The global rally revisited

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Choose your fighter: US vs the rest

Back in January, we noticed that many big stock markets worldwide had begun to outperform the US, and wondered whether that trend had legs. Investors seem to think so. From The Wall Street Journal yesterday:

[I]nvestors are increasingly looking for bargains overseas. They have added a net $14.4 billion to U.S. mutual and exchange-traded funds that buy international stocks this year, while pulling $34.1 billion from domestic stock funds, according to data from Refinitiv Lipper through March 1 .

They have pulled money from domestic equity funds for nine consecutive weeks, the longest stretch of outflows since June 2016. Meanwhile, shifting global economic fundamentals have increased the allure of diversifying into international stocks, investors and analysts say.

Back on January 23, when we last wrote on it, this is what the global rally looked like:

Everyone but Japan was beating the US. Since then — despite the investor flows described by the WSJ — the trend has fractured. Japan has outperformed, Europe and the US have gone sideways, while China and emerging markets have fallen:

Previously, we put the global rally down to three factors: a weaker dollar, lower energy prices, and renewed popularity of value stocks, which dominate many non-US indices. Let’s revisit each in turn.

A revitalised dollar, spurred by the rapid upwards revision of Fed rate expectations, has held back all stocks. It is most visible in the sagging performance of EM stocks — which care more about Fed policy than almost any other asset class — but also in the Europe and the US trading sideways, roughly in tandem with each other. Turns out that we highlighted the ex-US rally right at the nadir of recent dollar strength (readers can decide if that’s coincidence or causation):

Besides the Fed, the biggest force boosting the dollar here has been incremental weakness in Europe weighing on the euro. The burst of optimism that kicked off the year, driven by falling energy prices and China’s reopening from Covid-19 restrictions, has faded some. We’re nowhere near the doomerism of mid-2022, when many thought energy rationing and a European recession were foretold. But recession is a live possibility again, in large part because the European Central Bank is struggling to slay the inflation “monster”, as Christine Lagarde, its president, put it. Core inflation is at an all-time high.

In isolation, higher rates to curb inflation should help the euro, but the ECB is split on how high to go, with doves fearing the central bank will snap fragile growth. Some economic data has disappointed. Germany manufacturing surveys look limp, for example.

Rebecca Patterson, formerly of Bridgewater, made the case for taking profit in European stocks in a recent FT op-ed:

First, the bump in economic activity from China’s reopening after Covid-19 lockdowns is likely to prove a one-off rather than a sustained support for European growth . . . Second, the monetary backdrop in Europe will be getting significantly tighter at a time when global liquidity is also being withdrawn . . . Third, and part of the ECB’s challenge, will be the direction of natural gas prices, which remains highly uncertain . . . Fourth and finally, Europe — like the US — has a potential fiscal fight in store this year. The region’s stability and growth pact that requires fiscal prudence was suspended in 2020 but is set to come back into force in 2024.

Japan is, as ever, the odd man out, beating just about everyone and pulling up ex-US performance. Rising US rates and a delayed end to Japan’s ultra-loose yield control policy has widened rate differentials, weakening the yen. That in turn is helping export-exposed stocks such as machinery makers. Additional vim has come from a rally in Japanese small-caps, thanks to anticipated improvements in corporate governance (we hope to write more on this soon). With stocks weak across the world and Japan still cheap at a 13 forward p/e, global investors have poured in.

Next, energy. Lower energy prices help the rest of the world, relative to the US, because while expensive oil is a drag on growth everywhere, the US has the hedge of domestic production. Many overseas markets have a higher proportion of energy-intensive industries than the US, as well. Global prices have been well off their peaks since late last year and moving sideways, and Europe’s mild winter was wonderfully timed. But the outlook for oil prices has become more tenuous since January. The situation with Russian supply remains unpredictable, but the much predicted rebound in China demand has arrived in force, as Saudi Aramco chief executive Amin Nasser and oil traders have confirmed in recent days.

Meanwhile, our colleagues from FT Energy Source report from Houston that US shale producers do not expect increases in production, and Opec is not rushing to add supply, either:

Rick Muncrief, chief executive of Devon Energy, another top [US] shale producer, said thinning global supply capacity left him alarmed about the possibility of a new price surge as oil balances tightened.

“We’re just on a razor,” he told the FT. “That’s why I’ve talked about being concerned right now — but I think it gets really, really serious in the next 12 months . . . We’re 10 per cent of the world’s oil production and Opec plus Russia is a much larger percentage. So yeah, they can dictate things probably more than we would.”

In short, while the stronger dollar is helping keep energy prices flat for now, supporting global stocks, it is not obvious that this benign trend will continue.

The last piece of the case for global stocks is the shift away from growth and towards value stocks. But the value rally has paused in the past month or so, however:

We are frankly a bit surprised by this. Higher bond yields in recent weeks, and the prospect of a recession being pushed into the future, should help value. The larger trends towards value may remain in place; we can only wait and see.

The reason we were excited about the global rally is that we are fundamentally believers that valuations matter — that, as one investor put it to us recently, “good things happen to cheap stocks”. And relative to history, global stocks, particularly in Japan and Europe, remain cheap versus US stocks:

Valuation does nothing without a catalyst, though, and without help from the dollar, falling energy prices, or a shift in investors’ style preferences, it’s not clear that cheap relative valuations globally do investors much good, other than by providing diversification. Japan is an arguable exception, but in Europe and China the low-hanging fruit of falling energy prices and an end to zero-Covid has been picked. We still like global stocks as an investment, but as a trade, they have lost some of their oomph. (Armstrong & Wu)

One good read

Noam Chomsky against the ChatGPT hype.