The Case for Global Equities
By Bryan Dooley | April 20, 2017
President Donald J. Trump’s commitment to making America great again has helped drive U.S. stock prices to new all-time highs. The newly-elected President’s outspoken demeanor combined with soaring business confidence have stoked hopes for a more prosperous country – adding yet another leg to an extended risk rally which has made the major U.S. stock indices among the world’s best performers. Recently, however, global equity markets have been telling somewhat of a different story. Investors should pay attention.
Since the beginning of the current bull market, which started in March of 2009, the U.S.-based S&P 500 has advanced by a total of 250%, leaving most other countries in the dust. Over the same period, European markets, as measured by the Stoxx 600 index are up 131%, Asian markets have climbed by 129% and Emerging Markets increased by just 109%, or less than half the gain of the S&P. However, for the first quarter of 2017, the S&P 500 has lagged other developed markets by 1.32% and has fallen behind emerging markets by 5.38% as the so-called “Trump Trade” began to fade around the beginning of March. Could this be the beginning of a secular rotation?
Undoubtedly, the U.S. has been a strong performer relative to other countries over the long haul, but this has not been case for every single year. A closer look at U.S. versus non-U.S. investment returns clearly shows some cyclicality. Over the past 45 years, we have seen six intervals of U.S. outperformance, but also six periods of underperformance based on rolling three-year average investment returns. For this study, the S&P 500 is used to represent the U.S. while the widely-followed EAFE index, which stands for Europe Far East and Australasia, is used to represent the other developed country markets. Since 1972, the U.S. has outperformed the EAFE approximately 55% of the time on a rolling-return basis. But looking at individual annual returns the EAFE has actually outperformed the S&P 500 23 out of 45 years, or slightly more than half of the time.
The longevity of the present move is also worth considering. On average, U.S. market outperformance has lasted approximately fifty months during its growth spurts. Yet the current period of outperformance has lasted 88 months, making it the longest rolling three-year outperformance period over the past four and half decades.
On the surface, some level of investor favoritism makes sense. U.S. profit growth has been better than average in recent years while Europe, Japan and many of the emerging market countries have struggled with significant geopolitical issues. The European debt crisis, Japan’s deflationary headwinds and decelerating growth in China have kept American investors on the sidelines with respect to overseas equity allocations. Over time, geopolitical events tend to balance out though, and international stocks now look cheaper now on a relative basis.
Nobel Prize-winning economist, Robert Shiller popularized the concept of measuring market valuations by using cyclically adjusted price/earnings (CAPE) ratios. By this measure, the U.S. is presently trading at a relatively lofty 25 times earnings, while international markets in the aggregate trade at a somewhat more reasonable CAPE ratio of 15 times earnings. Meanwhile, Emerging Markets trade at only about 11 times their CAPE ratio. The U.S. has historically commanded a premium to other markets but its present valuation is considered by some to be rather stretched.
At LOM, we have long admired America’s resiliency during these more challenging times and indeed have viewed the world’s largest economy as the “cleanest dirty shirt in the laundry bin.” But around the globe, other economies have finally begun to perk up and are quite possibly offering better value without the political uncertainty of what America’s new government may or may not be able to accomplish. Recent economic reports suggest countries in Europe, Asia, Japan and Australia have finally stabilized and are growing again. An underlying trend towards a synchronized global economic resurgence is good news for countries overseas with spare resources, most of which, unlike the U.S. are not yet raising interest rates. Stronger global growth is helping boost corporate profits in the Euro zone, emerging markets and Japan.
Notwithstanding the challenging Brexit negotiations and potential for further populist backlashes, Europe appears to be on the upswing. The Euro zone flash purchasing manager survey just rose to its highest level in almost six years with the composite PMI registering a healthy reading of 56.7. From this robust level, economists extrapolate a growth on the continent approaching two percent, placing it within a half percent of the consensus expectations for U.S. forward progress. In a separate survey, unemployment in Germany, Europe’s largest labor market, fell to a post-reunification low of 5.8% in March.
It is important to consider the difference between what has been commonly referred to as the “Trump Trade” versus a much broader global reflation trend, which actually started months before America’s election. Already, many of the Trump Trade stocks, such as infrastructure-related companies and banks have traded well off their highs as doubts grow about the President’s ability to fulfill his campaign promises. At the same time, Europe and many parts of Asia are continuing to improve and certainly the better economic picture across these countries cannot be attributed to confidence in America’s political leadership.
Investors disappointed by the underperformance of more globally-positioned equity investment funds compared to the S&P 500 should not be discouraged. International allocations still provide important diversification benefits for U.S. dollar-based investors, including most Bermuda residents.
After years of reaping the rewards of being overweight U.S. stocks in most of our investment strategies we have begun to tilt towards some of the healthier international equity markets. It is our belief that a reversion back to the historical long term averages should provide meaningful additional investment returns if current trends persist.