Stock markets continued their move higher in May. International and emerging market equities were the strongest performers, but U.S. large cap stocks added to their YTD returns. Although U.S. political drama continued to escalate, economic data and corporate earnings reflected steady growth. The Federal Reserve also held rates steady and signaled a continued willingness to hike rates, albeit at a moderate rate, through the rest of the year.
European economic growth and business confidence have continued to increase despite rising tensions between the Trump administration and European political leaders. These economic gains are the result of a number of factors, including improving consumer sentiment and the potential for greater government spending as Eurozone countries lean more on domestic resources than their U.S. agreements. The upturn in Chinese economic conditions has also helped Europe, as China is a major trading partner.
The S&P 500 returned 1.41% in May while the MSCI All Country World Ex US Index, a gauge of foreign equities, returned 3.24%. Emerging market equities performed very well during the month, returning 2.96%.
U.S. small cap stocks, as measured by the Russell 2000, fell during the month as hopes for tax cuts continued to diminish. Small cap companies have much greater sensitivity to changes in the U.S. tax code and thus would benefit to a greater degree from tax reform, were it to happen.
Bonds were positive during the month, with the Barclays U.S. Aggregate Bond returning 0.77% and the Barclays Municipal Bond Index returning 1.59%. YTD, the U.S. Aggregate Bond Index has returned 2.38% as yields have fallen after their sharp increase towards the end of 2016.
Emerging market equities continue to be one of the strongest performing asset classes YTD, with a return of 17.25%. While they still trail U.S. equities over longer time periods, we continue to believe that emerging market equities offer stronger return prospects than U.S. stocks in the future.
The market adage “Sell in May and go away” has failed to materialize so far, as U.S. and international stock markets continued to move higher during the month. To many, the unperturbed ascent in stock prices seems to be a direct contradiction to the perturbed press that seems to come out of Washington, D.C. on a daily basis. As we’ve explained in prior versions of Insights, the equity market rally over the last year has not been only based on hopes of tax cuts and fiscal stimulus, but rather on improving economic growth and corporate earnings.
As a result, although the political turbulence may be disheartening to watch, it has yet to have much bearing on the market, primarily because it hasn’t had a material impact on economic policy and corporate planning. The direct result of drama in the White House is continued gridlock in D.C., which is not a bad thing for markets, because it basically protects capital market assumptions from being forced to undergo sharp changes. So far, this is why political volatility has not translated into market volatility. However, it is important to note that this may not always be the case. In the middle of May, after much calm in the markets, the introduction of a special counsel to investigate Russia’s involvement in the November U.S. presidential election prompted a spike in volatility. While the jump in volatility dissipated nearly as quickly as it appeared, at some point in the future, the market may decide that it does not like the uncertainty coming from Washington and may experience a correction of 10% or more. This would not be unusual in any environment – according to J.P. Morgan, the S&P 500 undergoes a 14% drop, on average, in a given calendar year – and is something to be cognizant of, especially given how strong equity returns have been in the early part of this year.
It is interesting to note that the turmoil in U.S. politics has diminished the hopes for fiscal stimulus, and as a result kept the Fed from hiking at a faster than expected rate. The continued easy monetary policy by the Fed has led to weakness in the dollar and, as a result, strength in emerging market currencies, which has helped to propel emerging market assets to the top of the YTD return leaderboard. Also boosting emerging market returns in 2017 has been improvement in Chinese economic data. Social financing, a broad measure of credit and liquidity in the economy, has increased over the last year, as have property starts. Although Chinese GDP growth decelerated from 2010 to 2016, it has finally stabilized and improved somewhat over the last few quarters.
Stabilization in China over the last year has been a welcome event and has led to improvement across many emerging market economies. EM corporate earnings have rebounded, and current account balances are at their highest levels in three years.
Emerging market bonds also offer very competitive yields compared to developed market bonds. The following chart shows 10-year government bond yields across a variety of countries, both developed and emerging. You can see that bonds in Switzerland are currently yielding negative 0.21% and bonds in Germany are yielding just 0.16%. The U.S. 10-Year Treasury yields 2.17%. By comparison, bonds in India are yielding 6.86%. Brazilian 10-year bonds are yielding 10.10%.
A number of emerging market economies are also in the process of easing their interest rate policy, which is positive for bond prices. By contrast, the U.S. is raising rates, which is negative for Treasury bond prices. The chart below, via BlackRock, is a simple, but clear illustration of why Sage maintains an allocation to emerging market bonds within our diversified portfolios. Developed foreign equities have continued to perform well and kept pace with emerging markets this year, thanks to improvement in Eurozone economic growth, including employment.
While many feared the potential for European political risk heading into the year, election results have been benign and markets have rallied as a result. Employment rates in the Eurozone have trended steadily higher over the last year.
Interestingly, the increase in U.S. political drama seems to be spurring on greater political cohesion within the Eurozone. Just three years ago, the risk that the continent would abandon the euro common currency loomed large. Now recent political outcomes and pro-Euro appeals by German Prime Minister Merkel and recently-elected French president Emmanuel Macron seem to indicate a rallying around the future of the continent. This has led to improving business confidence and a boost to corporate hiring and spending.
While it can feel good to have an allocation to international developed and emerging market stocks this year when they are sitting atop the asset class return leaderboard, we continue to stress the importance of maintaining a long-term vision with respect to investing. The saying “I know not what the future brings, so I diversify” remains valid. Although it was difficult to own international assets when they were underperforming the U.S. stock market, the sudden shift in return leadership (at a time when many were worried about international political risk) shows the importance of being patient with underperforming investments.
Looking forward, European equities are still undervalued relative to U.S. stocks. At present, the Shiller CAPE ratio, a valuation measure that looks at long-term earnings relative to the current price, shows that Euro equities at a CAPE ratio of 17x versus 30x for the U.S., a discount of 43%. European equities also have higher yields than the U.S. (3.0% vs. 2.0%) and easier central bank policy. These factors, combined with an improving economic environment and the potential for increased domestic spending as they carve out a bigger role in international trade agreements (particularly as the U.S. steps back), could lead to continued outperformance from international markets.
In closing, we believe that investors should be pleased with the strong returns across a variety of markets to start the year, but they should not grow complacent as volatility can reappear at a moment’s notice, as we saw in mid-May. The increasing political uncertainty out of Washington, D.C. may lead to a pullback in U.S. stocks, but also helps to make the case for international allocations, which have performed very well this year and could experience continued outperformance if U.S. equity returns weaken. Improving foreign economic growth abroad has helped to boost international equity returns, as has weakness in the U.S. dollar, which has come as a result of the Fed’s continuing its moderate pace of rate hikes. Looking forward, international equities still have attractive valuations, improving economic growth, and, in the case of emerging markets, very favorable demographic growth, on their side, which should contribute to positive long-term returns.
As always, we respect the trust you have placed in us, and we welcome any questions you may have about our views on the current economic and market environment.
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