted below). This is a level that was only ever breached twice before, briefly in 2021 and during 1999 and 2000. Using Robert Shiller’s own data, we can see prior long-term notable market tops peaked at 25x (1966), 33x (1929) and 26x (1901). The long-term average Shiller PE for the S&P 500 Index is 17.6x.

What are the implications of this record level of valuation? The Shiller PE has historically provided an excellent guide to the returns a long-term investor can expect in subsequent years. Looking back over the past 30 years, should you buy the S&P 500 Index at elevated prices, what are the subsequent 10-year expected total returns per annum? Purchasing equities with a Shiller PE of over 25x has never delivered double-digit annual returns – at a PE of over 30x returns have not exceeded 5% per annum and over 35x the vast majority of subsequent returns are negative (chart below). At the current PE of over 35x our best estimate of the total returns on the S&P 500 Index over the next decade is about -2% per annum. Note that this is a nominal return, and implies much lower real returns.

Attractive assets? US bonds are no longer acting as a portfolio safe haven
Unlike US equities, US bonds have not been attractive assets, with four years of very poor returns. Bonds underperformed both cash and gold in each of the past four years.

We believe the global macro environment has changed, with frequent supply shocks experienced since 2020 and more expected in the years ahead. Supply shocks simultaneously slow growth and boost inflation. Examples of supply shocks include energy price spikes, tariffs and trade wars, reshoring of supply chains and the curbing of immigration. This contrasts with the two decades prior to 2020, when the key issue was demand shocks. Why is this important? During periods when the key risk is demand, bond returns are negatively correlated with equity returns, making them fantastic safe-haven assets for global portfolios.

Most investors have negative bond/equity correlations in their risk system look-back period and, indeed, as their lived experience over their entire career as portfolio managers. The current positive correlation between bond and equity returns, which was so devastating to portfolios in 2022, is seen as an anomaly that will soon pass. We expect frequent supply shocks to continue, and by implication, positive correlations between developed market bond and equity returns. Investors need to look to a combination of gold, energy equities and cash for their global portfolio defences. Developed market bonds are relegated to trading assets and do not warrant a permanent allocation in portfolios.

The strong USD: A key underpin to the US exceptionalism narrative
Historically, periods of USD strength have closely correlated with US equity outperformance. This has once again been the case and as our first chart showed, the USD is at a 40-year high. Being the world’s premier reserve currency of course accords the US what was described by France’s finance minister Valery Giscard d’Estaing as the ‘exorbitant privilege’. This does not mean dramatic moves in the USD are unlikely, as that chart also illustrated. What it does mean is that the US has been given leeway to run much more extreme fiscal and current account deficits than would be tolerated by investors in other economies.

Fiscal prudence has been abandoned
Since Trump’s first term in 2017, the US has taken full advantage of the ‘exorbitant privilege’ and has run the largest deficits ever recorded outside of a war. While spending cuts have been talked about and we have Elon Musk’s ‘DOGE’, we see severe constraints on converting memes into genuine action. The demographic pressure from the retiring Baby Boomers on the two dominant spending categories, social security and medicare, makes future deficit reductions very difficult. These entitlements are very popular with both Republican and Democrat voters, and one of Trump’s explicit campaign promises was that neither entitlement nor defence spending (the third largest category) would be cut.

As a consequence, the net debt-to-GDP ratio has breached 100% and, combined with higher prevailing rates, resulted in the interest burden growing very rapidly as well. The US now spends more on debt service than defence and risks a spiralling negative feedback loop between higher rates and the widening deficit.

US international investment liabilities have exceeded US$61 trillion
As well as huge fiscal deficits, the US has consistently run wide current account deficits. These have expanded despite the shale oil boom transforming the US into a net energy exporter. These deficits have been funded by foreign capital inflows. Essentially, the US imports goods and ‘exports’ bonds and equities. This has been going on for many years, and the accumulated foreign claims on US assets are now enormous, some US$61 trillion or 2.3x US GDP. Of this, US$32.5 trillion is portfolio investment in bonds and equities.

