Have Non-US Stocks Finally Turned?

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Have Non-US Stocks Finally Turned?

For our Data section today we will extend the September performance review from “Markets” to consider non-US equity markets. Let’s start with a recap of month-to-date returns across geographies:

  • US Large Caps (S&P 500): +1.2% in September
  • US Large Caps (Russell 2000): +1.7%
  • MSCI EAFE (non-US developed economies) Index: +2.8% in dollar terms
  • MSCI Emerging Markets: +1.1% in dollar terms
  • MSCI All-Country World Index: +1.8%

The first question that pops out: why did EAFE stocks outperform this month? This group lags US equity returns YTD (+10.5% vs. +18.5% for the S&P/+12.8% for the Russell). So what made September so different?

Our answer is September’s remarkable rally in European bank stocks. To put some perspective around this, here is the YTD chart for the EURO STOXX Bank Index:

The group has surged by 8.0% this month, which is important because:

  • The European banking system has been under pressure for years due to ever-lower and now-negative interest rates. Even at current levels the EURO STOXX Bank Index is near +10 year lows.
  • Eurozone banks also face deep fundamental challenges, ranging from inefficient cost structures to increasing regulatory burdens.
  • At the start of the month the sector traded for barely 50% of book value, a sign that markets believe the industry will never come close to earning its cost of capital.
  • From a macro perspective, the troubled state of the European banking system is a concern since aggressive monetary policy may not work its way through to the real economy.
  • In terms of stock performance, Financials are the largest piece of the MSCI EAFE Index, at 18%. Not only is that larger than the S&P 500 (13%), but US large cap Financials lagged their European counterparts in September, rising only 4.3%.

Conclusion: MSCI EAFE benefited from a snapback rally in deeply oversold European Financials, which in turn got a lift from the sudden selloff in European sovereign bonds. For example, German 10-year yields went from -0.71% at the start of September to -0.45% just 2 weeks later.

Now, let’s turn to Emerging Markets, which as of Friday were slightly lagging US equities:

  • EM was actually outperforming US stocks until Friday’s news that the US was exploring the possibility of limiting Chinese companies’ access to American stock markets and investors. The MSCI EM index dropped 1.3% on that news.
  • EM equities have had a much tougher year than EAFE stocks, up only 4.1% versus 10.5%.
  • EM remains heavily overweight to China (30%), South Korea (12%) and Taiwan (12%). The Shanghai Stock Exchange Index is +1.6% for September in local currency terms, South Korea is +4.3% and Taiwan is +2.0%. All, however, have been rolling over in the last week.

Conclusion: Friday’s EM price action shows how sensitive it remains to trade war concerns. Our favorite indicator here remains the dollar value of the offshore-traded yuan, which is weakening again after a rally in the first half of September.

Here is the offshore yuan chart for the last month, and it clearly lines up well with the price action in EM equities (strong first half of September, weaker second half):

As far as what this means for portfolio positioning in Q4 2019, our thoughts on EAFE and EM stocks versus US equities:

If you believe the US and China will come to a substantive trade agreement in Q4 2019, both EM and EAFE stocks should at least keep pace with any rally in US equities:

  • Renewed confidence about the Eurozone economy would push sovereign yields higher, further lifting Financials. We believe that EURO STOXX Bank Index chart is the crux of the entire story for EAFE equities.
  • That EM stocks would sell off so hard on Friday shows just how twitchy investors remain on the region in the face of a possible trade war escalation. While we don’t love EM stocks (and explained why in last Monday’s report), a trade deal would clearly help market sentiment.

And if you are cautious on a trade deal happening soon – an opinion we share – then September’s EAFE outperformance/EM rally was nothing more than a head fake. When in doubt (and the current investment environment is nothing if not uncertain), it’s important to not overthink things.

Therefore we remain positive on US stocks over EAFE and EM, at least until a trade deal looks more certain. If that means missing a relative performance rally in non-US stocks for a few days, we’re OK with that. The penalty for guessing wrong on a trade deal is simply too high.