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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation report for Feb. 3, 2025. I'm Phil Adler. Investors looking for the next big opportunity might do best by not straying too far afield. Confluence Chief Market Strategist Patrick Fearon Hernandez joins us today to discuss why The US economy and US stocks still look plenty attractive.
Phil Adler:Patrick, let's begin with a look at investor psychology. True or false? A long rally tends to make investors nervous and focus too much on perceived negatives, which by the way may not be all that negative.
Patrick Fearon-Hernandez:Well, hi, Phil. And, yes, that's true. And I think it applies especially well to the current outperformance of The US stock market compared with foreign stock markets. The US market's total returns have not only bested foreign market returns for the last couple of years, but they've done so for more than a decade on average. So as if by clockwork, many observers continue to call for a period of US retrenchment and outperformance of foreign stocks.
Patrick Fearon-Hernandez:That's a key reason why we wrote this piece. Sometimes investor nervousness about a fast appreciating asset class is misplaced. Sometimes a well performing asset class has room to run. Looking at The US political and economic fundamentals, it seems to us that The recent US stock market outperformance could run further.
Phil Adler:Patrick, you're emphasizing in this week's report titled American Exceptionalism and the Markets, how positive The US economy and US stocks look when compared to the rest of the world. And 1 of those points of comparison that you discuss is gross domestic product growth. What stands out to you?
Patrick Fearon-Hernandez:Well, economic growth is obviously an important source of support for stock prices. In The US, GDP growth in recent quarters has been modestly better than the long run average of about 2.1% per year. Now, that may not sound so great, but keep in mind that very few of the other major developed countries have had recent economic growth above their long run trend. Most other developed economies are growing slower than average, sometimes dramatically so. Therefore, US stocks, which on average are geared toward the domestic US economy, have the wind at their back.
Phil Adler:Do signs suggest that this disparity will continue?
Patrick Fearon-Hernandez:Well, in the near term, yes. The economic data suggests that major economies ranging from the eurozone and The UK to Canada and Mexico are facing significant headwinds, at least in part because of the Trump administration's plan to impose big import tariffs on them. That suggests The US advantage will continue in the near term.
Phil Adler:Are there other key indicators that illustrate the superiority of The U. S. Economy?
Patrick Fearon-Hernandez:Well, we also like a range of structural U. S. Advantages, such as the country's deep, well regulated capital markets, its incentives for innovation, and its relatively high commitment to research and development spending. You could also probably include the way that key U. S.
Patrick Fearon-Hernandez:Industries have become oligarchic, which tends to produce outsized stable profit margins. Advantages like that are a lot less likely overseas.
Phil Adler:Another argument supporting American exceptionalism is the smooth transition of political power in The US since the election. Patrick, could you review how we compare to other developed countries?
Patrick Fearon-Hernandez:Well, we're especially struck by the relative political stability and clear mandate of the executive here in The US compared with most of Europe or Asia. Maybe the most striking difference is that so many of the parliamentary systems in Europe have produced really fractured parliaments where no party holds an outright majority, and sometimes the traditional party coalitions can't even form a majority government either. That's a recipe for paralysis or stagnation or both. In contrast, here in The US, the 2 party presidential system has produced a government with an apparently clear mandate for change. Whether or not you agree with president Trump and his agenda, the Republicans' clear majority in the November election is more stable than is the case in much of Europe and Asia.
Phil Adler:Let's focus on this for a moment. So you think that the parliamentary forms of government in Europe elevate multiple splits in voter opinions to a highly visible status, and this creates volatility in government transitions that The US does not normally experience?
Patrick Fearon-Hernandez:Yeah. That's part of it. Both the European style parliamentary system and The US's Two party system have advantages and disadvantages. Right? For example, the parliamentary system can make the government more responsive to the citizens shifting political preferences since the prime minister can typically be toppled and replaced by a no confidence vote and the legislature is typically made up of many different parties.
Patrick Fearon-Hernandez:In contrast, Americans are generally stuck with their president for a full four year term even if they get tired of him. So, right now, as much of the European electorate gradually shifts to the political right, the fractured parliaments are having trouble forming stable governments. But the US election produced narrow but relatively stable government here in The US.
Phil Adler:Patrick, you also consider in your report the simple performance of The US stock market compared to other markets around the world. How do we fare overall?