This build-up of foreign capital liabilities has accelerated recently and introduces significant tail risks. Looking forward, not only must the US attract sufficient new foreign capital to fund its deficits in any year, but it must also maintain the confidence of all the existing investors. The consequences of foreign investors deciding to repatriate even a relatively small slice of their investments would be extreme moves in asset prices and the currency. These imbalances are visible and acknowledged, but dismissed as the US dollar – the world’s premier reserve currency – is assumed to be immune to normal market forces. We would disagree – it is exactly this reserve currency status and a long period of price appreciation that enabled the build-up of the huge imbalances to the current dangerous levels. This is a classic Minsky risk. Market forces will prevail in due course.

Political polarisation has raised risk
Investors hate policy uncertainty. The US historically could be viewed as a global hegemon, affording all the protection of a stable democracy and the rule of law. This is no longer the case in today’s multi-polar world, with the USD being weaponised against political adversaries in a fashion that effectively deprives them of due legal process. Policy uncertainty is very high and likely to rise under the Trump administration. Indeed, the new administration has explicitly said they desire a much weaker US dollar, and it remains an open question whether they will attempt to intervene in policy decisions made by the Federal Reserve.

Military dominance
The US is expected to spend about US$850 billion on defence in 2025. This is about 3% of GDP and compares to Cold War spending levels of 8% to 10% of GDP. In absolute terms, the US spends more than the next nine nations combined. While the conventional warfare capabilities are unmatched, we note that a US carrier group quickly retreated from the Red Sea in 2024 when it became apparent that missile and drone attacks could breach their defences. The Yemen Houthi rebels were able to effectively close one of the world’s busiest shipping lanes at will.

We see many cracks in the fundamental pillars supporting the US dollar, and expect the market to critically re-evaluate the US exceptionalism narrative as price momentum falters in the years ahead.

Stronger growth in the US has some fragile underpinnings
Mathematically, GDP can be expressed as working-age population x employment rate x output per worker. The domestically born US labour force has been shrinking for several years, but strong growth in the foreign-born labour force, through immigration, has sustained an overall growth in the number of people employed, boosting output and consequently GDP growth. Trump’s planned crackdown on immigration and the deportation of illegal immigrants will reverse this process, pressurising future growth rates.

In addition, policymakers have re-discovered the powerful impact of fiscal spending on growth since the 2020 Covid-19 crisis. No country has embraced this more than the US. When comparing growth rates, we should remember that US government spending has cumulatively exceeded revenue by nearly 45% of GDP over the past five years, much more than other nations. When evaluating future growth rates, we need to assess whether this level of deficit spending is sustainable.

US exceptionalism rests on fragile foundations
Our analysis shows the underpinnings to US exceptionalism are not as solid as the prevailing narrative implies. Macroeconomic vulnerabilities and massive accumulated imbalances have so far been virtually ignored by the market. This is, we believe, by far the largest risk in global financial markets. When the US equity price rise falters, crowded positioning, extreme valuations and deteriorating economic fundamentals together raise the risk of large declines. Alternatively, we could see a ‘lost decade’ for the S&P 500 Index (similar to that experienced from 2000 to 2010) with nominal returns around or below zero and substantially negative real returns.

When an index is extremely overvalued and its composition is very concentrated in a handful of stocks, it becomes a dangerous benchmark. While this is rare (in the US it has happened three times in the last 50 years), it is certainly the case with the S&P 500 Index now. When it does happen, passive and index-hugging active mandates become immensely risky. We believe our funds, which build portfolios from our best ideas and are not benchmark constrained, will play an important role for clients by both generating good returns and providing important diversification.

Investors will also benefit from overlaying a healthy dose of common sense on the outputs of their quantitative risk systems. The embedded assumption that holding the index is ‘safe’ and risk comes from deviations to the index or tracking error is a particularly dangerous one in the current environment of concentrated and overvalued indices.

Reference:
Hyman Minsky, The Financial Instability Hypothesis, 1992.