Rally Goes Global, But U.S./China Trade Looms Large
November 2019
Last month’s ISO noted that while October has a reputation for being a challenging month for stocks, average equity returns from 1928 to 2018 have been slightly positive. Global stocks avoided an October pitfall this time around, with both domestic and foreign markets rallying throughout the month on trade-related optimism and better-than-expected earnings. For the month, the S&P500 climbed 2.1% to a new all-time high, the Russell 2000 rose 3.2%, the MSCI EAFE was up 3.0%, and the MSIC EM returned 4.2%. The most notable shift during the month was the relative strength exhibited by international markets, which although impressive still leaves the MSCI EAFE and MSCI EM trailing the S&P500 on a year-to-date basis through October, by 8.0% and 13.2% respectively.
With attractive valuations relative to history and versus domestic equities, and with economic growth expectations abroad showing early signs of bottoming, the divergence between domestic and international performance year-to-date may be poised to narrow somewhat into year-end. However, a few things must break the right way for international markets to build on October’s gains. Clarity on Brexit, with another vote in the U.K. set for mid-December, potential fiscal stimulus in the Eurozone, and de-escalation on the U.S./China trade front are just a few of the potential drivers of positive sentiment that may be necessary for October’s relative outperformance of international markets to persist. From a currency standpoint, the dollar needs to weaken or at least stabilize around the current levels, a trend that began taking shape last month as the probability of at least one more quarter-point cut in the Fed funds rate this calendar year rose, constructive Brexit chatter made the rounds, and trade-related optimism took hold. Significant dollar weakness isn’t our base case as relatively higher interest rates and economic growth expectations in the U.S. will likely lead to continued capital inflows into dollar-denominated assets. Should the dollar stabilize or weaken, it could be a tailwind for international economies, particularly emerging markets, and investor sentiment surrounding them.
Year-to-date, domestic equities have rebounded out of a deep oversold condition that developed in the 4th quarter of 2018 as the Federal Open Market Committee (FOMC) appeared unwavering in its resolve to tighten monetary policy, while failing to convince the market of the rationale behind doing so. In a meaningful about-face, the FOMC has since implemented three quarter-point rate cuts this calendar year, reversing last year’s backdrop of declining liquidity and aligning U.S. monetary policy with broad global money supply growth. With paltry global sovereign bond yields, tight credit spreads, and high interest rate sensitivity (duration), shifting capital to bonds from stocks at this point requires a fairly dire economic outlook. After a hiatus, the “TINA” (There Is No Alternative to stocks) trade prevalent in 2016 and 2017 due to low and falling bond yields appears to be making a comeback.
The S&P 500’s climb to a new all-time high has been characterized as liquidity-driven, an assessment with which we wouldn’t argue. Pundits have made the case against additional equity upside by stating that the sole driver of the year-to-date rally has been easing of monetary policy –this is the very definition of “fighting the Fed.” While corporate fundamentals remain important cornerstones of our investment process, we can only invest in the market environment we’re given, and swimming against the current tide of liquidity while arguing against the rationale behind it is counterproductive. Whether or not investors agree with global central bank actions makes little difference as cheap. or in some cases “free” money will need to be deployed in return-generating assets, providing a powerful tailwind capable of pushing stocks higher.
Since higher expected returns require the assumption of greater risk, investors should assume that the ride experienced investing in equities will continue to be a bumpy one. For investors focused on long-term investment goals, they must accept bouts of short-term volatility. The wall of worry we’ve discussed many times remains significant, and while a few of these items, specifically Brexit and U.S./China trade negotiations, appear to be trending in a more positive direction, eventual desirable outcomes remain far from assured, which presents both pitfalls and opportunities for investors. As such, we see little reason to alter our current course and remain overweight domestic large-cap stocks and emerging markets and underweight international developed markets relative to our long-term strategic targets. With impressive European price action and potential signs of an economic bottom, we continue to monitor progress abroad and will adjust our current positioning when/if appropriate.
Source: Bloomberg, Factset
