The end of US exceptionalism?

Key Points:

• The US equity market has fallen more than 9% from its recent peak, a reasonably normal occurrence in any given year.

• It has also underperformed the rest of the World since late last year.

• We think this reflects a deteriorating policy mix in the US, concern about capex overspend in the technology sector and some improvement in the prospects of markets other than the US.

• We don’t think this is the end of US exceptionalism, the core reasons the US has grown the best companies in the World has not gone away.

• However, given the high valuation gap between the US and the rest of the World, bad policy in the US and better policy elsewhere presents the best opportunity we have seen in a while for a narrowing of their relative returns.

The US market has underperformed the rest of the world by around 10% since late last year. While 10% may not seem like a lot in the grand scheme of things, this underperformance represents a break in a long period of US outperformance versus the rest of the World. In this month’s Market Insight, we take a look at the cause of this underperformance and whether the US will continue to hold the equity market trophy in the years ahead.

Has the Policy Environment Switched?

We have long been believers in the concept of US exceptionalism. We wrote about the concept in May 2021 . The key point we made back then being: The US produces the World’s most successful companies for a variety of reasons. It is an enormous single currency, single language market full of wealthy potential customers. Regulatory and legal structures are amenable to growing a business. It is easier to raise debt and equity finance on Wall Street than in La Défense or Bankenviertel. The Americans have an entrepreneurial spirit unmatched elsewhere which draws the world’s best and brightest.

The other side of the coin is how much of a basket case the rest of the World has been over the past fifteen years. Since the Euro Crisis, European governments have been much more concerned with transitioning to green energy and regulating their economies rather than growing them. China concentrated power back into the Central Government and crunched the economy to deal with decades of overinvestment in the housing market. The UK Brexited itself into irrelevancy. Australia and Canada decided to prioritise house price growth over all else. Is it any surprise that global capital found its way to the USA? This exceptionalism has seen US equities outperform the rest of the World since the Financial Crisis, taking the market to around ~65% of global equity market capitalisation.

Now, with Trump in the White House and MAGA Republicans holding power in Congress, markets are worried that they are poisoning the well. Although the modelled economic impact of tariff announcements on the US economy are not in isolation large enough to cause meaningful economic disruption (see last month’s Market Insight), most businesses won’t relish the idea of higher input costs in their supply chains. Even those businesses who do not import intermediate components from overseas and compete with overseas producers for their finished components (simply, those who should benefit from tariffs in isolation) will be impacted by the reciprocal tariffs other countries have announced.

Another problem is the will they, won’t they, announcements coming from this administration. Continuous policy uncertainty is a problem in and of itself. When the rules change every month, it is difficult to plan for years ahead. Trump clearly wants US corporates to reshore manufacturing, but why would someone plan to move a factory in this environment? The safest decision would be no investment until the rules are clear and stable. General odd-ball commentary like annexing Greenland or Canada can’t be helping either and by undermining faith in NATO and other alliances between liberal democracies, Trump has also increased global geopolitical risk.

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A Rest of World Comeback?

While this clown show continues in the US, some other parts of the world are slowly trying to get their acts together. China has stabilised its housing market, or at least offset the negative impact of the ongoing contraction on the rest of the economy and removed the risk of financial crisis. At the same time, there has been ongoing Government promises to loosen (though not remove) the regulatory noose around market sector companies as well as massive investment in high end manufacturing such as semiconductors, battery technology and advanced robotics. China is also well and truly in the AI mix, with recently released models comparable to those produced by US companies. Japanese equity markets are benefiting from ongoing corporate governance reform. Even Europe has made some progress. The new Grand Coalition in Germany has proposed a removal of the debt brake, which would allow for significantly easier fiscal policy (more stimulus) than has been enacted since reunification. Even though these changes aren’t enough to completely reverse the fortunes of lacklustre markets, the valuation gap between the US and the rest of the World is at an historic high so the market is looking upon any change extremely favourably.

Mini/Mega Tech Bubble Redux?

