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By Tyler Mordy  | Tuesday, May 19, 2015

It has been a long - and many would say - well-earned period of outperformance for U.S. assets. Since the global financial crisis, U.S. equities have soared, propelled by rising corporate profits and an easy Fed. But no upturn lasts forever. How to tell when it has ended?

The trouble with financial markets is that long cycles end, and begin, unceremoniously. No welcoming party greets the new trend. No reception is held. And no bunting is hung to mark the inflection point. Rather, the significance of important events that punctuate them is usually only revealed in retrospect.

Bulls and bears may dispute the reasons for the current longer-running cycle, but everyone will gape at the numbers. From October 2009 to February 2015, the MSCI USA Index returned 124%; almost triple the 43% return the MSCI World ex USA Index generated over the same period.

Yet, the trend of U.S. outperformance is showing telling signs of reaching its endpoint or, at least, a temporary remission. For global asset allocators, we offer the actionable takeaway in preview: Rotate equity weights away from the U.S. into the eurozone, or better yet, emerging Asian stocks. State Street’s SPDR DJ Euro Stoxx 50 ETF (NYSE: FEZ) and SPDR S&P Emerging Asia Pacific ETF (NYSE: GMF) provide targeted access to each respective region.

Overvaluation: A quaint reason to sell

It should be no surprise that worldwide stock markets are in orbit. In the era of zero - and now even negative-interest - rates, today’s system lacks an obvious anchor. With due respect to Messrs. Buffett and Graham, bottom-up valuation analysis has almost become an anachronism. Of course, its predictive abilities will surely surface again, but, for now, macro factors are driving capital markets.

This is why persistent calls for U.S. underperformance based on overvaluation (the S&P 500 trades on a Shiller CAPE of 27.9 versus its 30-year average of 23.5) have been - to put the most charitable spin on it - early.

Where, then, should investors focus? Consider three key drivers - all of which point to U.S. equity outperformance heading into reverse:

Global currency war: America losing

A notable feature since 2008 has been the emergence of far more aggressive currency management by governments, classically referred to as "competitive devaluation". The reasoning is straightforward: Capturing external demand is critical when domestic spending is constrained by weak income growth. Policymakers fully understand this (whether they admit it or not).

In the ongoing competition, it has been key to own equities in economies that have already successfully devalued their currency or currency-hedged equities in countries that are on an aggressive currency devaluation path. We have written extensively on this and positioned portfolios accordingly.

Since 2008, U.S. equities have been a clear winner. That makes sense. The U.S. dollar spent most of the 2000s on a debasement path, and the domestic economy emerged from the financial crisis extremely competitive.

U.S. dollar strength

All that is now changing. The U.S. dollar has rallied hard, up more than 18% for the euro and 10% for the yen in the last six months. In a very short period, the U.S. dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, and overvalued against key pairs like the euro and the yen.

Given that the effects from a strong U.S. dollar are unlikely to quickly abate, U.S. equity bulls must pin their hopes on a massive boom in domestic earnings. To be sure, that is not an unrealistic scenario. Private sector gross domestic product has been growing at a steady 3% to 3.5% for the past four years.

But why not play the U.S. consumer by buying European or Asian exporters, regions that have radically sharpened their competitiveness through currency debasement, benefit more from a lower oil price and, if one insists on measuring valuation, trade on much cheaper multiples?

Central banks now following the Fed’s lead

The Fed - with its proclivity for simple and intuitive language (note: tongue firmly in cheek) - has repeatedly spoken about the potential for a supposed "wealth effect" caused by quantitative easing. This is so-called trickle-down economics, in which asset price appreciation causes higher consumption, and eventually leads to greater real investment. That’s the theory anyway.

In reality, the opposite is actually occurring. While ultra-low rates and high monetary activism have surely boosted asset prices, they have simultaneously discouraged saving and, ultimately, led corporations to resort to financial engineering to boost earnings, as opposed to capital investment.

Where then does quantitative easing (QE) work best? The issue need not be hideously complex. While QE is often seen as a targeted approach, the channel where it works best is in the revival of investor animal spirits. QE - and the wider business of central banking - has always been a confidence game.

Therefore, U.S. monetary policy is widely seen as the successful post-crisis model. While it didn’t work as designed, it did engineer an upsurge in investor confidence.

This is why recent policy shifts in Europe have been so important. Overriding the political and philosophical opposition emanating from Germany (read: abandoning austerity and adopting QE) was everything. It means Europe has embraced the U.S. policy roadmap pioneered by Bernanke and Yellen. This was previously unthinkable.

Looking ahead, investors will start rewarding U.S.-style expansionary policies in the form of higher asset prices (whether one agrees with them or not is unimportant). This is already happening, with eurozone stock markets vastly outperforming the U.S. since the onset of QE. Expect this to continue.

Caution: U.S. dollar sentiment overwhelmingly bullish

Everyone knows the euro is plunging to parity. Even French President Hollande recently joined the chorus, lightening the deflationary mood with his own joie de vivre: "It makes things nice and clear: one euro equals a dollar".

But beware consensus forecasts. Our sentiment models are indicating near universal bullishness to the U.S. dollar. When everyone is thinking the same thing, who is left to place the marginal trade? Yes, the U.S. dollar could continue to strengthen into the stratosphere, but there is a high likelihood that several currency pairs stabilize, or even rally, from these levels.

The catalyst will be changing macro narratives. For the eurozone and Japan, capital will head back to these regions if a recovery takes hold. The resulting flows of global capital will at least stabilize the euro and yen.

Better yet, Asian currencies - which have been fairly resilient versus the U.S. dollar - could start to rally as a firm recovery materializes. Here the plunge in commodity prices is dramatically lowering inflation, paving the way for significant policy easing (six central banks in Asia have surprised with rate cuts this year). Perhaps more importantly, most Asian countries do not face the same liquidity traps as the developed world. Engineering a recovery by boosting domestic demand will be much easier.


In many ways, the above argument is not driven by a negative view on U.S. equities or the U.S. dollar. After all, history has shown that the senior currency becomes chronically strong in postfinancial crisis periods. This could still run for several years.

However, trends are not always linear. A pause is very likely. This will be driven by a recognition that worldwide policy is converging on the U.S. model and should deliver, at the very least, a multi-quarter bounce in economies outside the U.S.

It is also a recognition that the sponsorship of rising global asset markets by the world’s monetary authorities will continue for some time. Still, it is time to rotate away from America. Thank you Bernanke and Yellen. Our clients have enjoyed the ride.

© 2015 Hahn Investment Stewards. All rights reserved. Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the "best independent ETF experts". This article first appeared in Reprinted with permission.

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