The U.S. Versus the Rest of the World: Divergence and Correction
Looking at the S&P 500 versus the MSCI All Country World ex U.S. (Display 1) highlights just how large that performance gap has been: as much as 15% from May to September. An investor who gradually moved out of the U.S. as valuations started to go up, or who was positioned in a diversified portfolio with significant exposure to the rest of the world, would have underperformed compared to those positioned exclusively in the U.S. who captured the full force of that big rally in U.S. equities and the U.S. dollar.
The U.S. started to diverge from the rest of the world around May, when the trade war began to gather momentum. There are additional factors which have made the rest of the world relatively less attractive from that point, including weaker data, the first confidence shocks from Italy and the emerging market (EM) FX sell-off. However, it is likely that amplified trade rhetoric triggered the divergence. Although President Trump may have ramped up trade tensions in order to motivate his political base for the midterm elections, during periods of uncertainty the market tends to seek the safest haven, which is still the United States. We believe this helped drive a self-reinforcing momentum that has pushed relative valuations to extreme levels from which they may be unravelling now.
Extreme divergence is unsustainable
How long can this divergence last? We can look at past instances where the U.S. diverged from the rest of the world. They are generally correlated above 0.8, but we do periodically have downward spikes where the correlation disappears—and the current spike is the most extreme that we have seen since before 2002 (Display 2). The divergence, which was particularly evident between May to September 2018 was amplified by the appreciation of the US dollar.
Source: Bloomberg, MSIM. As of 28 September 2018.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.
While the spikes of divergence can be significant, historically they have been short-lived and have corrected quickly. This suggests we are likely to return to a more normal relationship between the U.S. and other Developed Markets, and the recent correction has provided signs of this.
The trade tensions between the U.S. and China in particular that have driven this divergence may get resolved after the U.S. midterm elections, if they are in fact politically driven, or through some development in negotiations or politics. So far though, neither side seems willing to make concessions. However, extended trade tensions and the uncertainty associated with this can have an adverse impact on the underlying global and U.S. economy.
The direct impact on China is already noticeable in the recent growth slowdown to 6.5%. Less obvious, but also significant is the potential negative impact that trade uncertainty may have on U.S. business fixed investment, that has been a key driver of U.S. growth. Any slowdown in this can lead to lower growth with negative implications for U.S. and global markets.
With lofty relative U.S. valuations, it has always been possible that a U.S. tumble could occur. Our focus is on the discrepancy itself, which we see as extreme. However, correcting the regional divergence does not necessarily imply that the U.S. will trip and fall. Europe and Japan could also catch up with the U.S. or they could meet somewhere in between. Recent market developments suggest the more volatile downward move in global equities may be the most likely outcome.
Tariffs: Consumer pain
Any ramp up of the tariffs is likely to be painful for the U.S. consumer. Of the $200 billion of Chinese goods most recently hit by U.S. tariffs, $78 billion are consumer products—which may be why the Trump administration has chosen to increase tariffs by only 10% before the U.S. November midterm elections, with the bump to 25% happening only after, in early January 2019.
The cost of switching to other countries for these imports is likely to be considerable, which means that the tariffs are unlikely to significantly decrease Chinese production. Instead, most of the burden will likely be borne by U.S. consumers simply paying more, and thus buying less.
Weakness in the “new safe haven” assets
A primary component of the U.S. outperformance since the beginning of the year has been the surge in technology stocks. Looking at relative values— including PE, PBV and PS ratios, for much of this year US technology stocks have traded at a premium to other sectors (Display 3).
However, we have already started to see some weakness in the stocks that have led the rally. Year-to-date to end September, the NYSE FANG Plus Index was up 14%, outperforming NASDAQ’s 17% and the S&P’s 11% (Display 4). Since then over subsequent periods the order has reversed and it looks like a technical reversal is occurring.
Source: Datastream, MSIM. As of 28 September 2018.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.
Our expectation that the divergence between the U.S. and the rest of the world will correct makes us wary of overexposure to the U.S., relative to the rest of the world. Non-U.S. markets provide possibilities that avoid the risk of a further correction in the U.S. and/or capture potential benefits from a correction that manifests through the rest of the world surging rather than from the U.S. market falling.
The key insight here is the relative discrepancy, which we believe will continue to correct. But it is rare for a big valuation discrepancy to correct without a significant degree of volatility, so a modest exposure to equities would be prudent, whilst still allowing for scope to capture opportunities. We maintain a moderate amount of risk with a relatively low weight in the U.S. and an overweight to other developed markets.
Emerging markets: Look at FX coverage ratios
Volatility is likely to continue in the emerging markets so long as trade tensions go on, but investors who are comfortable with the risks may want to position in those markets that have been oversold. Countries like Brazil and Mexico, for example, have comfortable FX coverage ratios.1 They have more reserves than their external debt. By contrast, Argentina and Turkey have insufficient reserves. Because a lot of the weakness in EM has been driven by the strong dollar, the weakness in Mexico and Brazil looks overdone given their ability to cover their foreign debt obligations. So the volatility in EM markets is creating opportunities in some countries.
China and Asia ex-Japan: Vulnerable
The trade tensions directly hit China at a time when the Chinese economy is vulnerable, as the government tries to transition from an investment to a consumption driven economy. Although this shift is positive in the long run, it causes a lot of dislocation that weakens the economy while the change is occurring and inefficient companies go bankrupt. The tariffs also impact the rest of Asia, as about half of the goods China sells to the U.S. include imported parts that are generally purchased from neighbouring Asian nations. To the extent that tariffs weaken China, they also weaken the countries that export these components to China.
Given spikes of divergence are generally short-lived, we expect the U.S. and the rest of the developed markets to return to a more normal relationship relatively soon. Whichever form the correction takes—whether by the U.S. rising less or falling—there is good evidence that the U.S. is likely to decline relative to these other regions. Corrections in significant divergences rarely occur quietly and there may be some fundamental damage to the global economy from the trade tensions. A prudent investor may wish to keep risk exposure low and be prepared for a longer period of weak markets until the divergence fully corrects.
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