It might seem like I am a big huge Kodiak grizzly bear on the markets. I can’t hide my belief that if the Federal Reserve continues positioning themselves as ready to pull the trigger on a rate rise at the slightest economic uptick, then risk assets will continue to struggle, and maybe even crash. Given the Federal Reserve’s reluctance to give up the hawkish rhetoric, even in the face of an economic downturn, US risk assets will have some tough slogging ahead of them. But I am by no means bearish on all risk assets.
For the past couple of years we have been inundated by investors touting their American stock purchases as “the cleanest shirt in the dirty laundry pile.” And it has worked for them. In spades. Between the massive US dollar rise (which has put an enormous tail wind on foreign investors’ purchases) and the huge outperformance of American stock indices, investing in the US equity markets has been a home run. But the end result of this rally is that compared to other countries, American stocks are now enormously overpriced. This is made all the more problematic by the skyrocketing US dollar. Not to mention the potential for a debt ceiling crisis that will at the very least, keep any fiscal stimulus on the back burners. And all of these negatives pale in comparison to the fact the Federal Reserve refuses to listen to the message the markets are sending about inflation expectations, and future economic activity. This adds up to an equity market that will have trouble continuing to outperform. The American stock market might not crash, but the days of massive outperformance are behind us.
Let’s look at how far US equities have run against emerging markets. I will chart the EEM ETF so that the US dollar strength is also taken into account.
Over the past 5 years US stocks are up over 70% and the emerging markets are down about 23%. That’s a huge outperformance. A money manager who has been on the wrong side of this trade had their face ripped off.
And we have now hit the stupid part of this divergence. Over the past quarter, emerging market equities have been sold aggressively. Sentiment is so bad even the shoe shine boys are long Glencore credit spread swaps to take advantage of the forecasted continued emerging market rout. No one is willing to predict the end of the emerging market collapse. Just today, the IMF dropped their world growth forecast down to a new low. All the hedgies are long US dollars, short commodities, leaning hard on the emerging market countries, and doing nothing more than their usual extrapolation of the current trend.
Even though almost all risk assets throughout the globe are relatively expensive due to the minuscule interest rates, emerging markets equities are trading at the lower band of their P/E ratio.
Although I don’t envision the Federal Reserve riding to the rescue of risk assets, let’s stop and think about the bigger picture. The rest of the world is desperately trying to reflate. Not only that, there has been a big shift in competitive advantage due to the large appreciation of the US dollar. I am a big believer in the saying that nothing cures low prices like low prices. It takes a while, but eventually it kicks in. The emerging markets have been hammered, and there is no denying things don’t look good. But isn’t that when you should be buying?
What country’s equity market would you rather own? The first one whose currency has appreciated significantly over the past year, where investors are dramatically overweight, and whose Central Bank has the most relatively hawkish monetary policy. Or would it maybe make sense to pick the countries whose currencies have collapsed, where investors are fleeing in droves, and whose Central Banks are aggressively easing?
I know it is not this simple. And I am well aware that a declining currency is good for your economy, until it isn’t… Capital flight is a real concern. If you think the world is going to sink into a deflationary collapse, then owning US assets is the correct bet.
But even though I am bearish on the US, I am more optimistic about the rest of the world. Other countries don’t need a Federal Reserve that is easing, they simply need one that isn’t threatening to tighten at every little economic uptick. There is plenty of stimulus out there, the Federal Reserve just has to settle down and let things ride.
I am starting to buy emerging markets equities. There is no rush as you never know when this sort of emotional selling will end. It could have already bottomed, or we could be headed another 20% lower.
However in the long run, given the demographics, emerging markets should eventually trade at P/E premiums to the developed countries. This trend of US outperformance has gone on a long way – too long. If you have been smart enough to be overweight US equities, then it is time to take some profits off the table. Don’t end up like Uncle Owen! Aunt Beru begged him to sell some US stocks, but he wouldn’t listen.
Thanks for reading,