February 10, 2020
Fading the U.S. FOMO Market and Five Keys to Outperformance in 2020
February 10, 2020
Fading the U.S. FOMO Market and Five Keys to Outperformance in 2020
February 10, 2020
2019’s robust S&P 500 return has continued the multiyear trend of U.S. equities outperforming the Rest of the World (RoW) with minimal dispersion in sectors and historically low levels of volatility. With earnings declining by -2%, multiple expansion was responsible for more than 80% of the U.S. equity market’s gain seen in 2019.1 At this point, U.S. relative outperformance is more than two standard deviations above a nearly 100-year average.2 This is an unprecedented development that looks to have run too far given much stretched relative valuations and weak earnings trends. Fittingly, as investors have continued to favor U.S. stocks over all others, some have dubbed the strong run as “the FOMO (Fear of Missing Out) market.”
If fear of missing out has propelled the U.S. stock market over others, what can investors expect from the early years of the 2020s and the decade to come? The Active International Allocation team outlines their five key investment expectations, summarized below:
In summary, the Active International Allocation team expects a new market regime to raise the currently low levels of country, sector and industry dispersion, as well as result in more normal volatility of returns. As this occurs, it should open the door to a comeback for non-U.S. relative performance and should also favor active over passive allocation strategies. As we enter 2020, our portfolios are focused around large overweight positions in Germany, Netherlands, Ireland, Denmark, Spain, Singapore, Egypt, Peru, Argentina, Indonesia and India. Our large underweights include Australia, Japan, Italy, Canada and China. While getting the timing right is hard, we believe our country allocation framework coupled with our rigorous sector, industry and company selection process is well-suited to thrive in a regime that should reward a wider set of winners.
The zeitgeist of the 2010s was cleverly captured in acronyms like FOMO (Fear of Missing Out) and YOLO (You Only Live Once). Coined by millennials, these terms expressed an ethos of living in the moment and maximizing every opportunity, in a decade of transformative social and economic change. As millennials and their ideas have risen to positions of influence in the world of business, the adages of a generation that came of age in a period of post-crisis anxiety have also become apt descriptions of the mindset that has been permeating into areas of U.S. public and private investing.
After all, the sky-high private market valuations that until recently were placed on some fast growing but ultimately loss-making businesses would probably not have been possible were some investors not animated by an intense fear of missing the next big thing. The same observations could also apply to describing the IPO market of 2019, where more than 70% of companies listed in the last year were demonstrating fast growth but had yet to turn a profit.3 In fact, more public money was raised in 2019 for unprofitable companies than in any year since 2000 (the peak of the Tech bubble – Display 1).
Another peculiarity of 2019 was the continued standout performance of U.S. equities, despite a slowing U.S. and global economy, weak earnings trends, expensive relative valuations and ongoing trade tensions with China. The U.S. outperformed all other major global equity markets, despite earnings falling by 2%, and valuations that started the year at a historically elevated level and are now touching a twenty-year high (compared with median or below levels, ex-U.S.). This means that multiple expansion was responsible for more than 80% of the U.S. equity market’s gain seen in 2019.1 Although trade issues and other geopolitical uncertainties began to weigh negatively on business confidence and the earnings of globally exposed companies, U.S. investor sentiment remained unbowed in 2019, with especially large crowding into stocks favored by price momentum strategies taking place for most of the year.
In fact, 2019’s robust S&P 500 return has continued the multiyear trend that has seen U.S. equities outperform the RoW with minimal dispersion in sectors and historically low levels of volatility. U.S. equities began their run of outperformance in 2007 and have since then (aided by a strong U.S. dollar (USD) since 2011) outpaced non-US equities by more than 200% cumulatively!1 Amazingly, at this point, U.S. relative outperformance is more than two standard deviations above an established average trend line going back nearly 100 years (Display 2).
This is an unprecedented development, and for us it is fitting that some commentators have dubbed the strong run of U.S. equities as “the FOMO market.” After all, despite stretched valuations and slow earnings growth, few have wanted to sit on the sidelines of this market rally, particularly not when the U.S. Federal Reserve (Fed) is back to expanding its balance sheet!
If fear of missing out has been a strong force propelling the U.S. stock market over all others, what can we expect from the early years of the 2020s and the decade to come?
While calling a shift in market regimes is always difficult, we see signs of a new market zeitgeist developing, one where investors are going to be paid for greater discernment, and where they are likely to become less afraid of missing out on the continuation of the big trends of the 2010s.