Patrick Fearon-Hernandez:Well, as many of our listeners probably realize, The US stock market has really outperformed for more than a decade now. As I note in the article, the MSCI United States Total Return Stock Index rose 26.6% in 2024, while the MSCI all cap World ex US Index provided a total return of just 6.6%. Taking a somewhat longer view, The US index provided an average annual total return of 15.2% over the last five years, handily beating the average total return of 4.9% for the ACWYXUS index. The chart that I included in the article really illustrates how strongly The US market has risen compared with the average foreign market. Now, of course, past performance does not necessarily show what will happen in the future, especially since US stocks on average are very highly valued compared with foreign stocks.
Patrick Fearon-Hernandez:Nevertheless, there is reason to think The US stock market could continue to perform unusually well given that it's especially highly geared to fast growing sectors such as information technology and communication services.
Phil Adler:Patrick, how does the performance of The US stock market compare to China's market and what are the implications of this?
Patrick Fearon-Hernandez:Well, the MSCI China stock market has certainly had periods of good performance over the last decade or more. But since it has struggled more than most foreign markets. That reflects a number of big structural economic headwinds that investors have finally started to recognize in China, such as its excess industrial capacity and high debt, its weak consumer spending, its poor demographics, and the like. It's now pretty clear that those big structural headwinds can indeed really drive the stock market in China lower. So although many foreigners were enthralled by the earlier economic growth in China, they now are much more skeptical.
Patrick Fearon-Hernandez:So they're looking with greater interest at The US stock market and its good performance and the positive political and economic environment here in The US.
Phil Adler:Well, we know that a correction is always possible and may be triggered by a number of factors, and and we also know that buying opportunities can be created when markets over correct. But simply comparing The US stock market to others around the world are the factors that create the broad US strength likely to
Patrick Fearon-Hernandez:continue? At least in the near term, over 2025 and perhaps a year or two beyond that, we think it's possible to be optimistic about continued outperformance in The US. Not only are The US fundamentals good in a number of different respects, but the structural headwinds to stock markets in China and Europe mean investors may not want to be putting their capital to work there. There seems to be a good chance that investors will keep favoring The US as their preferred investment destination for a while yet. But Phil, I want to emphasize something important.
Patrick Fearon-Hernandez:Despite our favorable outlook for US stocks, we aren't saying that there won't be opportunities in foreign stocks or other asset classes. There certainly will be and keen eyed investors will likely be able to identify them. Many investors will also want to maintain exposure to foreign stocks and other asset classes simply for diversification purposes. All the same, our big picture analysis suggests that US stocks will have the most wind at their backs in 2025 and possibly for some time after that.
Phil Adler:Well, Patrick, this is all reassuring to those of us heavily invested in US stocks. Maybe this encourages us to take a a longer term and healthier perspective when we encounter the daily negative headlines. But before we wrap up, what are reasons for at least some nominal caution?
Patrick Fearon-Hernandez:Well, the answer is probably fairly standard. First, because of all the strong buying in US stocks in recent years, US valuations are stretched. And, of course, valuations for some big growth stocks such as the Magnificent Seven and others related to artificial intelligence are really stretched. On a related note, keep in mind that if there's an unexpected change in the AI technology space or competitive landscape, that could also force a repricing of those stocks. We got an inkling of that in when there was a report that a Chinese AI firm was able to develop a powerful model at a fraction of the cost of its US competitors.
Patrick Fearon-Hernandez:Finally, if the Federal Reserve fails to cut US interest rates further or hikes them from here, that could also spark a correction. With equities, there's always the potential for volatility, even when the overall trend has been upward.
Phil Adler:Well, we can't conclude without revisiting the tariff question. Do increased tariffs threaten US superiority?
Patrick Fearon-Hernandez:You know, I think that's actually hard to say right now. On the 1 hand, if the Trump administration imposes big, broad import tariffs, it would likely further boost the value of the dollar, and a strong dollar has historically been associated with a stronger US stock performance versus foreign stocks. On the other hand, if such tariffs were really disruptive to The US economy, you can imagine that US stocks could ultimately suffer. For now, until we have some clarity on any tariffs that actually get implemented, investors should probably consider them a potential source of volatility and plan accordingly.
Phil Adler:Thank you, Patrick. The title of this week's report is American Exceptionalism and the Markets, and you can find a link on the Confluence Investment Management webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.