Productivity drive
Paulson says improving productivity is the key to prolonging the recovery in the US, and also to dampening the impact of wage and pricing pressures on businesses.
“We are at a stage when demand is starting to outstrip supply. When you are at full employment and demand outstrips supply, financial markets have tended to struggle. Rising productivity dampens the challenge to margins. If productivity can be improved it stretches the earnings cycle.”
He says the US economy generally looks robust, with the housing market, jobs market, manufacturing and services sectors all doing well. The only weakness is in the small sliver of the economy related to the commodities industry – energy and mining – which is in deep recession. He says that most parts of the economy are working well.
For Paulsen, this is perhaps more important than the speed of the recovery.
The strength of the US also has wider market implications. It has reached full employment, but this is not replicated anywhere else. For a fully synchronised global economic recovery, there needs to be better growth outside the US. Paulsen is confident this can be achieved.
Favouring commodities
This does not necessarily make the US a good investment, says Paulson, who continues to favour non-US equities. “We like pretty much everywhere except the US as it has already been there and done that. There has already been quite a bit of improvement.”
Perhaps more surprisingly, Paulsen predicts that commodities will recover in 2016, and he favours industrial and commodity related companies over consumer companies. “One of the things that has surprised people most is that commodity prices have fallen in the middle of a recovery.”
He says that in three out of the past four economic cycles, commodity prices have collapsed mid recovery.
At no point did these commodity price falls signal the end of a recovery. In the majority of cases, the recovery accelerated and core inflation rose.
“In general, we see that the oil price delivers a V-shaped recovery,” he says. “It does not go down and then spend three to five years at the bottom.
Looking at valuations, he finds it difficult to see how the US market can sustain its current levels. Looking back as far as 1870, and with the exception of the dotcom boom, he says markets have seldom sustained valuations at this level. Markets either need a strong recovery in earnings or a year where valuations move lower.
Hobson’s choice
Paulson favours stocks over bonds, but that is more by default than any burning passion for equities. “Where else are you going to go? It is not going to be cash, because that pays nothing and you have got to be right in your timing. It is not going to be bonds.
“You might go to real assets – and we are overweight some of those – but it is difficult to do that in an efficient way. Equities are the best option.”
And for equities, he likes international markets, believing that, in general, they are under-owned and, if the economies turn, considerable flows could go their way. He also favours small and mid-cap stocks. In terms of sectors.
He says: “I would make this point across emerging and non-emerging markets. Core consumer prices have held up better than producer prices. It has been the consumer companies that have had pricing power.
This has allowed the US to dominate global markets. We believe there will be a shift from consumer to more industrial and capital goods. We are more inclined to those sectors, plus technology.”
Country comparison
Paulsen admits he got some things wrong in 2015. He thought commodity prices would have lifted by now and that rates would have risen; he thought there would be stronger wage growth. On the other hand, he did foresee the weakness in stock markets.
He is also out of step with much of the market in his views on the dollar. He believes it may go down rather than up. He points to the historical relationship between the dollar and commodities prices. “We consider it likely that the dollar is peaking and the mining sector is bottoming out.”
Paulsen concludes that the disparity between the US and the rest of the world may be vitally important in 2016. “If the world is picking up, everyone is going to start to notice the differences between countries. The eurozone looks like a good deal, while the US must contend with raising rates.
