Despite the recent sell-off, US equities have clearly separated from the rest of the global pack based on strong underlying economic fundamentals, aided by stimulus from tax reform and assorted deregulation. From that place of relative strength, US leadership is actively seeking concessions from trade partners, including both traditional allies (NAFTA, Europe) and strategic competitors (China). These measures, in and of themselves, are increasing tensions and uncertainty around the globe, and it would seem that equity markets are contemplating various adverse impacts. For example, several major markets in Europe – including the UK and Germany – as well as Hong Kong are down meaningfully on a year-to-date basis, which is in stark contrast to performance in the US.
There are likely multiple explanations for the divergence in performance. First, investors may be anticipating that the US is likely to emerge victorious from its various trade disputes, given that its economy is larger, stronger and relatively less dependent on exports than its partners. Second, underlying US economic conditions are accelerating, with improving gross domestic product (GDP), low unemployment and contained inflation. Third, a variety of headwinds are challenging other major economies. The Brexit negotiations between the UK and the European Union (EU) appear increasingly disorganised and chaotic, with each side entrenched in its own negotiating position ahead of the March 2019 deadline. In Italy, the new government has proposed fiscal measures that are increasingly in conflict with EU and European Central Bank rules, threatening a potential debt crisis. Fourth, emerging market currencies continue to decline in countries such as Turkey, Argentina, Brazil and India. This currency depreciation increases the risks for those countries that have to meet debt obligations, attract capital and sustain growth. Lastly, China’s ability to sustain its own debt-fuelled growth becomes more challenging in the face of massive US tariffs.
Potential downside risks
Despite all this elevated concern, stock market valuations in the US remain close to all-time highs, with multiples close to levels only previously eclipsed right before the collapse of the dot-com bubble. As tensions escalate, it appears that the US is serving as a ‘safe haven’ for many investors and attracting further capital. Still, it is important to consider downside risks in such scenarios. Stimulus measures eventually run their course and have diminishing marginal impact. We also observe that a strengthening dollar invested in markets outside the US generally buys significantly greater earnings than it would in the US.
Staying focused on valuation
Given the current environment, we are exploring those areas that are out of favour and where negative sentiment is weighing on the valuations of businesses with competitive strengths and the financial resources to endure near term challenges. Today, this often means focusing on opportunities outside the US, where multiples appear more attractive. It might also include stocks that traditionally fall into the ‘value’ bucket and tend to be cyclical in nature, including automotive, media, building products, materials and chemicals. We believe that gradually shifting into these types of equities could mitigate downside risks. In our opinion, when market performance diverges, deploying capital into such areas could deliver stronger relative returns in periods of elevated market stress.