Looking back over the last three to four years, global market performance has been driven mainly by quantitative easing, with little to no profit growth internationally. This, in turn, has led to significant multiple expansion. Market leadership has been driven by defensive stocks, such as consumer staples, as pricing power and emerging market demand for products and services helped them sustain growth.
Recently, volatility has been driven by investors’ concern about falling growth in China and implications for other emerging markets and commodities. This volatility was exacerbated by China’s stock market bubble and the subsequent collapse, followed by heavy-handed government intervention.
In my view, this period of underperformance differs from previous periods because it can be characterized by a profitless recovery with very different market leadership. But it’s important to remember that:
- Volatility provides greater opportunities for long-term investors to get exposure to high-quality companies.
- There is no historical correlation between gross domestic product growth and equity market performance.
Due to the weakness in equity markets, valuations have improved somewhat over the year. The most attractive area on forward-looking multiples appears to be emerging markets, which are currently trading at a discount to developed markets on both price-to-earnings (P/E) and price-to-book metrics. Emerging markets, together with non-Japan Asia, are seeing the largest negative earnings revisions, which may not yet have bottomed out.
In Europe, we’ve seen a reversal from negative earnings revisions to positive, although it’s mainly driven by foreign exchange tailwinds. Europe’s valuations — the MSCI European Union Index is currently trading at 13.8x P/E for the next 12 months and a 16.9x 10-year moving average P/E — compare to those of the US, which is about to enter a period of negative earnings revisions. The MSCI USA Index is trading at 15.4x P/E for the next 12 months and a 25x 10-year moving average P/E. The discount of Europe’s cyclically adjusted P/E versus that of the US is close to record high.
While markets overall look fully valued, defensive sectors — such as consumer staples, health care and momentum stocks, like cyclical growth — have some of the most stretched valuations and are therefore riskier than the rest of the market, from my perspective.
Currency volatility continued during the third quarter, driven mainly by weakness in emerging market currency, particularly another 20% fall in the Brazilian real. Most developed market currencies, though, were flat against the dollar for the quarter.
Given this volatility, our team is often asked whether we hedge currencies. The answer hasn’t changed over the 23-year history of our strategy: We don’t hedge our currency exposure for four main reasons:
- While foreign currency exposure introduces some volatility over the short term, we don’t believe it has a significant impact on long-term performance.
- In our view, one of the key benefits international funds can provide US-based investors is to lower correlations to the US market. Hedging currency exposure increases the correlation, thereby lowering the diversification benefit.
- Currency hedging is also redundant to a large degree because many foreign companies have global operations with exposure to many different currencies, and they often hedge their own currency exposure directly.
- Finally, hedging is costly and can introduce unwanted leverage to a portfolio.
As always, long-term stock selection is the key driver of our strategy, and we have full conviction in our earnings/quality/valuation (EQV) stock selection process to generate alpha for our investors over the long term.