U.S. Growth Style Equity Continues Its Dominance
Well, so much for the correction in ‘growth’ style equities that we highlighted in our July 2018 Market Commentary, following mixed earnings releases from growth stalwarts Facebook and Netflix. On 8/1/2018, Apple reported strong quarterly earnings, and investor sentiment quickly swung back into Nasdaq 100 which ended the month up 8.9% versus 3.3% for the S&P 500 Index. U.S. value stocks underperformed the broader markets, as its relative performance was partly hindered by a flatting U.S. yield curve which weighed on financial sector performance.
Investors’ clear preference for U.S. equities accelerated in August. The S&P returned 3.3% for the month versus -2.8% for MSCI Europe, 0.2% for MSCI Japan, and -2.7% for MSCI Emerging Markets (Figure 1). Except for 2017, global investors have not been rewarded for diversification relative to a U.S.-only allocation as U.S. equities have consistently outperformed non-U.S. equities on a rolling 5-year annualized basis following the 2008 financial crisis (Figure 2).
Figure 1 – U.S. Equities Handily Outperform All Other Major Regions
Figure 2 – U.S. Consistently Outperforms Non-U.S. On a Rolling 5-Year Basis
Several headlines emerged during the month that would increase the year-to-date disparity between the U.S. and rest of the world. While the U.S. was basking in a continuation of positive quarterly earnings releases (many from the consumer discretionary sector), emerging market headlines only brought bad news for investors. A Financial Times article discussing European Central Bank concerns over European bank exposure to Turkey helped contribute to a sell-off in European and Emerging Market equities as well as a lack of progress in trade discussions between the U.S. and China with the former threatening to impose $200 billion of tariffs on Chinese imports. The U.S. trade dispute with China puts a spotlight on the sustainability of China’s long-term growth outlook as the country seeks to support its state-owned enterprises at the expense of its private sector and host countries of China’s Belt and Road are pushing back on the heavy debt burden to fund the local infrastructure.
The relative poor performance of emerging markets is being driven by local political issues in Turkey, South Africa, and Brazil that encompass broader concerns over political interference into private businesses, financial markets, and central banking. In our prior blog article, “ When the Music Stopped but the Bankers Were Still Dancing,” we weighed attractive valuations against the increased risks of investing in local emerging markets due to these political risks as well as increased debt loads. We noted that the earnings picture has deteriorated for emerging markets (unlike the developed markets), and that weakening local currencies and a slower growth picture could make the high debt burdens taken on to fuel recent economic growth unmanageable. The concern for heavily indebted countries like Turkey is that much of this debt (dollar-denominated debt no less)has to be rolled over starting in 2019 (Figure 3).
Figure 3 – Emerging Markets Face the Prospect of Having to Roll Over Foreign Currency Debt Just as Lenders Start to Shut the Window on Further Borrowing
Source: Institute of International Finance (Courtesy of the Wall Street Journal)
The Growth Picture Doesn’t Look that Much Better for Ex-U.S. Developed
Although earnings are expected to grow in Europe and Japan, they are growing at a much slower pace relative to the U.S. The U.S. Dollar Spot Index (DXY) appreciated to a 1-year high in August nearing 97 before tapering off to just above 95 (Figure 4); further advances in DXY will likely signal investor expectations that worldwide exits from quantitative easing outside the U.S. will likely be delayed.
Figure 4 – U.S. Spot Index Reached a 1-Year High Before Tapering Off
Europe is grappling with renewed debt and economic growth issues surrounding Italy as well as expectations that the European Central Bank will delay exiting quantitative easing and normalizing interest rates. Dealing with the Periphery region (notably Italy)and loggerheads over Brexit, the ECB has floated the idea of prolonging the exit from quantitative easing through interim steps like 1)Operation Twist with central bank balance sheet purchases focused on the long end of government yield curves and 2)ending balance sheet purchases by year-end rather than reducing the balance sheet. Growth projections in Europe have already dropped this year, so any further hiccups in region-wide growth will only forestall the end of quantitative easing, now projected to occur in December 2019.
The growth picture in Japan is shaping up to be relatively better as capital spending, particularly spending focused on technology, is providing a boost to core drivers of future growth. Although manufacturing sentiment has leveled off from 1-year peak levels (perhaps due to U.S. tariff threats), the overall business environment for Japan still looks positive (Figure 5).
Figure 5 – Japan Business Sentiment Has Leveled Off from 1-Year Highs but Still Remains Positive
U.S. Growth Leads All Styles and Sectors
U.S. Small Caps and Growth Stocks (Figure 6a and 6b)continue to benefit from a growth environment that is perceived to be the domain of a handful of highly profitable companies and high growth prospects that have attracted the lion-share of investor capital.
Figures 6a and 6b - U.S. Small Cap and Growth Outperformed Large Caps and Value
As has been the case for much of the year, U.S. technology led all major sectors (Figure 7) followed by consumer discretionary and health care. Late state cyclicals such as industrials, materials, and energy lagged.
Figure 7 – Technology Leads All Major Sectors in August
Among major factors (Figure 8), ‘Momentum’ and ‘Quality’ outperformed ‘Value’ and ‘High Dividend’. It’s been a growth investors market for most of the year with value and dividend focused investors lagging.
Figure 8 – Momentum and Quality Outperform Value and Dividend
There is no denying that the U.S. is experiencing a growth phase much different from the rest of the world. Despite trade war rhetoric, plans for future capital spending expenditures (Figure 9) remain at elevated levels
Figure 9 – Future Capital Spending Sentiment Remains at High Levels
And despite higher interest rates, U.S. financial conditions have sharply recovered from the second quarter while financial stress has declined (Figure 10).
Figure 10 – Easing Financial Conditions Provide More Tailwinds for U.S. Growth
Regardless of U.S. political sentiment, the U.S. remains in the growth driver’s seat, leaving much of the world behind (which will only get exasperated should more trade tariffs be imposed). Perhaps the Trump Administration realizes this and is willing to press forward on trade tariffs in order to ‘cut a better deal.’ Investors have recognized the disparity in growth prospects between the U.S. and the rest of the world which has shown up in the disparity in relative stock market performance.
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