Stock prices moved higher in July, especially in developed and emerging markets outside the U.S. The broad, large-company S&P 500 Index rose 2.06%. The MSCI Emerging Market Index gained nearly three times that, gaining 5.96%. Core bond prices were modestly higher, and the U.S. 10-Year Treasury note ended the month with a yield largely unchanged from June at just 2.30%.
In July, we saw more of the same modestly expanding global economic activity that has characterized the year so far. Inflation remains subdued in the U.S., and employment data remains solid. Manufacturing activity and the moderate outcomes to elections in France and the Netherlands, for instance, have helped to push European economic growth higher. In the second quarter, the Eurozone grew 2.3%, similar to the U.S.’s 2.6% annualized rate. Over the last 18 months, however, the Eurozone has grown a bit faster than has the U.S. As we discuss in this month’s Sage Insights, we think that strength in markets abroad is likely to continue.
U.S. equity performance was positive once again in July, led by the NASDAQ’s 3.42%. U.S. large-cap stocks in the Russell 1000 Index returned 1.98%. Foreign stocks performed even better. The broad MSCI All Country World Index ex-USA gained 3.69% in July, and emerging market equities are up 25.49% YTD in 2017 through July.
Core bond prices were positive during the month, especially municipals. The Barclays Municipal TR Index rose 0.81% in July, nearly twice the Barclays U.S. Aggregate Bond Index’s 0.43%. High yield bonds gained 1.15%. Emerging market bonds have also continued to perform very well this year. The JP Morgan U.S. dollar-denominated emerging market bond index is up 7.08% this year through July, and the local currency emerging market bond index has risen 12.65%.
Last month we focused Sage Insights on, among other things, the relative valuation differences between foreign, especially emerging market, stocks and those in the United States. Given the wide return spread this year between foreign and U.S. stocks as noted above, one question that we receive pertains to whether the foreign economic and return music will stop. That is, someone might ask: Is this sustainable, or will it reverse? In this issue of Insights, we answer this question by extending our analysis from last month concerning foreign stocks, this time highlighting not only EM equities in particular but also non-U.S. equities in general. In three ways, we believe that developed (not only emerging) foreign markets are poised for potential continued expansion: economic strength, political stability, and valuation.
First, the chart below reinforces what we noted in the introduction about the relative strength of manufacturing activity abroad relative to the U.S. You can see, for instance, that developed markets as a whole are expanding more than emerging markets, and that the activity in the Euro area, the UK, and Canada, among others are above the levels in the U.S. and are strongly contributing to the developed market expansion. (For reference, a number above 50 indicates expansion.)
Moreover, companies outside of the U.S. have been increasing their earnings levels at a time when earnings in the U.S. are hitting peak levels of this cycle. The chart nearby examines the last twelve months earnings per share (EPS) across U.S., developed foreign (represented by the MSCI EAFE Index), and emerging markets (via the MSCI EM Index) countries. What you observe is that U.S. earnings have already reached their prior cycle high. In contrast, earnings per share in foreign developed markets and emerging markets have not yet regained their prior cycle highs. If history is a guide, they have more room to run before topping out.
You can see a similar story from the second global earnings chart below on the next page. Earnings by companies in the U.S. have been mostly rising since the end of the global financial crisis and are at very high levels. In contrast, earning-per-share in Europe and EM countries in particular are just now recovering from an earnings recession that bottomed out last year.
Stronger exports is one reason that Europe in general, and a place like Germany in particular (with a PMI reading of nearly 60), has been posting improving numbers amid a stable economic and political backdrop.
That leads, second, to the political scene abroad. Entering the year, worries on the political front revolved around Europe and anticipated elections there. Both national elections in the Netherlands and France put moderate political parties into power. We have noted this before in the initial wake of the election results; however, it is worth pointing out now in this connection since, with both the passage of time and the benefit of reflection, we can see the extent to which these non-extreme outcomes help to furnish the stability upon which economic activity and market growth can build.
Third, valuations in foreign market equities remain lower than the U.S. on a relative basis. The table below compares estimated next twelve months price-to-earnings (P/E) levels and dividend yield for the S&P 500 Index (as a proxy for U.S. stocks) and the MSCI All Country World ex-US Index (for all developed/emerging non-U.S. stocks). It also lists their respective 20-year averages. On both measures—valuation and income generation—foreign stocks post superior numbers relative to large-cap U.S. stocks: foreign stocks are trading at lower valuations than are U.S. stocks currently, and foreign stocks are trading lower than their 20-year average, whereas U.S. stocks are trading currently above their long-term average.