Another risk to US exceptionalism would be a significant downgrade in the prospects of the technology sector. Much of the excess return and earnings growth in the US market has been driven by mega-cap technology companies. The Magnificent 7 is around a third of the S&P 500 Index, and probably for good reason. These companies dominate their industries globally and have amazing track records (in the aggregate) of delivering earnings. Most people on the planet interface with most of them in some form on a daily basis. They are ubiquitous and seemingly unstoppable.

The last leg higher in technology names has been driven by AI hype following the launch of ChatGPT in late 2022 and the subsequent release of better and better models. However, models are very expensive to train and run. Importantly, the advances in models have for the most part been achieved by throwing more resources at them (rather than smarter code, with some exceptions). This means better models require more chips, more data centres and more electricity. No major tech company wants to be left behind in this arms race and as a result they are investing heavily. The technology and consumer discretionary (which includes names like Amazon, Tesla and Netflix) sectors were already quite capex intensive, but the AI boom has kicked the spending up a notch (see below). This arms race has yet to pay off in terms of earnings. AI is amazing, but it remains to be seen whether the capex spending is commercial.

At the same time as some market participants are questioning capex spending, especially following the release of DeepSeek, a model out of China which appeared cheaper to train, forward earnings estimates for the technology sector have begun to roll over. Earnings growth estimates are still exceptionally high, but are lower than they have been for the past couple of years, especially for larger cap companies. With valuations for this sector close to extremes, this segment of the market is very sensitive to any downgrades to earnings growth. Above market growth is needed to justify current valuations, especially with interest rates now well above zero.

‍A Big Picture View

All the above sounds pretty negative for the US, and at the margin it is. Trump got 2.3 million more votes than Harris and because of that we have up to four years of considerable policy uncertainty from the White House. However, markets get in the habit of overfocussing on the nuance. If Harris got elected, we probably would have had four more years of over-regulation. Although Trump’s statements have been swinging markets, the net macroeconomic effect of what has actually been announced, little of which has been implemented, is relatively small. US equity markets have only erased the strong gains posted since his election, in effect balancing the good with the bad. Tariffs will lower growth and raise inflation at the margin, but sell-side estimates of earnings impacts are in the low single digits. That is not catastrophic.

Trump has made the situation worse in the US, but everywhere else was so bad to start with that there is still a lot of clear air in terms of which region will host the companies who deliver the strongest earnings growth over the long term. Global equities ex the US haven’t delivered earnings growth since the Financial Crisis, while US corporate earnings are up 175% (see below). Not enough has changed in the US or anywhere else to convince us that the rest of the World will deliver more earnings growth than the US in the decade ahead unless things start to go seriously wrong in the US (a shift towards authoritarianism by Trump for example).

While the policy mix in the US has gotten worse, we don’t think things have deteriorated so much that the market will face a massive correction. Things can always get worse, but Trump is running out of market negative things to announce. What is next after tariffing everywhere? The US won’t actually invade Greenland. The improvement in the policy mix in Europe, Japan and China is a net positive for markets. These areas are very cheap relative to history and if they can begin to deliver some earnings growth, prospects for excess returns are good. This is still a big if though, and the fifteen year track record of sideways earnings doesn’t give us enormous confidence. Also, notwithstanding the risk of capex overspend, prospects for the technology sector in the US remain good. These companies have an amazing track record of delivering earnings growth. If AI is fully commercialised, the prospects are even better. Perhaps the net of the above is a pause in US exceptionalism, allowing some catch up from everywhere else. Importantly, Australia is absent from this equation. Our market is extremely expensive and our economic policy remains terrible.

‍Portfolio Positioning

Last month we moved the portfolios underweight global equities. This move reflected a view that at around historic highs, markets were not pricing in any uncertainty around US policy making, particularly around tariffs and DOGE. The subsequent correction has borne out this risk, with US equities around 10% below their highs at the time of writing. The portfolios were already underweight Australian equities based on high valuations and low earnings growth (see December’s Market Insight, Down Under And Out). With announcements around tariffs changing on an apparently daily basis, this uncertainty remains for now and we think equities will remain under some pressure until there is more clarity around the policy mix going forward.