American stocks, global laggards

Good morning. Bonds got a bump yesterday after a soggy retail sales report made clear that the US economy is slowing. Stocks fell, and the worst hit among them were consumer staples. Kraft Heinz, the cheese-and-ketchup maker, sank 6 per cent. The latest flows data from Bank of America show staples losing out to beat-up tech and communication services stocks. With growthy stuff cheaper and the two-year yielding a riskless 4 per cent, are defensives losing their edge? Email us: [email protected] and [email protected]. 

World stocks > US stocks

Since late October, global stocks have been consistently outperforming US stocks. This does not happen much. Here is a two-decade chart of relative performance of the MSCI World ex-US local currency index versus the Russell 3000 index, which captures substantially the whole US market. We chose local currency rather than dollar terms for the global index for reasons that will become clear shortly:

You will notice how tiny the current surge in rest-of-world (ROW) stocks is, relative to the years of gobsmacking US dominance that went before. Does the ROW comeback have more room to run?

Zooming in a bit, here is two years of the same ratio, plotted against the dollar index. The dollar index is inverted, so the dollar is weakening as the line goes up:

Global markets were rising relative to the US — again, in local currency terms — before the dollar started to weaken. But the weakening dollar (that is, the rising dark blue line on the right) appears to have added to their momentum. This makes sense. When the US Federal Reserve was increasing rates more aggressively than most other developed world central banks, that strengthened the dollar. That increased costs for many companies outside the US and, more importantly, pulled global capital towards the US. Now that — according to market consensus, at least — the Fed is slowing down its rate increases, and other central banks are set to catch up, the dollar has weakened, and that pattern has reversed.

Of course, if global stock performance is reported in dollar terms, this relationship is much tighter — but it is also partly circular, as the stronger dollar will depress dollar-denominated ex-US performance by pure maths.

So before leaping on the ROW bandwagon, we need to take a view on the dollar. But this is not just a currency story. Energy prices may play an important role, too. Here is the same US/ROW relative performance chart, this time plotted against Brent crude inverted:

It makes sense that cheaper energy would help the US rally relative to the rest of the world. High oil prices were pushing many energy-importing nations towards recession; the US got the offsetting effect of being a major oil producer. Further, European, Japanese and many emerging exchanges feature a high proportion of energy-intensive industrial sectors. And because energy is priced in dollars, a weaker dollar makes energy even cheaper abroad.

Another relationship may be in play too: the shift away from growth stocks — an area where the US dominates — to value stocks. Here is the US/ROW chart, this time with the relative performance of US value and growth stocks:

A striking correlation, even if the causal relationship is not obvious. But it looks like as investors get interested in value, they get interested in ROW stocks, too. This also makes sense. Markets outside the US are heavy on value sectors such as energy, banks and industrials. Moreover — for those willing to simply define “value stocks” as “cheap stocks” — global stocks are cheaper. The S&P 500 still trades at a premium of almost 50 per cent to the Euro Stoxx 600 or Japan’s Topix (measured in terms of price/earnings ratios). That’s about as wide as the discount gets, in recent decades.

So, at least three factors are at play in the ex-US rally: dollar weakness, energy prices falling, and the move towards value. We’ll have more to say about each next week.

Equity risk premium

Yesterday we showed you the chart below of the equity risk premium, the additional pay-off stock investors demand over bonds for equities’ higher risk. Our basic point here was, boy, a decade-low ERP seems a mighty modest premium for a very precarious investing environment:

Admittedly, though, the ERP is more a loose concept than a fixed formula, and entire academic careers have been spent debating the right way to calculate it. By one count, there are 27 published methods to do so. New York University’s Aswath Damodaran has published a regular treatise on the practical difficulties of estimating the ERP every year since 2008; last year’s runs to 146 pages.

So, as you’ll see in the chart’s footnote above, we picked the barest-bones ERP calculation: S&P 500 earnings yield (which is just 12-month trailing earnings/share price) minus the 10-year Treasury yield. But one reader took issue with our method, arguing it is distorted by inflation:

Simply doing earnings yield minus 10yr Treasury yield will result in a low number during times of higher (expected) inflation (eg, 80s and 90s) and higher numbers when inflation is expected to be low (2000s). That is why this measure is low now (as inflation expectations have risen), not due to stocks being overvalued.

In other words, Treasury yields go up when inflation fears do, artificially depressing the ERP without saying much about stock valuations. This is a reasonable hypothesis but, as best we can tell, it doesn’t hold up. As a first pass, here is the ERP calculated once bond yields are adjusted by 10-year inflation expectations (chart from Ed Yardeni of Yardeni Research; he uses forward instead of trailing earnings):

Some historical periods do look different. As our reader suggests, adjusting for inflation expectations makes the ERP in the 1980s and 1990s (average expected 10-year inflation: 3.8 per cent) look a lot like the pre-crisis 2000s (2.5 per cent). But the recent trend is unchanged from our nominal 10-year chart up above: the ERP for the fourth quarter of 2022 is at a decade-or-so low, roughly in line with the financial crisis. That doesn’t match the idea today’s low ERP is primarily an inflation story.

The good folks at Absolute Strategy Research have done more detailed work on the ERP. They calculate nine different ERP methodologies — throwing in simple formulas that even Unhedged can understand, as well as more sophisticated academic methods — and take the median output. Here’s what that looks like over the past 70 years, courtesy of ASR’s Ian Harnett:

Two things jump out. First, the recent downtrend observed in both Unhedged’s chart and Yardeni’s is intact, suggesting again that higher inflation expectations are not behind today’s lower ERP. Second, a low ERP is not necessarily a recession indicator, but it reliably rises when recession hits and investors flee stocks.

A falling ERP is therefore not what you’d expect in a market bracing for the most anticipated downturn ever. The most obvious explanation, to us anyway, is that the market has not priced in much economic pain. Let us know what you think. (Ethan Wu)

Two good reads

From the FT’s Patrick McGee, how Apple became dependent on China, and whether it is stuck that way.