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 ETF.com. Reprinted with permission.