Investment Outlook – Trend 2, Published Mar 16, 2017
While developed markets have outperformed emerging markets recently, they are richly valued and are increasingly regressing in terms of fiscal stability.
Developed Markets have Outperformed EMs for 6 Years…
Emerging markets have underperformed developed markets by nearly 50% in U.S dollar terms, and coming on almost six years since April 2011. The outperformance has been driven by the Fed taking interest rates to effectively zero on the short end, allowing U.S. valuations to expand to stratospheric levels. U.S. corporations have used the opportunity to reduce costs and deliver earnings via refinancing and share buy backs.
Now, a Shift to Fiscal from Monetary Policy is Coming
After years of failed QE, investors are enthused about the prospect of real global growth. Monetary policy has been code for making loans super cheap for wealthy people to buy stuff. Fiscal policy is code for actual action, in this case, the government spending money on goods and services.
But Valuations are at Historically Peak Levels
The consensus trade today has been a rotation towards and a bet on the U.S. economic recovery. But equity valuations in the U.S. are historically high. Forward returns from high valuations are invariably sub-par. The Fed is hiking rates; inflation, commodities and the dollar are rising as we mentioned earlier. Bullish sentiment has reached multi-year highs when looking at Consumer Confidence. 2016 saw a historic bottom in U.S. treasury bonds and going forward, interest rates will be a headwind once the 10 year crosses 2.70%. As a result, the five-year P/E expansion cycle has likely come to an end.
A rational analysis would suggest that equities in the U.S. will deliver sub-par returns over the longer term. Further, the Fed was the key driver of the U.S. equity market returns over the past decade. We think the U.S. has stretched the engineered earnings, buybacks and refinancing game to the limit. Now as the Fed raises rates and liquidity is withdrawn, it may be a tougher battle than many envision.
Challenges in Japan and Europe Remain
As long term fundamentally driven investors, we view Japan as a trade opportunity, but not a long term allocation, given the massively challenged demographics and lack of fundamental drivers.
Europe carries significant event risks and cracks are becoming distinctly visible with the future of the Eurozone looking clearly in doubt. Neither are compelling regions for us to be interested in as long term investors, particularly when we compare it to other emerging markets and India.
We Prefer Secular Growth Over Regressive Convergence
Over the next ten years, it will be a positive surprise to see the U.S. grow sustainably at 3% a year, while a 3% growth rate for China, India or other emerging markets will be a disappointment.
Developed markets, to unbiased investors, are restarting to look a lot like the emerging markets of old with weaker political systems, unsustainable debt levels, unpredictable leadership, instability and unpredictable policy. It is unprecedented that emerging markets are being perceived as having less political uncertainty than the advanced countries. India is emerging as a haven for growth. Welcome to regressive convergence.
Investment Outlook 2017