The great American tax cut

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Ian Heslop, Head of global equities and manager of the Old Mutual North American Equity Fund, Old Mututal Global Investors.

The American Dream is alive and well. To this day the US remains a highly aspirational economy, characterised by the kind of can-do attitude for which it is renowned. But this economic vibrancy – itself the great draw for US equity investors – needs to be seen in the context of a society that is increasingly polarised.

The economic picture itself is subtle. I believe investors need to ask themselves where they expect growth to be paid for when growth itself is a scarce commodity. The real question, therefore, is where else, outside the US, is it possible to find the economic, jobs and profitability growth that the US is enjoying? The answer, of course, is essentially nowhere, or at least not on anything like the scale found in the US.

In an increasingly globalised economy, it is highly unlikely that the US will be able to continue to grow without some improvement in the economic fortunes of its major trading partners, including Europe and Asia.

On this basis, the fact that the US is the only area of real economic growth in the world could be seen in a positive light for equity investors. Conversely, given the trend towards globalisation and economic interdependency, that the US is the only area of real economic growth in the world could just as easily be seen rather less favourably.

The bull case is multifaceted, but that age-old symbol of the American Dream, the automobile is a good starting point. With the US consuming approximately 135 billion gallons of gasoline per year, the current fall in gas prices are acting as an enormous tax cut. Barclays estimates that a 20% fall in the oil price could result in $70bn consumer savings. Given the pump price has fallen from $3.50/gallon to $2.17/gallon (a 38% decline), this has had a significant impact on the amount of dollars in consumers’ pockets.

Declining oil and energy costs also translate into declining input costs for businesses. As businesses’ costs fall, essentially one of two things can happen: either, savings are passed on to consumers, or those businesses’ profitability increases.

From an investment perspective, while profit margins for many US corporates are relatively high there is still an opportunity for improving operating leverage as revenue growth continues, particularly with low wage inflation. If and when operating leverage does improve, we would expect to see growth in revenues being reflected more quickly in corporates’ operating income. 

It’s not all shiny new Ford Mustangs and sparkling white goods, however. The Federal Reserve is retrenching, and can no longer be expected to provide the tail winds markets have grown accustomed to through both quantitative easing and persistently low interest rates. Our view, which is broadly in line with the consensus, is that US policy rates will start to rise from the middle of 2015, all other things being equal. Furthermore, employment figures continue to surprise to the upside, making it increasingly difficult for the Fed to maintain its easy monetary policy stance.

US equity valuations are, by any traditional measure, relatively high. This masks a certain reality however, making it easy to misinterpret time series of historical price/earnings ratios since, in practice, the data can convey different meanings at different times.

On the face of it, the strengthening of the US dollar versus sterling (as well as virtually all other major currencies) should be a boon for sterling-based investors. Conversely, this may be an over simplistic view, given the fact that the proportion of S&P500 earnings derived overseas is rising, with dollar strength therefore having potentially negative implications for US corporate earnings.

We are also concerned by the significant weighting of financials in the S&P500. Financial sector earnings are subject to certain regulatory/taxation risks that the market may be overlooking; in an era of populist politics, a little “banker bashing” can do little damage to popularity ratings.

Weak December consumer spending data only add to the somewhat mixed picture. That said, I wouldn’t be the first to say that it is a brave investor who bets against the resilience of the US economy and the US consumer. The fillip that is the fall in the oil price feels like it should send the bears back to their cages – at least for the moment. 

Bull points:

  • The oil price decline should be a major boost for both US consumers and corporates.
  • Profit margins are already strong, but there remains scope for improved operating leverage.
  • Economic and employment growth show the US already has the momentum lacking in many other areas.

Bear points:

  • Rise of the dollar versus other major currencies is a headwind for US exporters, as is the growth differential between the US and pretty much everywhere else.
  • The ability of the Fed to continue to be as supportive as it has been is starting to look stretched.

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