By: Jon Eggins, Senior Portfolio Manager, Global Equity
Paul Eitelman, Investment Strategist
In the month since the U.S. election
, the S&P 500® Index has rallied 5%, outpacing European (MSCI Europe Index) and emerging
markets (Russell Emerging Markets Index) in U.S.-Dollar terms. The prospect of a post-Trump fiscal stimulus package and concerns about the impact to non-U.S. markets of rising protectionism on both sides of the Atlantic has led to forecasts that U.S. assets are poised for a run of outperformance.
We think these expectations are overly optimistic. Instead, we continue to see value in non-U.S. equities despite their recent underperformance and believe that U.S. equities may have over-shot based on fundamentals.
Let us explain.
Non-U.S. equity market outlook
- Geopolitical risk has risen, but is unlikely to derail the European expansion. Absent a populist upset for Marine Le Pen in France in early 2017, Trump’s victory doesn’t have a meaningful impact on our cyclical outlook for non-U.S. developed markets. His nationalist strategy, is mostly targeted against China and Mexico. Europe isn’t in the cross-hairs, and could actually benefit if fiscal stimulus boosts U.S. growth. Nevertheless, trade wars are a risk to the global expansion.
- Fiscal stimulus in the U.S. may boost growth, but a rising dollar helps Japan and Europe. Trump’s plan to inject more growth into the U.S. economy should nudge inflation upward. This makes it easier for the U.S. Federal Reserve to hike interest rates and the 10-year Treasury yield has already shot up to 2.4% in recent weeks (as of Dec. 8), a full percentage point increase from where it stood in July. This affects global markets, especially Japan, where the central bank is pegging the 10-year Japanese Government Bond yield at 0%. The widening interest rate differential has led to a stronger U.S. dollar – a headwind for U.S. multinational companies’ profitability and a tailwind for similar businesses in Europe and Japan. As a result, Japan actually outperformed the U.S. (S&P 500 Index) in local currency terms in November and the fourth quarter-to-date (as of Dec. 7), with the Tokyo Stock Price Index up approximately 9% in local currency terms between Nov. 8 and Dec 7.
- Non-U.S. fundamentals are solid. Cutting through the political noise, we have seen a fundamental improvement in non-U.S. markets. According to the Markit Eurozone Composite PMI, Europe shrugged off the Brexit vote with leading economic indicators at an 11-month high in November, and the region showed stronger earnings growth and profit margins in the third quarter. The Bank of Japan has effectively committed to finance government spending with a 0% 10-year yield target and a major fiscal program could be a positive game changer.
U.S. equity market outlook
- Cycle – Neutral (but on upgrade watch). The advent of economic populism is a tail risk for the European currency union but economic and earnings fundamentals have improved.
- Valuation – Attractive. Euro zone and Japanese equities are slightly cheap in an absolute sense and outright cheap relative to the U.S.
- Sentiment – Neutral. Price momentum is roughly flat in Europe and Japan. Markets are starting to swing into a euphoria phase but those concerns are more pronounced in the U.S.
- Injecting stimulus into an economy near full capacity may fan the flames of inflation. Rising labor costs are already one of the biggest obstacles for the U.S. earnings outlook and fiscal stimulus could exacerbate the pressure on profit margins.
- The U.S. equity market is already expensive. One of the rationalizations for high valuation multiples was that interest rates were low. But with the 10-year U.S. Treasury yield now up to 2.4% (as of Dec. 2) post-Trump, these higher discount rates pose a more meaningful headwind to the U.S. market.
- Intra-market performance has varied quite strongly since the election. Those parts of the U.S. equity market that benefit from higher interest rates and more fiscal stimulus have been outperforming other sectors: For example, in the month of November alone the S&P 500® Index Financials sector outperformed the S&P 500® Index Utilities sector by nearly 20 percentage points. Looking forward, we continue to see more upside in Value stocks than expensive Low Volatility stocks as U.S. interest rates rise.
- The dollar appreciated on the election outcome and now stands at its highest level since 2003. Dollar strength acts as a speed brake on the economy (by hampering exports). According to our research, recent currency moves could also subtract 1.5 percentage points from S&P 500® Index earnings growth in 2017.
We continue to prefer non-U.S. developed equity markets in global portfolios, primarily on the back of their attractive valuations. Within both the U.S. and non-U.S. equity markets, we prefer Value factors to the expensive, seemingly defensive market segments.