Summary
US growth is likely to slow sharply, and recession risk has risen meaningfully. A slower rate of earnings in the US will also no longer justify US equities’ premium valuation. In contrast, Asian markets are trading just under historic average valuations and so relatively defensive.
What’s top of investors’ minds
US equity underperformance to resume as the year progresses
Our expectation for US equities to derate at least 10%, and more likely more than 15% this year forms the basis of our portfolio strategy. The S&P 500 12m forward P/E ratio is 19.8x at the time of writing, a 9% premium to its 35- year average based on Bloomberg data. A premium valuation made sense last year when the US economy was growing above its trend rate and much faster than other developed economies. However, we estimate that the Trump Administration policy – much less immigration, cuts to Federal spending and employment, and a roughly 20 percentage point increase in the US’ effective tariff rate – will cut US growth to sub-1% this year with a negative effect on corporate earnings. This sharp fall in the US growth trajectory and slower rate of earnings growth no longer justify US equities’ premium valuations. We expect the S&P 500 to derate to at least its long-term (35-year) average and more likely to below this.
Premium US valuation no longer justified by US growth
In contrast, Asian markets are trading just under historic average valuations and so relatively defensive. Our focus is on a) countries that can deliver policy stimulus to offset some of the tariff shock, b) markets where company specific factors are pushing up return on equity, and c) low volatility equity strategies to manage risk.
India stands out to us as being well positioned to weather the tariff shock this year. India’s exports of goods to the US are the second lowest in Asia at only 2.2% of GDP. Importantly, India’s government had begun proposing tariff rate cuts to the US even before Trump announced “reciprocal” tariffs on April 2, increasing the likelihood of a trade deal with the US. India may also benefit from global companies relocating production from China to reduce tariff exposure. Equally important, the sharp fall in Indian inflation to less than 4% yoy gives the Reserve Bank of India room to cut interest rates another 50bps and possibly 75bps in an effort to reflate the economy and asset prices.
We acknowledge that tariffs reduce Japan’s growth potential this year, particularly auto tariffs, and we now expect GDP growth of only 0.6% - 0.8%, down from 1.1% previously. However, rising wage growth should allow a bounce in consumption growth that works to offset some of the hit from tariffs. We also see continued improvement in corporate governance that works to raise return on equity, distribute excessive cash holdings, and unlock value via mergers and acquisitions.
China is admittedly tricky for investors because of the large headwind to growth that tariffs imply. The increase in the US tariff rate on China to 125% represents a roughly 3% of GDP drag on growth if sustained for the full year. However, China’s government announced 2% of GDP worth of fiscal stimulus at the NPC in March and we expect it to increase this significantly to try to keep GDP growth above 4%. This implies large support for consumption, accelerated purchases of idle property, and increased investment in industry, particularly in technology.
Nonetheless, with US growth likely to slow sharply and recession risk having risen meaningfully, we expect government bond yields to grind lower over the course of the year. Most central banks, including the Federal Reserve ultimately, are likely to cut policy rates significantly, pulling down yield levels.
Low Asian inflation leaves room for rate cuts and lower yields
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