Growing attractiveness of non-US markets
After reaching a low on 23 March, global equities (as measured by the MSCI All Country World Index) gained 44%1. Much of the rally was supported by the US market and its “FAAMG” growth stocks of Facebook, Apple, Amazon, Microsoft and Google: essentially, the S&P 500 index should perhaps be called the S&P 5! The secular growth story for the FAAMGs has been around for a while, but their group performance was supercharged by COVID-19. Investors considered these stocks to be beneficiaries of government lock downs, as video conferencing (e.g. Microsoft’s Teams), social media and ecommerce use boomed while people worked from home. For instance, US June online retail sales surged by 23%1 from a year ago, gaining market share from physical shops, whose operations have been significantly disrupted by the pandemic.
Notwithstanding the risk over whether the online sector (e.g. Amazon) can maintain its current market share as economies are opened-up again, the market capitalisation of the FAAMGs has risen by over $1.8tn so far this year, after rising $3.1tn during 2014-191.
Fundamentally, the rise in FAAMGs’ market value has far exceeded their $80bn increase in profits — to $159bn — over the 5 years to 20192. Moreover, given that Facebook and Google already account for a third of global advertising spending, a key driver of their profitability, it may become more difficult to squeeze out further market share gains to boost future earnings2.
The FAAMGs also face political risk from the US election in November. Should the Democrats win a clean sweep of the White House, House of Representatives and Senate, it could lead to a regulatory backlash. Moreover, ever-easier fiscal and monetary policy around the world increases the chances that GDP and Earnings Per Share (EPS) in other countries can catch up with the US.
There is also the added risk that corporate tax hikes under a potential Joe Biden presidency could halve US EPS growth (see our July Investment Outlook). Under that scenario, investors would be likely to allocate more capital outside of the US where there is more fundamental support and less risk of corporate tax rises. This view may already be playing out; after dominating global equities over the past decade, the MSCI US index has underperformed the rest of the world by 2% since peaking on the 22 May1.
On a risk-to-reward basis, we see investment opportunities outside of the US on less demanding valuations. For example, MSCI UK, Europe ex-UK and Emerging Markets trade on 2021 forward Price- to-Earnings (PE) multiple of 13.6x, 17.0x and 13.5x, respectively, compared to 21.1x for the US1.
Investment opportunities in Emerging Markets
The term Emerging Markets (EM) was coined by author Antoine van Agtmael in the early 1980s. Technical definitions vary, but generally an EM is understood to be a low to middle income per capita country transitioning to a more open market economy (e.g. China, Thailand or Brazil). Historically, EM returns have been volatile, but there have been long periods when EMs have significantly outperformed Developed Markets (DMs) — see market highlights opposite. Looking forward, we see four key reasons why the scales may tilt towards EMs:
#1) EMs relative valuations look attractive. EMs are assumed to entail more risk and generally trade at a discount to DMs, However, the EM 1-year forward PE ratio is 28% cheaper than DMs, below the historic average of a 23% discount1.
#2) China’s economic rebound. In the second quarter, China’s real GDP grew +3.2% from a year ago, higher than consensus expectations of +2.0% and up from a -6.8% contraction in the first quarter1. As the first economy to enter and emerge from COVID-19, China’s policy- supported recovery is driving demand for materials and consequently EMs through its large manufacturing base. Further, China represents 39% of the MSCI EM index so to a large extent the fates of EMs are entwined with China3.
#3) Risk-adjusted returns look attractive at this phase of recovery. In the July Investment Outlook, we outlined why we believe a new business cycle has started. Our Tactical Equity Allocator (TEA – an aggregate of historic economic and financial data) shows that EMs tend to be less volatile when the global economy is recovering and offers better risk-adjusted returns than over other phases of the business cycle.
#4) A weakening US dollar. EMs tend to outperform DMs when the dollar weakens and vice versa. That’s because large quantities of dollar-denominated debt held by EMs is easier to pay back in times of dollar weakness. With record US money supply trickling into the global financial system, the US dollar trade weighted (DXY) index has fallen 9% since peaking in March1. The Greenback could depreciate further as rising US dollar supply is absorbed by foreign exchange markets. Nonetheless, acute risks persist, with US-Sino relations somewhat frosty and COVID-19 is less under-control in some EMs (e.g. India and Brazil). However, should FAAMGs and growth stocks consolidate at current levels, the conditions for a re-emergence of relative EM outperformance exist, and especially so in Asia.
1 Refinitiv Datastream, data as at 31 July 2020
2 Have Equities Become A Bubble?, Gavekal, 10 July 2020
3 Refinitiv Datastream, data as at 27 July 2020
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.