We expect this new market regime to raise the currently low levels of country, sector and industry dispersion, as well as return to more normal volatility of returns. As this occurs, it should open the door to a comeback for non-U.S. relative performance and should also favor active over passive allocation strategies.
Below we sketch some of the key drivers of these shifts:
1. U.S. equity outperformance looks hard to sustain: The FOMO market got a big lift in August when the United States and China, responding to signs that their tariff battles were undermining the global markets and economy, began to tone down the rhetoric. That boost has been sustained since early October by the announcement of a Phase 1 deal. However, in our view, the enthusiasm over the Phase 1 deal may be reaching unwarranted levels of optimism. While a negotiated truce serves the purposes of Washington and Beijing going into a politically important 2020, the economic, financial and trade decoupling of the U.S. and China will continue after a brief, convenient pause. No matter which party wins the U.S. elections, U.S.-China relations are likely to remain tense for years. This dynamic will continue to impact numerous U.S. sectors and industries, and should raise the relative discount rate for the U.S. stock market from the very low levels prevailing today.
This is important because many global investors have favored the U.S. economy and stock market because of the perception that the U.S. is mostly insulated from trade tensions, helping to drive its outperformance in 2019. However, over the last year, U.S. earnings growth has decelerated from +26% to -2%,4 weighed down by the same trade and geopolitical uncertainty that have impacted virtually all foreign markets. U.S. earnings did hold up slightly better than the Rest of the World (which saw earnings shrink by -6%);5 however, investors have paid for slight fundamental earnings outperformance by buying in at substantially higher valuation multiples. By our calculations, relative price-to-cash-earnings (best back-tested indicator for forward returns in our view) is already at the 97th percentile, an extreme level. U.S. stocks have only been more expensive relative to non-U.S. stocks just 3% of the time since the data started in 1970 (Display 3).
Therefore it is difficult to see further multiple expansion for U.S. equities versus the RoW, or better forward-looking relative returns. Our analysis shows that at the current valuation starting point, the implied relative returns for U.S. versus global equities are in the worst decile,
consistent with -6.9% one-year, -8.9% three-years and -8.0% five-years out (Display 4).
To sum up, slightly better U.S. economic and earnings expectations look fully priced in versus the RoW, and overweighting U.S. equities may no longer be a good relative position. Importantly, our thesis is based on the extreme valuation divergence present today and doesn’t rely on a scenario of relative economic and earnings fundamentals shifting decidedly in favor of non-U.S. countries. Having said that, as highlighted in the next bullet points of this outlook, we think the fundamental backdrop is now more supportive of such a development occurring. With foreign markets currently much more attractively valued than their U.S. counterparts, it wouldn’t take much improvement in fundamentals to drive strong relative outperformance.
2. The repo market fiasco of 2019 demonstrates that the liquidity environment will be more supportive towards non-U.S. assets. The Fed’s experiment with unconventional monetary policies in the wake of the global financial crisis was always filled with a high degree of uncertainty about the ability to unwind and exit the “emergency” policies. Global financial markets have now witnessed several years of central banks trying to withdraw from large-scale monetary accommodation and recent events have actually moved policymakers to once again use unconventional tools. Developments during 2019 showed that the Fed’s quantitative tightening (QT) policy destroyed too many excess reserves, especially in a world where large regulated financial institutions have to abide by rigorous capital standards. As this has become clear to policymakers, they have called off the first monetary tightening campaign since the Global Financial Crisis of 2008-09 (GFC). Over the last year, the Fed and a few other major central banks abandoned their respective attempts to wean the markets off of unconventional policy in the face of ever-present record-high public and private indebtedness and the downward pressure that this factor exerts on world economic growth.
The exact impact of the Fed’s QT on funding markets is difficult to quantify directly, but there is no question that this policy disproportionately impacted international financial markets, especially the EMs. The lagging effects of QT were an especially large headwind to growth outside the USD area, creating a scramble for liquidity that set off funding challenges for numerous countries, while at the same time promoting USD strength. As global and U.S. economic growth and earnings all undershot even the most modest projections over the last year, the Fed not only cut rates three times but was also forced by repo market issues to once again expand its balance sheet. The exact size and duration of the Fed’s balance sheet expansion is up for debate, but it is clear that policymakers’ bias has shifted toward maintaining an environment of ample liquidity in funding markets.
