Over the past several months, there has been one primary story in the global stock market: the U.S. has done very well, with major indexes rallying to records, while the rest of the world has done very badly, with some markets falling into bear territory.
This trend has raised a key question for investors: is this divergence sustainable? And if it isn’t, will it be resolved by international stocks recovering or the U.S. falling?
So far this year, the S&P 500
has risen 9%, making it the best performer of the world’s major equity markets by far. The strength of the U.S. has helped keep the iShares MSCI ACWI ETF
— an exchange-traded fund that tracks the global equity market — in positive territory for the year. It is up 3.2% in 2018; to compare, an ETF that tracks the global equity market while excluding the U.S.
is down 4.8%.
In contrast to 2017, when global stocks rose broadly in every month of the year, the synchronized global growth story has broken down in 2018, with the weakness spread across major regions. A major index of European shares is down 2.6% in 2018, while the Vanguard FTSE Emerging Markets ETF
has dropped 10%, and a major index of Chinese stocks has plunged about 25%.
The divergence between the U.S. and emerging-market stocks recently hit its most extreme level in 14 years. Vincent Deluard, global macro strategist at INTL FCStone, called the scale of the disparity between the U.S. and the rest of the world “incredible.”
According to Morgan Stanley, the percentage of companies outperforming the all-world index — a proxy for the entire global equity market — is near historic lows. In the past, such extremes get corrected with either the U.S. dropping to match the weaker performance of overseas markets, or with international markets catching up to the U.S. In the chart below, green numbers refer to times when international markets recovered without a hit to the U.S., while red ones signify times when the U.S. fell.
“It’s worth pointing out that the red dates either preceded an actual recession in the U.S. (January 1991, September 2008) or the fear and pricing of one (November 2015),” wrote the investment bank, which has been calling for a sharp sell-off in U.S. stocks for months.
There seems to be little consensus on whether it is more likely that the U.S. falters or international stocks recover.
The September BofA Merrill Lynch survey of fund managers asked how the “current decoupling in the global economy” was likely to be resolved. Nearly half of those polled — 48% — said the disparity would be corrected by U.S. growth decelerating, up from 32% in the previous month. Only 22% of respondents said it would be resolved by an acceleration in Asian and European markets, down from 28% in August’s survey. (Roughly 24% of those polled said the decoupling was likely to continue.)
“There’s a well-worn saying relating to the prominent position of the United States in financial markets: ‘When America sneezes, the rest of the world catches a cold,’” said John Toohey, head of equities at USAA. “The rest of the world is already showing some symptoms, so the question to ask is whether the U.S. can stay healthy if those overseas economies are actually coming down with the flu.”
Advocates for either outcome can marshall plenty of evidence in favor of their view.
Overseas markets are struggling with signs of slowing growth, trade-policy uncertainty, and political turmoil, but such factors may already be priced into the markets, leaving them primed for a rebound.
Meanwhile, the U.S. has seen nearly uninterrupted upward momentum — the current bull market is the longest ever, by one measure — which could continue, although Wall Street is facing an environment with less-accommodative monetary policy, elevated valuations, and signs the outlook for corporate earnings growth is worsening.
“We believe the hurdle for U.S. earnings to surprise on the upside is now very high. The impact of corporate tax cuts on earnings will soon disappear, and both borrowing costs and wages are headed higher. A slowdown in earnings growth will take away one of the main supports for U.S. outperformance relative to other markets,” Russell Investments wrote in its fourth-quarter outlook.
That was echoed by David Joy, chief market strategist at Ameriprise Financial, who said that “the data overseas has been very good, and U.S. valuations look stretched by many metrics. We’re almost neutral on the U.S.; it’s hard to see how much higher we could go from here.”
Both Ameriprise and Russell, however, said that limited prospects for the U.S. didn’t mean they were expecting a sharp pullback on Wall Street.
Joy said he expected the divergence to be moderated by overseas markets recovering, noting that Ameriprise had added to its emerging-market holdings and is “positioned for overseas stocks to recover.” Similarly, the Russell analysts said that they “like the idea of leaning into eurozone equity exposure after its recent underperformance.”
Matt Forester, chief investment officer of BNY Mellon’s Lockwood Advisors, said that the divergence between the U.S. and markets abroad “opens up the consideration of value in Europe and emerging-market equities relative to the U.S.”
“Generally speaking, it’s pretty easy to make the case that EM and Europe are undervalued relative to the U.S., although the U.S. environment remains very positive, even if we are stretching the valuation band really far,” he said.
Morgan Stanley, pointing to the extreme reading of companies outperforming the world index, wrote that “we think we’ve reached a point where active managers must pick one or the other,” referring to the U.S. or overseas markets.
“In the absence of a recession or fear of one, we think the more likely outcome is one in which international markets recover while the U.S. lags,” it wrote. “No imminent recession is probably the biggest factor supporting our view for a positive recoupling and relative international outperformance.”
Friday marked both the final trading day of the month of September and the third quarter of 2018.
For the month, the Dow rose 1.9%, its third straight monthly gain, while the S&P gained 0.4% in its sixth straight monthly advance. The Nasdaq fell 0.8% in September, snapping a five-month winning streak. Over the past three months, the S&P rose 7.2%, for its biggest quarterly advance since the fourth quarter of 2013. The Dow saw a 9% quarterly advance; both the Dow and the S&P have risen in 11 of the past 12 quarters. The Nasdaq rose 7.1% over the quarter, marking its ninth straight quarterly gain.
The first week of the fourth quarter comes with a number of data points that will also be in focus for investors. Data on September manufacturing activity from both Markit and the Institute for Supply Management will be released on Monday, as well as figures on August construction spending. Similar data on the services sector will come out on Wednesday.
Perhaps the most anticipated report, however, will come on Friday, with the release of the September payroll report, which is expected to show 201,000 jobs added in the month, and the unemployment rate at 3.9%.
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