Further, the dividend yield of U.S. stocks is essentially in line with its long-term average; however, the dividend yield of foreign stocks is a bit above its 20-year average and, more important, about 50% higher than the dividend yield of U.S. stocks (3.2% for ex-USA versus 2.1% for US stocks). Both measures suggest that foreign stocks on a basis relative to U.S. equities continue to hold out the promise of solid or even superior total returns. Additional support for this inference about potential future prospects comes from a comparison of cash flow yields. The current cash flow yield on U.S. stocks is, according to Northern Trust, about 7.0%, which is solid but lower than Europe (9.3%) and Japan (12.3%). Historically, there is a strong relation between high relative cash flow yields and high relative future returns. If that relationship continues to hold, European and Japanese stocks may also continue, as they have this year already, to outperform U.S. stocks.
Taken together, these various elements – economic growth momentum, political stability, and valuation – suggest that we may be witnessing the beginning phases of a longer-term outperformance period for foreign stocks. We have frequently observed the tendency for asset classes to rotate their performance leadership. In fact, we illustrated this last month with a table comparing periodic returns of EM and U.S. stocks to make this very point. The graph below similarly compares times when developed foreign stocks have underperformed or outperformed U.S. stocks. Since the end of the global financial crisis in 2009, U.S. stocks in the MSCI U.S. Index have posted significant returns in excess of stock returns in the MSCI World ex-US Index. This graph presents a visual picture as vivid as any we know of the periodicity of outperformance.
It is extremely difficult to call in advance with precision the beginning and ending of any regime; however, we can observe them in hindsight. So, it is with hindsight that we look at the reversal in excess returns this year and, in light of the evidence presented above, wonder if 2017 has marked a turning point.
Some may point out that central banks are likely, in the case of the U.S. Federal Reserve, to continue to raise interest rates and, in the case of the European Central Bank, to taper its quantitative easing and begin a “tightening” cycle given European growth and firming inflation. Others may wonder if the stock market party might stop when the central banks take away the punch bowl of accommodative policy. We would reply that the Fed has ceased its quantitative easing and begun its interest rate hiking policy for about 18 months now with no major adverse consequences for U.S. equities.
Moreover, as we noted last month, the Fed is not moving forward at the same pace of rate hikes as it has in the past. During the current cycle, the Fed hiked rates once per year in 2015 and 2016, and has now hiked rates twice this year, with the committee anticipating that it will hike 1-2 more times this year. By comparison, in previous rate-hiking cycles, the Fed has moved more aggressively, hiking 6-8 times a year. The U.S. central bank is moving more slowly this time around primarily because inflation has remained subdued and risk-taking appears to be in line (not withstanding that major U.S. equity market indices like the S&P 500 near all-time highs).
The graph and inset tables below show current Federal Reserve forecasts for GDP growth, unemployment levels, inflation, and the level and path of Federal Funds interest rates. Inflation remains well-contained. The country is already at full-employment, which suggests that the Fed does not need to do much with rate policy to improve this part of its dual mandate. Third, economic growth (GDP) is modest in the low 2% range, but the Fed has also adjusted its long-run forecast for average growth to essentially this level or below. Finally, the long-run Fed projection for the Fed Funds rate average is currently 3%, lower than the 4.90% average from 1954 through June 30, 2017. The upshot is that the Fed’s moving too aggressively to hike rates is a potential risk to the equity market in the second half of the year and beyond; however, indications are that the Fed is very content to move patiently and slowly to levels lower than what some market observers might fear based on past precedent.
What about the ECB? President Mario Draghi has, similar to Chair Janet Yellen at the Fed, firmly committed to using all the tools at his disposal to ensure price and credit market stability. When the ECB does act to lessen its accommodative policy, we believe that, despite some potential temporary market volatility, the moves will be well-telegraphed by the ECB and well-anticipated by the markets.
All told, then, the combination of improving economic growth especially in the Euro area, political stability in developed nations abroad, and relatively more attractive equity valuations, combined with favorable and restrained central bank policy at home and abroad, are likely in our view to help boost future equity prices. We believe that the elements are in place for foreign stocks to continue to post returns in excess of broad U.S. equities, notwithstanding the year-to-date outperformance of foreign stocks, and with the caveat that any such potential return path may not be without periods of volatility. Investors should be aware of the potential for a faster than expected hiking policy to reintroduce volatility into U.S. equity markets, although that is not our present base-case projection. Given the likelihood of higher interest rate policy in the U.S, contrasted with continued easy money policy in Europe and Japan, we believe investors are likely to experience continued outperformance from their international investments. Improving economic growth and continued attractive valuations still form a core part of the case for holding international investments in a diversified portfolio. 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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