As Global Stocks Diverge, Valuation Comes into Sharp Focus
Portfolio Managers Greg Kolb and George Maglares discuss the diverging returns of U.S. and non-U.S. equities and how that’s shaping investment opportunities.
- Despite a recent sell-off, U.S. stocks have outperformed global markets year to date due, in part, to a strong U.S. economy and geopolitical worries in Europe and Asia.
- However, as multiples for U.S. stocks rise, we think it is all the more important for investors to consider downside risks and stay focused on valuation.
- In our opinion, that means focusing on stocks outside the U.S., as well as value and cyclical companies, which have lagged growth peers in recent years.
Despite the recent sell-off, U.S. equities have clearly separated from the rest of the global pack based on strong underlying economic fundamentals aided by stimulus from tax reform and assorted deregulation. From that place of relative strength, U.S. leadership is actively seeking concessions from trade partners, including both traditional allies (NAFTA, Europe) and strategic competitors (China). These measures, in and of themselves, are increasing tensions and uncertainty around the globe, and it would seem that equity markets are contemplating various adverse impacts. For example, several major markets in Europe – such as the UK and Germany – as well as Hong Kong are down meaningfully on a year-to-date basis, which is a stark contrast to performance in the U.S.
There are likely multiple explanations for this bifurcation in performance. First, investors may be anticipating that the U.S. is likelier to emerge victorious amid these various trade disputes given that its economy is larger, stronger and relatively less dependent on exports than partners. Second, underlying U.S. economic conditions are accelerating with improving GDP, low unemployment and contained inflation. Third, a variety of headwinds are challenging other major economies. The Brexit negotiations between the UK and the European Union (EU) appear increasingly disorganized and chaotic with each side entrenched in its own negotiating position before a firm March 2019 deadline. In Italy, the new government has proposed fiscal measures that are increasingly in conflict with EU and European Central Bank rules, threatening a potential debt crisis. Fourth, emerging market currencies continue to decline in countries such as Turkey, Argentina, Brazil and India. This currency depreciation increases the risks for those countries to meet debt obligations, attract capital and sustain growth. Lastly, China’s ability to sustain its own debt-fueled growth becomes more challenging in the face of massive U.S. tariffs.
Potential Downside Risks
And yet through all this elevated concern, stock market valuations in the U.S. remain near all-time highs, with multiples close to levels only previously eclipsed right before the dot-com bubble collapsed. As tensions escalate, it appears that the U.S. is serving as a “safe haven” for many investors and attracting further capital. Still, it is important to consider downside risks in such scenarios. Stimulus measures eventually run their course and have diminishing marginal impact. We also observe that a strengthening dollar invested in markets outside the U.S. generally buys significantly greater earnings than it would in the U.S.
Staying Focused on Valuation
Given the current environment, we encourage investors to explore areas that are out of favor and where negative sentiment weighs on the valuations of businesses with competitive strengths and financial resources to endure near-term challenges. Today, this often means focusing on opportunities outside of the U.S. where multiples appear more attractive. It might also include stocks that traditionally fall into the “value” bucket and tend to be cyclical in nature, including automotive, media, building products, materials and chemicals. We believe gradually shifting into these types of equities could mitigate downside risks. In our opinion, when market performance diverges, deploying capital into such areas could deliver stronger relative returns in periods of elevated market stress.