This means that a tight USD liquidity environment that acted as a strong headwind to economic growth outside the U.S. is abating. In turn, the Fed’s easy posture should not only improve the global funding environment for those that need USD, but also should result in better growth dynamics outside the U.S., which should in turn attract more currency inflows toward the cheapest and most high-yielding currencies (most of which are in EM). These dynamics set up a favorable backdrop for non-U.S. assets and is another factor that argues for rotation away from U.S. equities.
3. The strong U.S. dollar faces weakening fundamentals and rising political uncertainty that could take its toll: Our proprietary foreign exchange (FX) framework, which considers many intrinsic variables to derive relative values for all currencies, has shown that the USD’s strong run since 2011 has made it very expensive relative to virtually all global currencies. On top of stretched valuation, a large and widening fiscal deficit, as well as a more accommodative Fed all make the dollar more of a sell than a buy. Interestingly, over the past decade, more than 16 trillion USD of foreign capital have flowed into the U.S.6 attracted by its relatively higher growth dynamics, yield advantages, a robust equity market and capital friendly policies. While other currencies have been frequently undermined by negative political surprises (e.g., EU breakup fears, Brexit, crises and government scandals in numerous EMs), the USD has been regarded as the bastion of stability in an uncertain world. However, in our view, the challenged fundamentals outlined above, in addition to deepening political division in Washington and the uncertainty stemming from the upcoming 2020 presidential and congressional elections, could dent the Teflon status of the USD.
Foreign investors who have sent all that capital into the U.S. have thus far been resilient in the face of mounting government dysfunction, extreme partisanship in Washington and stark polarization between the coasts and the middle of the country. As the 2020 electoral race gathers pace, foreign investors may struggle to handicap the election outcomes and the real-world impacts of the vastly different policy proposals being espoused by the two major parties. With one party clearly in favor of increasing taxes on the wealthy, implementing more redistributive policies and proposing intervention in several large sectors of the economy, while the incumbent administration looks to continue with assertive trade re-negotiation and efforts to make the USD more competitive versus other currencies, we see the possibility of unusually large moves and higher volatility (in rates, in U.S. equities, and above all in FX). All of this is important, because in recent years FX volatility has been very low, and complacency about the USD has been high.
In sum, as the future direction of U.S. politics look less certain, investors may increasingly question the premium valuation of the dollar, especially in the face of the fundamental challenges outlined above and a better non-U.S. growth and liquidity environment. Therefore, the strong USD – a key pillar of support for U.S. asset outperformance since 2011 – could fade in the months to come.
4. Emerging Markets offers better return prospects in 2020─and the decade to come. The 2010s were not a great decade for EM equities as their returns significantly lagged the U.S. and other Developed Markets. However, the painful decade of underperformance has now produced relative valuations that are at the most favorable levels in about twenty years, and are close to those seen during the fantastic buying opportunity seen in the wake of the Asian Financial Crisis in the late 1990s (Display 5).
Outside of China, many EM currencies are now cheap, and many EM governments have been reducing external vulnerabilities, deleveraging, reforming and generally putting their economic house in order. In addition to attractive equity and FX valuations, the fundamental improvements seen over the last decade and the recent improvement in the global liquidity environment should all overpower the headwinds that have confronted the asset class since 2011. Over the next year, a negotiated trade truce should be good for the entirety of emerging markets, and should result in better relative and absolute growth and earnings trends for the broad EM composite.
Looking out a bit further, as China and the United States continue to restructure their trade relationship, emerging economies will have to choose which wagon to hitch themselves to. While this dynamic is still nascent, the race to technological and geopolitical supremacy will test superpower relations with existing and potential allies from the Far East and Southeast Asia to Latin America. The nations that adapt quickly will attract foreign direct and supply chain investment, as well as support from foreign investors. Others will struggle. And as this split widens, we believe there will be a much clearer distinction between winners and losers, as well as contrarian opportunities. Given their starting point today, EM equities look poised to reverse their decade of underperformance, but post a-broad-2020 rally, a narrower and highly active approach will be needed to truly find those EM countries, sectors and industries that can sustain multiyear outperformance.
5. The FOMO market will fade and active management will come back into vogue: The U.S. FOMO market characterized not only 2019 but much of the 2010s. Afraid to miss out on the big trends, most global investors favored the same country, investment style and few sectors for the same reasons. When investors are all taking the same positions, and profiting in an unusually calm market, there are fewer reasons to pay an active manager. As U.S. equity volatility plumbed new record lows, cheap passive funds took off over the last decade. As money flowed into passive funds, it went into the same narrow positions, which made it difficult for active managers to outperform, which encouraged more flows into passive funds.
