As calendar year 2016 came to an end, we highlighted that the U.S. equity market was at a crossroads. After six consecutive quarters of negative corporate earnings growth, Q3:16 and Q4:16 were not only positive, but Wall Street announced that it expected a shocking 11.6% corporate earnings growth rate during the 2017 calendar year. Simply put, 2017 was going to validate the (valuation expansion driven) equity bull market or be the catalyst for the inevitable correction.
We all know what happened next: Trump was elected in late 2016 and despite political contention, the U.S. economy took over as the global leader (for developed markets) in GDP growth. 2017 corporate earnings were better than expected and the Trump corporate tax plan paved the way for the U.S. to lead the world in 2018 corporate earnings growth. This jolt was the only fundamentally based narrative (aside from a 10-20% market correction) that could “re-price” the U.S. equity market. Over the past 12 months, the S&P 500 has seen the forward price/earnings ratio reduce from 18x future earnings to 16x future earnings. This reduction has brought U.S. equities back in the range of being fairly valued based on historical norms.
Table 1: U.S. vs. International Valuations.
Source: JP Morgan
International Growth Finally Real?
International equities and currencies lagged the U.S. during the 2009-2016 period as the global economy failed to recover as quickly as the U.S. Because of this, investors couldn’t get comfortable and valuations abroad did not experience the same “expansion” as the U.S. market.
This changed in late 2016 – early 2017. European and Asian economies finally caught traction triggering investors to consider shifting longer-term allocations towards the much cheaper international markets. This shift caused international equities to outpace U.S. equities during 2017. It also caused a dramatic correction in the U.S. dollar versus international currencies.
Economies are either getting better slowly or getting worse quickly. As we can see in the U.S. and abroad, the fundamentals remain positive. With that being said, we continue to favor an overweight to international equities (on a relative basis) for a few reasons:
- Economic expansion: The U.S. economy is late in the cycle. In 2009, we saw unemployment increase to 10% in the United States. We now stand at 3.8%. This decrease in the unemployment rate (and therefore increase in personal income/consumption) has created a tailwind for GDP growth over the past decade. With an unemployment rate of more than twice the U.S., Europe is at an earlier stage of the economic recovery and will have tailwinds for the next few years as the U.S. nears full capacity.
- Monetary policy: Because of the different stages in economic recovery, the U.S. Federal Reserve and European Central Bank have implemented different monetary policies. The Federal Reserve is well ahead of the ECB in raising interest rates. Stock valuations typically expand during decreasing interest rate environments (what fueled the 2009-2016 stock rally), and contract or hold somewhat constant in rising rate environments. With rates rising, it should be difficult for U.S. stock prices to grow at a much faster rate than corporate earnings growth.
It is worth noting that we do remain positive on U.S. equities; we just believe it is time to focus on sectors that are positively correlated to rising rates (Finance, Tech, Industrials, Materials, Healthcare) and avoid sectors that react negatively to rising rates (Utilities, Telecom, REITs).
- Relative value: Home country bias is real. Americans invest in the U.S., Europeans invest in Europe and Asians invest in Asia. With U.S. fixed income investments already yielding 100-300bps above comparable global fixed income investments (and continuing to rise), the relative value of fixed income assets in the U.S. should increase versus risk assets in the coming years. With rates remaining near all-time lows and more accommodative monetary policy, European and Asian investors should continue to favor risk assets on a relative basis.
As always, we will continue to monitor.
Reid Davis, Chief Investment Officer
Reid Davis serves as Chief Investment Officer at Pinnacle Trust. You can reach him by email at email@example.com or by calling the office at 601-957-0323.