By Veronica Fulton, Research Analyst
The U.S.’s prolonged outperformance relative to international equities has many investors wondering if the global markets are overdue for a change in leadership. Additionally, international valuations are historically low relative to the U.S. That coupled with a rising dollar makes these companies even cheaper for domestic investors, and potentially offers an opportune time to add some exposure in the space. As a result, clients have asked “Why don’t we own more international?”. The answer is simple: Based on our analysis of current macroeconomic conditions, we’ve yet to find evidence that is compelling enough to change our positioning.
Within the last 2 years, the entire global landscape has seemingly shifted as governments and central banks around the world take on varied approaches to confront a multitude of economic headwinds. Most countries are dealing with the repercussions of inflation, the rising dollar, higher energy prices, and re-opening after-COVID, but the effects of these economic hurdles vary in magnitude for each independent nation.
Surging energy prices brought on by the Russia/Ukraine war have created unprecedented consequences globally, but most notably in Europe. According to officials and energy executives, the continent faces years of higher energy prices and possible shortages as efforts to replace Russian imports have been inadequate, to say the least. There are economists that believe Europe’s recession is imminent, if not already here. Euro area composite PMIs are in contraction territory and business confidence in Germany, Europe’s largest economy, points to weakness ahead. Similarly, the U.K. is feeling the effects of rising energy prices as well. They will increase the annual price cap on household electricity this October by 3x last year’s cap. This alone is estimated to cause a further inflation surge, driving CPI as high as 18% by January.
The rising dollar continues to be a headwind for emerging markets as many of these nations struggle to service their dollar-denominated debt. These countries will have to tax their already weakening economies more, issue more of the local currency (which is inflationary), or simply borrow more money which only exacerbates the initial issue. Any of these three scenarios could ultimately lead to a recession, hyper-inflation, or a sovereign debt crisis. Most recently, the country of Sri Lanka has fallen victim to the latter, defaulting on its debt for the first time in its history.
While the rest of the world appears to be battling the aftermath of both policy responses to COVID and the Russia-Ukraine war, China seems to be in a more isolated position as they are still battling COVID itself. The country has committed to a zero-COVID policy, repeatedly arguing that the cost of allowing COVID to spread through the community is not acceptable. Their government continues to spend and cut interest rates in hopes of offsetting weaker economic growth brought on by constant lockdowns and sentiment deteriorating among businesses and consumers who are growing more reluctant to spend or borrow. The country has been relatively unaffected by the violence and sanctions in Europe and has maintained its trade and energy relationships with Russia. However, they are having their own energy-related battle due to droughts in key production areas across the country.
We must mention Japan, which is actually experiencing economic growth and moderate inflation. However, they are seeing extreme currency depreciation, as the yen fell to a 24-year low relative to the dollar in preparation for a hawkish Fed at Jackson Hole. As a country that primarily imports raw materials, this type of depreciation could prove to have adverse effects on corporate profits and corporations. We are monitoring this situation closely.
We also acknowledge that some individual countries may actually be benefitting from the current environment. Most notably the major commodity producers such as Canada, Australia, and Brazil. However, we also note that historically the dollar and commodities are inversely correlated. The current relationship between the two, as we see it, fundamentally, cannot continue. Given the weight of the evidence, we have no clear indication of which way things will break – the evidence is mixed at best. Considering the huge amount of assets flowing out of international ETFs, we believe the lows could be near, but are waiting and watching for more confirmation.
The countries mentioned here, of course do not make up the entire global market, but when evaluated on an individual basis they give some insight into how the overall broad market is faring. In the U.S., we too are facing similar hurdles – namely inflation and deteriorating economic indicators. But relatively, the U.S. appears to be better positioned to combat these headwinds.
The Fed continues to tighten in hopes of taming inflation which some believe has peaked. American consumers have been able to bear the brunt of higher prices without eating too far into discretionary spending, due to the buffer of excess purchasing power created during the pandemic. The strong dollar, at least near-term, does not pose any significant threats to our economy. Long-term a stronger dollar would reduce our exports and potentially hurt our trade deficit, however, at present, foreign investors continue to flock to U.S. equities and assets as their currency depreciates. On the energy front, we are self-sustaining thus not at the mercy of the reduced shortage brought about by the Russia/Ukraine war. Additionally, unlike China, the U.S. economy has fully opened back up post-COVID.
All things considered, we prefer to stick with leadership and allocate to spaces that are better suited to outperform under the aforementioned economic conditions and extremes. For us, that remains U.S. equities over broad international equities. We remain nimble and on high alert for strategic or tactical opportunities to present themselves as the dynamics of global market conditions can change just as quickly as they have developed.
Sources: Fortune, MacroStrategy, Strategas
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