Baron Rothschild is credited with some timeless advice. “The time to buy is when there is blood in the streets.” As volatility returned this year, it brought shaky investor sentiment back into play. Coming into 2018, U.S. valuations were extremely high, and that didn’t change after a period of strong earnings. Meanwhile, international valuations have been much more attractive. But through the first half of the year, the U.S. has continued its outperformance. That seemed to be amplified during the second quarter as the S&P 500 outperformed the MSCI ACWX by more than 6%.
Digging a little deeper uncovers some interesting prospects. Individual countries followed the S&P much more closely, and some outperformed it. Two countries in a great position for further outperformance are Canada and the United Kingdom. The iShares single-country ETFs (EWC and EWU) give broad exposure to their equity markets. We believe negative sentiment has investors missing the train on some extremely attractive investment opportunities with these two ETFs.
Relative Performance: More than Meets the Eye
The U.S. dollar rallied in the second quarter after extended losses against foreign currencies. This had a large effect on foreign investments. An extreme example was the iShares South Africa single-country ETF, EZA. The fund had a total return of nearly -15% over the second quarter. Without the effect of the U.S. dollar, the ETF’s return was just over -1%. More than 90% of the country’s negative return was due to a weakening local currency. It is important to consider both sides of a single-country ETF’s return: the local stock market performance and the local currency performance against the U.S. dollar.
Of course, this can go both ways. When the dollar weakens, such as it did in 2017, foreign ETFs receive a performance boost from the added strength of the local currency. Both EWC and EWU suffered from dollar strength hurting their second quarter returns. EWC saw about 200 bps of negative performance attributable to currency performance, while EWU saw more than 600 bps. So not only have their stock markets been beaten up, their currencies have taken it on the chin, setting up multiple opportunities for outperformance in the future.
So why is there so much angst toward foreign companies? It could come back to a home bias. With talk of trade tensions and higher volatility, investors commonly view the U.S. as the safer place to invest funds. But with valuations extremely stretched, we believe the U.S. may be hit harder if worldwide economic growth slows and we enter a bear market – another reason EWC and EWU are attractive.
Divergence in Valuations
Undervalued securities tend to outperform in the long run. This is why we, at CLS, keep valuations at the forefront of our decision-making process. Both the U.K. and Canada are far below their historical relative valuations to global markets as shown in the first charts below. With the U.K. more than one standard deviation below and Canada right at one standard deviation below, both areas look like great bargains compared to the rest of the world.
Looking a little deeper provides another interesting story. Although relative prices in both countries have continued to plummet, the EPS of each country has rebounded nicely. This can be seen in the second group of charts below. The top chart for each country shows the country’s index price relative to ACWI, while the second chart shows EPS for the country relative to ACWI. This combination even further compresses the price-to-earnings ratios, causing the countries to appear undervalued when fundamentals have indeed improved.
Sentiment: A Short-Term Driver
In both breakdowns, prices continued to sell off even though EPS has improved and now steadied near historical averages. We believe investor sentiment is a likely culprit. The U.K. has experienced ongoing unease due to Brexit concerns, and various geopolitical risks have dominated headlines this year. But while geopolitical news may drive prices in the short term, investors must remember fundamentals drive stock market performance in the long term, and fundamentals have been improving in the U.K. It is only a matter of time that the negative headlines will fade and favorable market fundamentals will again drive performance.
Canada is seeing a similar situation that is more focused on the energy industry, which is a big driver of the Canadian economy. Energy companies had been beaten up as oil prices dropped significantly over the last couple of years and they were forced to take heavy losses. But the lower oil prices prompted many to become leaner and more efficient to survive in the changing environment. Now that oil prices have risen by 50% this year, energy companies are positioned to have outstanding earnings. They have not yet seen the same boost as oil, but this could be due to the lingering negative sentiment toward the sector.
Investors Rejoice When Blood is in the Street
When many markets are overvalued, it can be difficult to find attractive valuations. But negative sentiment has opened the door to an opportunity in EWC and EWU. The combinations of beat-up stock markets, beat-up local currencies, negative sentiment, and rebounding earnings has set the stage for future outperformance.
Not only do these countries appear to be on sale, but they have improving fundamentals that could drive future returns. Scared investors can stay on the sidelines or hold tight to their domestic securities as volatility shakes out the markets. But as active managers, (to paraphrase Mr. Rothschild) we should rejoice when blood is in the streets.
This article was written by Rusty Vanneman, Chief Investment Officer, and Michael Hadden, Investment Research Analyst. at CLS Investments, a participant in the ETF Strategist Channel. Rusty can be reached at Rusty.Vanneman@CLSInvest.com.
Disclosure Information
The views expressed herein are exclusively those of CLS Investments, LLC, and are not meant as investment advice and are subject to change. No part of this report may be reproduced in any manner without the express written permission of CLS Investments, LLC. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed here and should understand that statements regarding future prospects may not be realized. You should note that security values may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Investing in any security involves certain systematic risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any unsystematic risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. 1749-CLS-7/27/2018