Has US exceptionalism run away from fundamentals?
For over a decade, the US economy maintained a material outperformance versus its global peers. From 2014 to 2024, US real GDP expanded +27%, far ahead of most developed economies. US equities surged +186% relative to the average cumulative growth of 29% in the rest of the world. Much of this outperformance has of course come from the meteoric rise of the Magnificent Seven, who have undoubtedly carried the “US exceptionalism” narrative along with them.
Figure 1 – Change in forward EPS for various indices
Figure 1 reflects this, with earnings growth for both the S&P 500 (“US”) and Nasdaq 100’s equal-weighted index consistently lagging its market cap-weighted counterpart for the past six years. Looking at US small caps (proxied by the Russell 2000), we can see that growth for the group has been mostly equivalent to what can be expected in other international economies. Given the mirror that the Russell 2000’s small caps have to the real economy, the business backbone in America has been relegated to the backseat.
The US Chamber of Commerce recently asked the Trump administration for tariff exemptions to certain businesses and products, raising concerns about an eventual recession otherwise. Despite Trump’s reiteration of the effort to re-shore their manufacturing, his tariff exemptions have been otherwise largely to the benefit of the US tech sector, such as data processing units. Risk exposures for small businesses have not received similar concessions, which has a likely link to the pessimism we have seen in consumer sentiment.
Evidently, mega-cap tech shares have dominated in performance since 2020, driven in large part by the network effects of their business models. Customers choose platforms and services provided by the likes of Meta and Microsoft often because everyone else simply does too, creating a strong competitive moat.
Does the AI trade have a fault in its thesis?
Anecdotally, the current investment cycle into Artificial Intelligence (“AI”) stands as an interesting departure to this moat deepening, rather than a continuation. Personal consumption of ChatGPT does not create network benefits from the fact that others use it (beyond a vague and eventually diminishing return on model training). With the unprecedented R&D poured into the sector, the competitive advantage once sought may ironically turn into a market of perfect competition. This thought is echoed by the often-indistinguishable quality between the Large Language Models (“LLMs”) used in the flood of AI-related products released to date. The AI industry could eventually become not all that dissimilar from the predatory pricing of airline markets. Both being capital-intensive with high depreciation rates and ultimately producing a commodity-like output.
If today’s large-cap US tech companies are forced to continue with their lofty R&D regime and returns remain uncertain, their outperformance cycle could see an eventual end, weakening their long-term profitability.
Figure 2 – Correlations among R&D and labour productivity for various countries
Figure 3 – R&D expenditure as a % of GDP
R&D spending so far has shown to have a material and positive correlation with the labour productivity in its related economy – see Figure 2. This relationship is most apparent with the US and its market leaders in AI. The rest of the world has noticeably lagged, with China being the only recent contender of some regard – see Figure 3. Europe and other developed areas simply lack the capital market depth to enter this competition – notably as it is a venture capital dominated space, something Europe materially lacks versus the US.
Despite the speculation on a gloomy AI outlook, Europe may actually stand to benefit from their laggard position. With a mass-rollout of AI tools and its various productivity gains, Europe and similar economies may stand to reap the same benefits of AI over the medium term, with a fraction of the expenditure needed to get there. This mirrors a similar narrative that Europe experienced with the internet boom in the early 2000s.
Does hard data imply a recession yet?
Viewing this narrative empirically, these cracks in exceptionalism have already begun to feature in 2025’s first quarter, with productivity advantages narrowing. Figure 4 provides evidence that the US’s outperformance in GDP growth has been primarily driven by its productivity growth, not labour force expansion.
Figure 4 – Decomposition of component contributions to the real GDP growth of various economies
This edge has however been eroding. Recent productivity gains are relatively modest, and the broader economy is now seeing diminishing returns from the digitization cycle. This is not aided by the fact that immigration, a vital source of US labour force growth, has plummeted and further exacerbated the downward pressure on output potential.
On the production/output side, PMI has yet to turn recessionary for the US. In the euro area, the manufacturing PMI has been trending higher. We have seen a contraction in US real GDP, with growth at -0.3% on a quarter-over-quarter basis, the weakest growth in the US economy since Q1 of 2022. The shrinkage is primarily due to a large drag in net exports. The cause for this drag is logical, given the front-running of import activities before any further tariffs.
Figure 5 – Change in import volumes
Overall, hard data has remained resilient despite the bearish sentiment growing in consumer data, potentially due to the trade war only truly causing ripples after April 2nd. The trade skirmishes earlier this year, instigated by the US with Canada and Mexico, were material from a signaling effect. However, while these countries are significant trade partners with the US, they are simply not large enough to cause a dislocation in hard data for now.
The pricing of exuberance
Trump announced a 90-day pause on most tariffs in early April, and US shares have taken the initiative in an extended rally since – completely erasing the drop brought about on Liberation Day. April 2025’s stronger-than-expected job report has provided yet another round of hard data validation for the relief rally in US equity. This is not to say there has been no concerning data released since then – it is just that the market has not been pricing it as eagerly. For now, robust earnings and temporary tariff pauses have managed to preserve the positivity in markets.
Certain cautionary signs, however, are slowly becoming more evident. The ISM Manufacturing Index’s April release told a different story to the positivity from the jobs report. The headline slipped to 48.7, a level consistent with recessionary implications – see Figure 6. More concerning, new export orders plunged to 43.1, mirroring the decline during the Trump 1.0 trade war. Rising inventories and weak demand paint the picture of soft data’s sentiment reaching the real economy eventually.
Figure 6 – ISM manufacturing index
Tariff policy has admittedly become a wildcard in any forecast but remains a key headwind that has potentially been underpriced by the broad market. Even best-case scenarios for the upcoming tariff ultimatums could see short-term productivity stagnations and other transitory effects not currently accounted for in equity prices.
Investment takeaway
The data so far suggests that today’s equity prices (specifically in the US) might be priced on hard data that is not reflective of what a post-tariff market regime would look like from June 2025. Soft indicators and news headlines have played a major role in fueling both brief market downturns (e.g. following Liberation Day) and rallies driven by positive developments. This fluctuation can be expected to continue over the next months as the soft data evolves. This makes volatility certain, but the permanency of any movement unlikely until the economic decline gets properly priced in.
We remain overweight on defensive equities in our equity funds with a preference for cash and fixed income over risk assets in our multi asset solution, the Integrity Global Flexible Fund. This, as we await June’s tariff ultimatum, and the eventual re-pricing of the market once sentiment-matching hard data begins to emerge.
If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.
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Source: Bloomberg, 30 April 2025