Global equity markets continued to march higher this week on the back of the apparent de-escalation of the trade war. We discuss recent developments in this ongoing saga. We also return to a question that was on our minds well before the trade war began: the sustainability of U.S. outperformance.
De-escalation of trade war has been significant.
A de-escalation in trade tensions has emerged over the past month. The U.S. and China took meaningful steps. This week, both countries agreed to reduce their tariffs for the next three months, carving out time for a more comprehensive trade deal to be negotiated. In addition, the U.K. and the U.S. agreed to a limited bilateral trade deal. Some sectors will remain subject to duties, but others will be spared entirely, indicating that the U.S. administration may be approaching things more strategically than previously appeared. Both trade deals leave in place the baseline 10% global tariff rate imposed on "Liberation Day". This 10% rate is broadly in-line with what investors expected earlier this year.
The reduction in tariffs to a more manageable level reduces near-term risks to global growth. Nevertheless, the effective U.S. tariff rate is still at its highest level since the 1930s. This elevated rate may create some stagflationary headwinds, particularly in the U.S., with economic growth slowing and prices rising. There have been few signs of tariff-induced pricing pressures thus far, however, these pressures are expected to emerge over the next few months.
Can U.S. exceptionalism prevail?
The U.S. stock market has recovered the losses experienced in early April. As a result, the stock market is at about the same place it was when the year began. In January, we were contemplating whether the long-term trend of U.S. stock market outperformance could continue. Its outperformance over the past decade has been driven by a combination of strong earnings growth and a valuation re-rating over the years. Investors had been willing to pay more for a dollar of earnings than they did in the past. This valuation “premium” can be justified to some extent by the U.S. stock market’s strong track record of consistently generating attractive earnings growth, elevated profit margins, and high returns on capital. The willingness of investors to push the valuation premium higher over the past decade has left U.S. stocks rather expensive.
While we are confident in the ability of U.S. stocks to continue to generate strong earnings growth in the years ahead, we are less convinced that the valuation multiple can move higher in a similar fashion to what we have witnessed over the past decade. We expect that the returns from U.S. stocks in the years to come will be less impressive than over the past ten years.
Less concerned and less enthusiastic about the investing environment
As noted above, recent trade policy developments have lowered some of the risks to the global economic outlook. The risks have not, however, completely disappeared. Existing tariffs may still result in slower growth and a rise in inflationary pressures. U.S. tariff policy could become more aggressive again. Overall though, we are less concerned about the near-term outlook than we were a month ago. This more optimistic view is, however, already reflected in current stock prices.
Opportunities to invest tend to arise during periods of market dislocations, when prices reflect investor concerns, elevated uncertainty, and higher risks. This type of period unfolded last month, but it proved to be relatively short lived. Inevitably, there will be future surprises that may result in periods of more prolonged market weakness that may provide more opportunity, either through rebalancing across our client portfolios or through targeted investments.
If you have any questions, please feel free contact us.
Drew M. Pallett LL.B.
Senior Portfolio Manager and Investment Advisor
RBC Dominion Securities
Email: drew.pallett@rbc.com