Last week saw the risk-off trade localized to the U.S. markets, as traders rolled back assumptions about the administration’s agenda. Despite stabilization in the oil market, the energy sector was again the weakest, falling 2.5%, followed by the consumer discretionary (-1.8%) and industrial (-1%) sectors. The somewhat defensive utilities sector posted the largest advance over the week, picking up 1.2%. The consumer staples managed to finish in the green (+0.2%) last week, thanks largely to the release of Walmart’s strong July quarter results. The bond market continues to attract investors, as last week’s report of lower-than-anticipated inflation in the U.K. further fanned deflation fears. The U.S. ten-year Treasury bond slipped to a 2.194% yield. The coupon area of the curve, the two-year to thirty-year maturities, slipped lower. The differential now stands at 1.47%, versus the 2.65% ten-year average. European markets rebounded last week posting a positive 1.2%, with markets in Asia widely disbursed, from a 1.3% loss for the Nikkei to a 1.9% advance in Shanghai.
The question about investing in emerging markets surfaced again last week in a meeting with customers and colleagues. In this meeting, the statement was made that the question comes down to your view on China (and judging by the nodding heads, many agreed with the comment). I pointed out that this year’s strongest emerging market is not China (+22%); it is Turkey and Latvia, both up 38%. In fact, most of the strongest market returns this year are not in Asia at all, but are to be found in neighboring former communist bloc countries. The Czech Republic, Hungary, Lithuania, Poland and Romania are not often talked about, but the opportunities exist nonetheless. There was a collective sigh of relief amongst investors in the group last week as Argentine voters did not embrace a return by former President, Cristina Fernandez de Kirchner. Shares on the Argentine exchange gained 6% following the results, further boosted another 2% by a rally in the currency.
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Source: All statistics herein obtained from Bloomberg.
One of today’s most pressing investment questions is the valuation level of the U.S. equity market. To understand the nature of the question, we review the relative valuation of competing asset classes, in particular, those that are comparable in terms of overall characteristics. In the table on page 2, we contrast other classes of equities against the dominant domestic benchmark, the Standard & Poor’s 500® Index. The point of this process is to identify more favorable risk versus potential return environments. As you can see from the two charts on the left, the domestic equity market, medium and small capitalization, has been remarkably homogeneous. This is particularly true since 2009, and an anomaly from a historical perspective. It really speaks more to the devastation of the financial crisis. So, there does not appear to be a broadly neglected and, thus, undervalued segment within the domestic equity sphere. But looking at the charts on the right, a very different situation becomes clear. Relative to the U.S. market,both the emerging and, in particular, the developed international markets have, until this year, underperformed.While the year-to-date performance of both the EAFE® and EM has been strong, they have considerable ground to cover to match the returns posted by U.S. stocks during the last decade.
I have repeatedly written about the level of complacency pervading the domestic market, so much so that the opportunities elsewhere may be overlooked. At the close of the recent earnings reporting season, the forecast for revenue growth of the S&P 500® Index was lifted to 7%, while the outlook for the EAFE® constituents was raised to 8% and 11%-12% for the EM. International investing does entail additional risks, such as currency fluctuations, liquidity and, of course, political. It is critical to be mindful of these challenges and have a time horizon sufficient toweather the increased volatility. At this time, two facts can be agreed upon: valuations ex-U.S. are lower and growth expectations are higher. The goal of investing is to be adequately compensated for the risk taken, and a lost opportunity is a risk as well.
The world continues to anticipate the priorities of the new administration. Investors have been quick to seize upon each executive order as though future economic results are all but guaranteed. To quote Warren Buffet, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” To that end, a quick review of the announcements thus far this earnings season should be somewhat sobering. With the exception of the extractive industries and other commodity-related sectors, we have seen a disconcerting number of earnings and, even worse, revenue misses. Drowned out by the rush to join the parade of domestic job creators are the announcements of store closings and job cuts in the retail space. The recent holiday season was not a tide lifting all boats. As Comerica’s Chief Economist, Robert Dye, points out, we will see unit labor cost rising this year due to minimum wage hikes, implementation of new overtime rules and the spike in health care costs for this year. Even the robust auto sales data masked some early warning signs as its composition reveals that the light truck sector drove unit sales. With fuel prices higher year-over-year, that is a performance that may prove tough to match.
Aside from the economic realities, we should also consider the market mechanics of what has been going on since Election Day. The prospect of interest rates mounting a sustained advance has led to a large scale portfolio rebalancing with investors moving from long duration fixed assets to shorter duration equities. Here it is critical to consider the relative scale. The $3 trillion in bonds sold between November 9th and the end of the year created only a modest ripple in the bond market, but the same cannot be said of what that amount did to stock prices. There was a term coined during the last rotation from large cap to small cap stocks – “buckets-into-thimbles.” Going from bonds to stocks is creating the same distortions. There are some crowded trades lingering, and this is where we need to be proactive. We should be unwinding any stretch for yield, regardless of asset class. With the rebound in commodity prices in the face of global overcapacity, it is important to address the size and composition of the alternative holdings. Perhaps one of the most difficult challenges will be addressing the exposure to emerging markets. There is evidence that many of these economies have begun the migration from export orientation to domestic consumption, with projected GDP growth in some cases double that of the developed economies. These markets are under-owned and have upside surprise potential that warrants consideration.
We are in an enviable position; the long post crisis advance has been stable and fairly uniform. It is early in a new tax year, enabling us to reposition portfolios to reduce downside risk and enhance prospective returns. Accounts with funds to invest domestically should look to small and mid-cap equities with a bias towards value and growth at a reasonable price (GARP). Accounts for which global exposure is appropriate should look first to emerging markets.
Note: Important Information
This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein has been obtained from sources we consider to be reliable but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.
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