Re-Emerging Markets

The idea: Emerging markets, represented by the MSCI Emerging Markets Index in US dollars, delivered a very disappointing 1.8% annualized in the 10 years ended December 2022 versus 12.5% annualized for the S&P 500. But while the past decade belonged to US stocks, emerging markets stocks may be poised to outperform.

The strategy: While many emerging markets have suffered from regulatory issues, corruption, currency collapses and more, there are, encouragingly, limits to policymaker and corporate bad behavior. Securities markets remain the ultimate disciplinarians globally — especially in emerging countries. You want capital? Then you must behave. With global financial liquidity shrinking, the bond market straightjacket on profligate emerging countries will likely result in improved fiscal and monetary prudence. This should create a propitious backdrop for inflation, rising productivity and private-sector, expansion-stoking growth.

The big picture: The price is right as the emerging markets index trades at a 20-year low versus the US market, at less than half the price-to-book ratio, a price-to-earnings ratio that is about 60% lower, and with about twice the dividend yield.  

Stay Defensive 

The idea: Our models suggest that this could be the best opportunity to switch out of equities and into bonds since the tech bubble of 1999-2000. Despite the S&P 500 falling almost 20% last year and the Nasdaq losing more than 30%, equity valuations are not yet cheap. 

The strategy: While investor sentiment has improved in recent months as inflation and the pace of rate rises moderated, increasing hopes of a shorter and less deep slowdown for 2023, we suspect this optimism is premature. The full impact of last year’s rate rises have yet to feed into the real economy, but orders continue to weaken, while there are signs of housing stress around the world. In previous cycles, these factors tended to warn of rising unemployment and steep earnings declines.

Locking in close to 4% on three-year to five-year US Treasuries looks attractive. However, if you want more risk in your portfolio, look outside the US and to the low valuation of the yen and Japanese equities. Japanese banks look cheap and Japanese hotels should gain as the economy reopens to global visitors looking to take advantage of superior service at a price unimaginable a few years ago.

The big picture: We see two key dangers of getting more risk-hungry right now. First, if the Federal Reserve tightens into the slowdown, more of the financial structures that were created and thrived in the zero-interest-rate era will be challenged. In 2022, this “quantitative destruction,” as we call it, undermined crypto and UK debt. In 2023, we expect the credit markets to be challenged. Secondly, when the Fed pivots, it will do so because of economic or financial stress. Following the last 12 Fed pivots, US equities typically lost over 20% in absolute terms over bonds.

Head to Europe

The idea: In recent years, US investors have done best sticking close to home. But today, investors should consider increasing their allocation to European equities.

The strategy: Investors were rightly concerned about the fallout from the war in the Ukraine. Thankfully, an exceptionally mild winter has lowered the likelihood of a crippling energy shock. European equities are also benefiting from cheaper valuations, particularly in the financial sector. There are numerous reasons to be cautious on Chinese equities, but in the near-term the economy is benefiting from a rapid reopening and supportive policy. For investors understandably reluctant to commit directly to China, Europe offers an alternative, and several segments of its economy, from French luxury goods to German industrials, will directly benefit from China’s reopening.

The big picture: During the past five years, European equities have underperformed the US by roughly 30%. However, that has started to change. Today, European stocks stand to benefit from three tailwinds: a less severe energy shock, cheaper valuations, and better leverage to China’s reopening. 

International Diversification

The idea: Internationally diversified portfolios are poised to benefit from favorable valuations and a falling US dollar. Capital market assumptions around Wall Street are largely in consensus that international markets are forecast to outperform the US over the next 10 to 15 years.

The strategy: The US dollar peaked in September 2022 after surging to levels not experienced since the early 2000s and 1980s. After the dollar peaked in February 1985 and September 2001, international markets outperformed the US for four consecutive years (1985 to 1988) and six consecutive years (2002 to 2007), respectively. The US dollar may well be headed toward normalization as the Fed is expected to wind down its tightening cycle in 2023. An improvement in growth expectations abroad would serve as an additional headwind to the dollar. A falling dollar benefits US investors allocating capital abroad. Earnings in foreign markets are converted to a weaker US dollar, boosting returns. 

The big picture: There is still significant uncertainty weighing on international markets, particularly the Russia-Ukraine war and accompanying European energy crisis, and China’s reversal of its longstanding Zero Covid policy. In light of these risks, valuations for the MSCI EAFE Index have fallen to 16% below the index’s 10-year average, with a forward price-earnings multiple of 12.1 as of Dec. 31.