How Will The Great Outperformance Unfold?

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Includes: BABA, BIDU, TCEHY
by: Claudio Brocado
Summary

2018 has been a year of strong outperformance by US equities. As we enter seasonally-strong period for global stocks, I expect better performance by international equities.

While I have been wrong in the short term, I continue to like German stocks for the long haul.

Not recommending any major changes to my 2018 portfolio, but after avoiding fixed income, I see a great contrarian opportunity in Italian debt.

Italy has been in the news lately, and there are manynegatives…Still, global investors are fully aware of them, and the risks are inthe price.

The country will remain in the Eurozone, let alone the EU,and can still gradually lower its debt to GDP. Moreover, Italian citizens own alot of the country’s bonds, and domestic savings are high (not only the debtlevels).

The often-challenging month of September is now behind us, and US equity indices hover near record highs. Contrary to 2017, when US stocks performed in line with those of many foreign bourses, 2018 has been a year of meaningful outperformance by US equities.

Tax cuts and repatriation-fueled stock buybacks have undoubtedly represented wind at the back of US equity markets. The question as we enter the seasonally-strong period for global stocks is whether the strong outperformance by US equities will resolve itself by international stocks playing catch-up of otherwise.

As the perennial optimist (though as I often insist, no 'permabull'), my base case scenario is for the degree of US outperformance to diminish through relatively solid performance by international stocks. The fourth quarter is seasonally strong for German equities, and I expect these to finally play catch-up. Admittedly, I have been wrongly bullish on Germans stocks this year, and my track record when it comes to short-term forecasts leaves a lot to be desired.

Nonetheless, I maintain a high level of conviction that European stocks, and German equities in particular, will provide strong long-term performance. I would continue advocating not to hedge the currency exposure, as the euro is fundamentally undervalued, and should provide a long-term tailwind to the returns from German stocks available to dollar-based investors.

Brief update to global asset allocation thoughts for final quarter of 2018

As I wrote at the time of my 2018 asset allocation ideas, making one-year forecasts is challenging, fraught with risks and unlikely to prove successful, particularly on a consistent basis. That said, since I undertook sharing my allocation thoughts and equity top picks for 2018, I must stay on top of them and provide periodic updates. Given my much longer-term orientation, however, I do not feel compelled to recommend any changes at the moment. My recommended allocations provide sufficient diversification to stand the test of time, in my view.

Foreign stocks on which I have pounded the table in the past but that I deliberately did not include among my 2018 top picks include Alibaba (BABA), Baidu (BIDU) and Tencent. (OTCPK:TCEHY). While I continue to very much like them for the long haul, they did not represent contrarian calls at the end of 2017. Now having underperformed and much more out of favor, I do see them again representing somewhat contrarian long-term buying opportunities.

In my comments ahead of this year I stated that I would not feel uncomfortable not owning any fixed income in 2018. My position has not changed significantly, although there has been enough underperformance in global bond markets as to present some (at least tactical) opportunities. I believe this is currently the case with Italian sovereign bonds. In the last few days, the Mediterranean country's securities have soared in my proprietary net positive score (NPS) process, as the many negatives have become universally known and largely discounted.

While still yielding little more than US 10-year Treasury notes, the Italian sovereign bonds of similar maturities had long offered an even punier yield than US bonds. Admittedly, Italian debt to GDP is significantly more worrisome than that of the US. Furthermore, everybody knows Italy cannot print its own currency to inflate its debt burden away (and a good thing that is!).

My base case scenario solidly remains for Italy to in the long run continue to be part of the Eurozone, let alone the EU. Italians, despite the country's well-known economic and fiscal woes, are relatively rich, command large household savings and hold a meaningful portion of the country's large sovereign debt.

Furthermore, I do believe it is still possible to keep the net debt to GDP ratio from rising, even after the current government went against the recommendations by finance minister Giovanni Tria to keep the upcoming year's budget deficit under 2% of GDP. The country enjoys a current account surplus, and will continue to be a meaningful beneficiary from the European Central Bank's extremely accommodative monetary policy.

Recommending Italian debt is certainly a contrarian thing to do. Even as the country's 10-year sovereign debt yields little more than US Treasury notes of similar maturities, this is in euros vs. dollars, and European investors now still get a negative yield on US 10-year debt when it's hedged back into euros. Thus, the over 3.3% yield European investors get on Italian bonds seems increasingly compelling.

Disclosure: I am/we are long BABA, BIDU, TCEHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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