In this month’s video, Investment Director, Ritu Vohora looks at the sharp divergence in equity markets. Are we at an inflection point?
Global equity markets sit at an important juncture. They have diverged sharply this year, with the US roaring to new highs, while most non-US equity markets have faltered since hitting cyclical peaks earlier this year. The outperformance of US versus the rest of the world has now hit historical extremes. Indeed, a successful strategy over the past eight years has been to own US stocks against other regions and a preference for growth over value. There is a strong correlation between these two strategies. But are we nearing an inflection point?
Global growth in aggregate remains robust, but patterns are no longer synchronized. While the fiscally boosted US expansion goes on, growth in Europe and Japan has slowed, Chinese efforts for deleveraging have led to some moderation, and the outlook for parts of EM has deteriorated. The combination of trade tensions, higher oil prices and tighter dollar liquidity are weighing not only on China and other emerging markets, but also on export-reliant developed countries such as Europe.
The US is comparatively insulated and still retains several advantages including superior domestic economic growth momentum, strong corporate earnings – boosted by this year’s tax cut and dollar appreciation. Rising trade tensions have also seen investors flock to the safety of the US. This coupled with slow-but-steady Fed hikes, has sparked significant inflows into the US, boosting US-dollar assets. The latest Bank of America Merrill Lynch fund manager survey shows the largest overweight to US equities since 2015 and it is now the top equity region. But with relative outperformance and valuations looking extended – is all the good news now priced in?
The rich US valuation premium by itself is unlikely to be a catalyst for a reversal of relative share price performance. However, combined with stretched relative performance, any shift in underlying earnings fundamentals could trigger a pronounced swing in performance.
The divergence in stock market moves contrasts with the similar path of analysts’ earnings estimates for companies across the US, Japan and Europe. Analysts’ consensus estimates for earnings over the next 12 months are rising at a high single-digit to low double-digit pace across all three regions.
The divergence between stock performance and earnings estimates may be attributable to widening differences in the degree of confidence in those forecasts, due to tax cuts and trade tensions, among other factors, affecting the relative growth outlooks. Although earlier this year, economic data was better than expected in the US, it was worse than expected in Europe and Japan. The economic surprise indices now reveal that data in the US, Europe, and Japan is coming in close to expectations. If economic data begins to come in better than expected broadly across all regions, it is possible that performance divergence may unwind, as confidence in the earnings outlook improves outside of the US.
Further, a shift in relative earnings momentum would coincide with the one-time boost from US tax reform and fiscal stimulus starting to wane. A re-convergence of earnings growth expectations between US and select non-US markets should narrow the current valuation gap. That would also argue for value to do better than growth, especially in the US, as momentum starts to roll-over.
Near-term risks have risen, but that can help the long-running bull market continue, as lack of investor enthusiasm means there is room for markets to grind higher. Risks exist on both sides — pullbacks are possible but so are breakouts to the upside. Selectivity will be important in the months ahead.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.