Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, we believe investors should maintain a modest tilt away from US equities and toward global ex US stocks. Even though the US equity market’s performance leadership this cycle has been partly underpinned by structural factors, today’s historically wide relative valuation spreads and stretched relative fundamentals suggest that the ex US overweight should benefit from mean reversion over time. Importantly, threats to US equities’ fundamental advantages may be starting to emerge.
With US net profit margins at all-time peaks and US equity valuations in the top decile of historical observations, US stocks would be quite vulnerable to margin contraction and valuation de-rating should cyclical and structural tailwinds shift to headwinds. Cyclically, US corporate earnings are already seeing headwinds from fading domestic fiscal stimulus, rising input prices, and slowing external growth. Structurally, record US corporate profits have triggered a growing political backlash and populist anger toward corporations, which foreshadow a more challenging operating environment.
The extent of US equity outperformance this cycle has been extreme—US stocks have outperformed global ex US equivalents by nearly 600 basis points per annum in local currency terms over the past decade. Yet, such dominant results for US equities versus global ex US equivalents have been largely justified by cumulative relative growth in per-share cash earnings. Thus, markets appear to be pricing in perpetual US dominance, given historically stretched relative valuations and rosy long-term forward earnings growth expectations from the sell side. The key questions for investors today are whether the extended divergence in fundamentals, valuations, and returns are sustainable, and if not, to what extent and how quickly they might revert. To answer these questions, we must first understand the underlying drivers.
US companies have benefited from US policymakers’ more aggressive response to the global financial crisis (GFC) and have taken advantage of trade, regulatory, and financial markets developments to increase pricing power, boost both operating and financial leverage, and drive down costs. Manufacturing-oriented US multinationals aggressively outsourced production to lower-cost developing markets over the past two decades. Relatively lax antitrust enforcement has allowed US corporations to pursue mergers & acquisitions to grow scale and snuff out competition. US companies have also benefited from deeper capital markets and a healthier banking sector, lowering the cost of capital for US stocks relative to global ex US firms.
Outside the United States, in contrast, policy decisions since the GFC have perpetuated bank fragility and deflation fears, exacerbated political divisions, and stymied progress on crucial economic reforms, all of which have weighed on non-US equity fundamentals and valuations. Somewhat ironically, recurring economic crises could ultimately serve as the necessary catalysts to adopt more pro-growth and market-friendly policies, a process that has begun to unfold in some non-US economies.
Global ex US equities have outperformed the US market on average during the late stages of past US business cycles, but have usually underperformed during US recessions. Hence, one important consideration to our overweight global ex US equities recommendation is the advanced age of the current US expansion. However, this cycle has been somewhat anomalous, with global ex US stocks failing to outperform for any sustained period. After very modestly outperforming from second quarter 2016 through fourth quarter 2017, negative developments with regard to US tax and trade policy announcements, China’s growth slowdown, and European politics may have derailed global ex US equities’ typical late-cycle run. As a result, whereas non-US equities have typically traded around parity with US stocks at the start of past late-cycle and recessionary phases, global ex US valuations sit at historically wide discounts today. Notably, during last year’s recession scare, US stocks suffered a greater peak-to-trough drawdown than global ex US equivalents on a local currency basis.
We continue to recommend a modest tactical overweight to global ex US stocks vis-à-vis US equities because we believe that equity investors have extrapolated permanent structural advantages for US stocks. While the timing of mean reversion is uncertain, recent cyclical headwinds for non-US equities are starting to abate, and the structural advantages that have supported the US stock market’s historic run appear at risk of erosion. Ultimately, relative valuations are in global ex US equities’ favor, and suggest that they will eventually have their day in the sun.
Michael Salerno, Senior Investment Director on Cambridge Associates’ Global Investment Research Team