American Exceptionalism
The Key to American Exceptionalism: ROE Trumps Rule of Law Every Time
There is much discussion about the end of American Exceptionalism - politically, culturally, economically, and financially. A well-known value money manager’s latest quarterly letter expounds that this slippage should soon close the performance gap between the US and international equity markets.
They posit that most of the recent outperformance of US markets comes principally from multiple expansion rather than fundamental improvements. Admittedly, one could poke many holes at the manner in which this manager measures valuation, especially because their methodology does not account for capital budgeting efficiency and governance, including the market for corporate control and shareholder activism, which are key differential attributes of US firms and US capital markets.
The S&P500 index of US large cap companies has a significantly higher return on equity (ROE) than European, Japanese, or Emerging Markets indices. This higher profitability justifies most if not all of the valuation premium of 22x earnings vs 15x earnings, especially when considering the large weight of cyclical companies, such as financials, in non-US indices.
AI will yield more than European defense spending
Clearly the return on invested capital on the hundreds of billions that will be invested in developing Artificial Intelligence will be a key factor. However, we are comfortable that it is unlikely to be lower than the return on defence spending in Europe. Especially as European governments try to create national champions in defence by spending hundreds of billions on already obsolete military equipment such as tanks and armoured vehicles, slow moving targets for swarms of drones on modern battlefields.
At the same time, the United States’s vaunted institutional stability, buttressed by the constitutional checks and balances between branches of government, appears to be tittering on the verge of collapse. The swing from the extra judiciary blight of cancel culture to the prosecutions of political enemies by the Trump administration suggests a general contempt for the rule of law and constitutional tradition. Should these attacks from the President continue, the diminished stature of the rule of law may result in a higher cost of capital for US firms, especially if foreign investors abandon the US Treasury market.
Back to TINA, again
This presents investors with the non-trivial problem of where to allocate those funds. Japanese, Chinese, and European equity markets have all recovered sharply and are now trading at multiples of earnings in the mid-teens that can only be justified by earnings per share growth rates of 6-7%, significantly higher than historical earnings or nominal GDP growth rates in two of those geographies. In addition, Emerging Markets exposure may add volatility and not much performance for long stretches of time. On the surface, leaving the U.S. market is much easier said than done.
The Biden Administration unabashedly intervened in the economy with a combination of government programs such as the CHIPs and Science Act or the Inflations Reduction Act, and with the antitrust actions against Big Tech or banking oversight. The Trump campaign emphasised deregulation and indeed one of the first Executive Orders targeted “Unleashing prosperity through Deregulation.” However, the populist faction of the MAGA movement appeared to support potentially harmful new regulations such as prohibiting IT outsourcing to India or raising the H-1B visa fee to $100,000 - which some applaud because they suggest the system was rigged in favour of foreign IT services businesses. (N.B. The President’s Nobel Peace Prize ambitions and Mr Modi’s reluctance to give him credit for ending a conflict with Pakistan may ruin relations between these two countries at a time when the US could use a friend in that neighbourhood).
Government fingers in the pie
The administration is finalising the sale of a controlling stake of TikTok’s US business, as mandated since 2024 by the Protecting Americans from Foreign Adversary Controlled Applications Act, to a group of US investors (who coincidentally happen to be big GOP donors). The government has also taken an equity stake in Intel and is encouraging large US tech companies to finance that company’s new semiconductor manufacturing facilities. The micromanagement extends to exercising a golden share right to prohibit US Steel from shutting down a plant that has been idle for years.
This all adds new layers of complexity in the investment decision-making process. Perhaps we will look back with nostalgia to the period of globalisation that started with the consolidation of the General Agreement on Tariffs and Trade into the World Trade Organisation in 1995, which has been in accelerating decline since Donald Trump’s first term in office. But there is no room for crying over spilled milk in the investment profession.
Within weeks of the demise of Lehman Brothers, the US and the UK were actively talking down their currencies to soften the blow. This “strong dollar only in name policy” was so effective that by the outset of the euro area’s sovereign and banking crises in 2010, the euro was trading near its all-time high.
Another “dash for trash?”
Should we see a large USD depreciation again it will prove costly not only for investors holding US assets. It will also generate strong head winds for the already anaemic European economy. Indeed, the recent investor enthusiasm for European equity markets is somewhat puzzling as there is little economic and no earnings growth outside of financials which some people should be reminded are cyclical businesses and not utilities.
This new wave is reminiscent of the “dash for trash” of 2013. That year, many innocents abroad were fleeced when they enthusiastically participated in several rounds of equity issuance by Greek banks that ultimately lost 100% of their value. Some were defrauded outright by such great investment opportunities as Abengoa in Spain or Banco Espirito Santo of Portugal. Once again, we are reminded that in finance, knowledge is cyclical, not cumulative.
The European solution to trying to bridge its productivity gap versus the rest of the world, and not just the US as critics point out, allegedly hinges on the recommendations of two former Italian Prime Ministers, Dr Mario Draghi and Enrico Letta (and by the way this is not the opening line of a joke). Draghi and Letta ask the European Commission, the unelected bureaucracy that runs the EU, to strengthen and complete the single market, which they say will boost investment and mobilize private capital; to reform regulation; and address competitiveness gaps and transitions while meeting two growth handicapping policy goals: net-zero net emissions by 2050 and the 2030 Agenda for Sustainable Development.
Instead of paying heed to these two members of the intellectual elite as obedient descendants of the Enlightenment, EU politicians are rushing to strengthen national champions in the defence industry, as they so successfully have done in the past in steel, auto manufacturing, telecommunications, semiconductors, telecom equipment, and banking.
Thus, Germany is accused of kicking out Dassault Aviation from the European fighter jet project because its government wants Airbus Industrie and not the French to lead. To quote Ken Griffin “when the state gets involved in picking winner and losers, there is only one way this game ends: all of us lose.”
How long is long-term? Don’t get confused
In sum, it is unclear to us why some people conclude that the US has become un-investable, and at the same time discover that miraculously the EU has become a wonderful destination for global savings. It would be wise not to confuse short-term flows of cross border capital and the US Treasury engaging in currency manipulation with a long-term investment trend. Moreover, let us not confuse what ought to be with what can be, no matter how much you may dislike current US policies.