However, the market pendulum is always in motion, and we think it is now poised to swing from passive back to active management. As we have argued in this outlook, continuing trade and geopolitical tensions, stretched U.S. relative valuations, and tangible threats to the strong USD are likely to inaugurate a trend of greater dispersion in the markets, and a rotation toward non-U.S. assets. There are however, other factors that bear consideration. A decade of easy money has been good for financial assets, but has also encouraged the capital misallocation that has underpinned rapid rises in debt and real estate prices in many economies. Loose monetary policies have increased the wealth of those who own financial assets; however, they have also fueled the resentment of those who do not. In turn, populist political movements promising to correct built-up imbalances are rising, alongside massive public protests, in virtually every developed democratic state (save Japan). As a result of popular upheaval, record high debt levels and stubbornly low economic growth, various political factions around the world are clamoring to combine monetary and fiscal forces into a potent cocktail known as Modern Monetary Theory (MMT), all with the goal of seeking more effective influence over markets and economic outcomes. Politicians of all stripes are not only pondering new tools such as MMT, but are also advocating for heavier regulation and taxation of the very same companies that were the big winners of the last decade. These dynamics are creating a very different political and investment environment than that seen in the decade following the GFC. We think that even traditional and centrist political parties are going to be pressured to expand their voter base away from more extreme poles by broadening their policies towards some prescriptions that may not be part of mainstream economic thought. Because these measures are bound to vary in content and impact and from country to country, industry to industry, and company to company, the uncertainty they create will also likely increase dispersion and volatility of returns.
All of the above lead to why we believe that a playing field that has been favorable for passive investment will transition into an environment that favors active management. The shifting landscape will inevitably require more differentiation between winners and losers and reward those who are able to take advantage of country selection, sector and industry distinctions and rising volatility to add value. In short, it should be an environment in which active managers set themselves apart from the benchmark-driven crowd.
Calling a shift in market regimes is always difficult, but there are nascent signs that investors will be less likely to continue piling onto the big trends of the 2010s, bringing the U.S. FOMO market to a close. Our work shows the last decade has seen an unprecedented period of outperformance by the U.S. equity market, as well as an unusual combination of low sector dispersion and muted volatility. We believe that the case for a continuation of this trend is no longer underpinned by relative valuations or economic and financial market fundamentals. Encouragingly, in recent months, non-U.S. markets have performed as strongly as the U.S. equity market, while the USD has generally been weaker. These are just a few supporting anecdotes, but it could mark the transition to a new phase in which the market is rotating away from the narrow leadership of the last several years.
Looking to the year ahead, the 2020 global equity market is likely to be more varied and therefore much more favorable to active country, sector and company selection than it was in 2019 and the last decade. With U.S. relative valuations being at extreme levels (more expensive than just 3% of the time since 1970), we see non-U.S. equities outperforming in the next year as well as three and five years out. EM in particular combine very attractive valuations in equities and FX with opportunities to benefit from a USD that could be hobbled by the upcoming 2020 election, expensive relative valuations, a widening fiscal deficit and continued shadow easing by the Fed.
As the most attractive global equity opportunity set shifts away from its U.S.-centric focus of the last several years, we see many non-U.S. equity markets that offer attractive relative and absolute valuations as well as fundamental growth trends. When combining a favorable non-U.S. valuation backdrop with our proprietary “Rules of the Road” country selection criteria, the list narrows the most attractive global equity opportunities to include large undervalued markets in Europe, Asia and Latin America (Display 6).
As we enter 2020, our portfolios are focused around large overweight positions in Germany, Netherlands, Ireland, Denmark, Spain, Singapore, Egypt, Peru, Argentina, Indonesia and India. Our large underweights include Australia, Japan, Italy, Canada and China. While getting the timing right is a hard endeavor, we believe that our country allocation framework, coupled with our rigorous sector, industry and company selection process, is well-suited to thrive in a regime that should reward a wider set of winners. In sum, while the shift to a new market regime may unnerve some global investors, we see it as a playing field for which our Active International Allocation strategy is well-suited.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Privately placed and restricted securities may be subject to resale restrictions as well as a lack of publicly available information, which will increase their illiquidity and could adversely affect the ability to value and sell them (liquidity risk).