After a strong start to the year, global equities have lost some of their zip. Here are Q2 returns-to-date for a variety of US and global stock indices in dollar terms:
- S&P 500: +0.9%
- Russell 2000: -0.3%
- MSCI EAFE Index (non-US developed economies): -0.1%
- MSCI Emerging Markets: -6.1%
- MSCI All-World ex-US: -1.6%
- Worth noting: the DXY dollar index has strengthened by 0.8%, but even correcting for that the MSCI EAFE Index has underperformed the S&P 500.
It’s easy to spot the odd-market-out: US large caps. You’d think trade talk uncertainty would have left global equities all in the red for the quarter. But that has not been the case and here is why we think that is:
#1: As we mentioned in “Markets”, investors expect a change in Fed policy:
- As of Friday’s close Fed Funds Futures discount a 73% chance that the Fed will cut its benchmark rates by at least 25 basis points before the end of the year. This market sees sub-par US inflation readings and worries about the economic uncertainties of a trade war as pushing the Fed to act, perhaps as soon as September.
- Two-year Treasury price action is consistent with this point of view. At a 2.20% payout, 2-years sport their lowest yields since Q1 2018.
- Ten-year Treasury yields, the risk-free rate that is the bedrock of US equity valuations, have fallen from their January 2019 highs of 2.79% to just 2.39% now on the same concerns.
- Since Q1 US corporate earnings came in better than expected, renewed investor confidence in business profits combined with lower long-term rates has translated into resilient US large cap stock prices. That’s how we end up with a 16.5x price/earnings multiple on the S&P despite only 3-4% earnings growth.
#2: US small caps (Russell 2000) have not fared as well in Q2 because their growth profile often requires access to outside capital like high yield debt.Pricing in this market is going in the wrong direction:
- The spread over Treasuries for US non-investment grade corporate debt stands at 4.06% today.
- This is notably higher than the 3.71% spread a year ago on this date as well as the 3.5% average of Q3 2018.
- Given that we are in a very late part of the cycle and that the high yield/leveraged finance issuance calendar looks robust for the remainder of Q2 and into Q3, we do not expect high yield spreads to tighten any time soon.
#3: As for why non-US equity markets are lagging, that comes down to understanding what exactly is in these indices:
- While the S&P 500’s official weighting to Technology sector is 21%, remember that Amazon, Google, Facebook and other names are not in this category.
- Once you add in these and other names that are certainly “Tech” regardless of S&P classification, Technology’s real weighting in the 500 is 30%.
- The MSCI EAFE Index, by contrast, is just 6% Technology. Its heavyweight sectors are Financials (19%), Industrials (14%), Consumer Staples (12%) and Health Care (11%). None, obviously, are as fundamentally attractive as US Tech shares and the two largest exposures – Financials and Industrials – are cyclical groups with negative operating leverage should the current expansion come to an end.
- The MSCI Emerging Markets index does have similar Tech exposure (28%) as the S&P 500 once you perform the same adjustments as our first point, but most of that is in Chinese names. Tencent and Alibaba are 9.5% of MSCI EM, and those are primarily Greater China plays rather than having the broader global exposure of an Apple or Microsoft (the 2 largest names in the S&P at a 7.6% combined weight).
Summing up: global equity markets face largely the same fundamental trade-related risks for the remainder of Q2, but will likely continue to respond somewhat differently.
- As much as US large caps are reliant on a Fed change of course, at least they have shown good earnings power in 2019. Expectations for Q2 profits seem low enough to beat as well, and analysts are still trimming their numbers for 2019.
- US small caps are no safe haven from the trade kerfuffle – their valuations ride on a late-cycle high yield market.
- And as for EAFE and Emerging Markets, we expect these two areas to have the greatest challenges. Both may be cheap relative to US large caps, but valuation alone is never enough to make an asset class work. For that, you need a catalyst. And we don’t see much on the horizon, at least until trade talks are closer to completion.