3rd Quarter Update: Earnings, GDP, U.S. Dollar All Higher

Earnings for companies in the S&P500 grew by more than 20% year over year during the second quarter, repeating first quarter’s Tax Reform-boosted performance.  Companies that beat estimates were rewarded, and companies that missed either on guidance or sales were pushed down, but not to the degree we saw in the first quarter.   The increase in earnings has taken the market (SP 500) trailing P/E ratio down from very expensive 24.3 to modestly expensive  22.6.   Sentiment remains constructive with investors mildly positive, but below average bullishness for stocks’ outlook over the next 6 months.

Economic data is coming in mixed.  While GDP for the second quarter (4.1%) came in at the 5th fastest pace over the past 9 years, a large portion of this can be attributed to increased govt spending and the ‘pull-forward’ effect the Trade War tariffs have had on areas affected by increased taxes.   Adjusting GDP for these areas to average still gives a GDP read in the upper 2% range which indicates growth in the second quarter was strong.    The last previous 4% reads were followed by sequentially lower GDP prints over the following year however.

Real wages have stagnated year over year as inflation has increased its pace.  Wages climbed 2.9% while inflation is running at 2.9% year over year.    Wages had been the feared cause of inflation arising from Tax Reform stimulus.   The 70% climb in oil prices, along with healthcare and housing costs and tariffs/taxes being passed along to consumers are the actual drivers over the past 12 months.

As I referred to in my January Observations and Outlook, the US Dollar was destined to climb in 2018 after an incessant decline throughout 2017 (despite many factors that should have supported the greenback).   In January large traders were certain the US Dollar would continue to fall, and European and Emerging stock markets would do at least as well as US stocks.   Now seven months later, indeed the US Dollar has climbed dramatically while most stock markets outside the US are negative year to date.    The strong dollar has also taken its toll on precious and base metals.  Given the price declines abroad (and attendant airtime and print space) and US Dollar rapid increase, pundits are talking about ‘how bad can it get’, and reasons why the US Dollar will continue to strengthen, it may be time to again take the contrarian side of the dollar argument.

Valuations in emerging markets look much more attractive at lower prices, and no one seems to own gold anymore.  Vanguard recently shuttered one of its metals and mining mutual funds.  The price you pay for an asset has a tremendous impact on the return one sees, and currently prices are low.

Observations and Outlook July 2018

July 5, 2018

Selected Index Returns Year to Date/ 2nd Quarter Returns

Dow Jones Industrials    -.73%/1.26%        S&P 500   2.65%/3.43% 

MSCI Europe   -3.23%/-1.27%         Small Cap (Russell 2000)   7.66%/7.75% 

Emerging Mkts -7.68%/-8.66%     High Yld Bonds  .08%/1.0%

US Aggregate Bond -1.7%/-.17%       US Treasury 20+Yr -2.66%/.07%  

Commodity (S&P GSCI) 5.47%/4.09%  

The second quarter ended with a sharp decline from the mid-June highs, with US stock indexes retreating about 4.5% and ex-U. S markets losing upwards of 6%.  This pulled year-to-date returns back close to zero in the broad stock market indexes.  The only areas doing well on a year to date basis are US small cap and the technology sector.  Equity markets outside the US are in the red year to date languishing under the burden of a strengthening US Dollar and the constant threat of a tit-for-tat Trade War.  Areas of the market with exposure to global trade (US large cap, emerging markets, eurozone stocks) have had marginal performances while areas perceived to be somewhat immune to concerns about a Trade War have fared better.

Additionally, the bond market has only recently seen a slight reprieve as interest rates have eased as economic data has consistently come in below expectations—still expanding, but not expanding more rapidly.   Job creation, wage growth, and GDP growth all continue to expand but only at a similar pace that we have seen over the past several years.  The stronger US Dollar has wreaked havoc on emerging market bond indexes have fallen by more than 12% year to date.  And in the U.S., investment grade bond prices have fallen by more than 5% year to date, hit by a double whammy of higher interest rates and a widening credit spread (risk of default vs. US treasuries) has edged up.

On the bright side, per share earnings continue to grow more than 20%, with second quarter earnings expected to climb more than 20%, thanks in large part to the Tax Reform passed late in 2017.    As earnings have climbed and prices remain subdued, the market Price to Earnings ratio (P/E) has fallen making the market appear relatively less expensive and sentiment as measured by the AAII (American Assoc. of Individual Investors) has fallen from near 60% bullish on January 4th to 28% on June 28th, a level equal to the May 3 reading when the February-April correction ended. The Dow is approximately 800 points higher than the May 3 intraday low.

With reduced bullishness, increasing earnings, and expanding (albeit slow) GDP growth, there is room for equities to move up.  Bonds too have a chance for gains.  The meme of Global Synchronized Growth which justified the November-January run in stock prices and interest rates has all but died, given Europe’s frequent economic data misses and Japan’s negative GDP print in the first quarter.   This has taken pressure off interest rates and allowed the US 10-year Treasury yield to fall from a high of 3.11% on May 15 to 2.85% at quarter end.  I would not be surprised to see the 10-year yield fall further in the coming weeks.  Muted economic data with solid earnings growth would be beneficial to bonds and stocks respectively.

In my January Outlook I mentioned how the rise in ex-US stock markets followed closely the decline in the US Dollar.   The Dollar bottomed in late February and has gained dramatically since April.  This has been a weight around European and emerging market share prices and has been at the core of the emerging market debt problems mentioned above.  Fortunately, the Dollar’s climb has lost momentum and appears ready to pull back, likely offering a reprieve to shares priced in currencies other than the US Dollar.  It may also aid in US company earnings. So, while global economic and market conditions have changed since January, hindering prices of most assets, I believe we will see an echo of the 2016-2018 conditions that supported financial asset prices globally.   A declining dollar, muted investor bullishness, slowing global growth all should conspire to allow stock, bond and even precious metal prices to rise over the coming weeks, at least until investor bullishness gets well above average and the expectation of new lows for the US Dollar become entrenched again.

Looking Ahead

As second quarter earnings begin in earnest in mid-July, expectations are for approximately 20% climb in earnings.  A large portion is estimated to be due to tax reform passed late in 2017.  With market prices subdued and earnings climbing, the market’s valuation (Price to Earnings ratio) is looking more attractive.  While not cheap by any metric, this should give investors a reason to put money to work.  In the first quarter, analysts underestimated profits and had raised estimates all the way into the start of earnings season.  This is very rare.  The chart below shows us that generally analysts’ estimates decline going into earnings season.  Estimates start off high and then get lowered multiple times usually.   Second quarter of 2018 is setting up to be another rare event where we see again earnings estimates being raised into reporting season.
factset earnings 7 2018

The downside to the effect tax reform is having on earnings will be seen in 2019.   When comparisons to 2018 and 2019 quarterly earnings start to come out (in late 2018) the impact of lower taxes on the change in earnings will be gone.  In 2019 we will only see the change in earnings without the impact of tax reform.   Earnings growth will likely come down to the upper single digits.   How investors feel about this dramatic slowing in 2019 will dictate the path of stock prices.

Quantitative Tightening (QT) will dominate the headlines towards the end of the year.  Over the past 9 years central banks have pumped more than $12 trillion in liquidity into financial markets.  The US Fed stopped adding liquidity and has begun to let its balance sheet shrink, removing liquidity from financial markets.    During 2017 and 2018 the European Central bank and Bank of Japan more than made up for the US absence.   Europe and Japan are scheduled to reduce and eventually cease all new liquidity injections during 2019.  Combined with the Fed’s liquidity reductions, global financial markets will see a net reduction in liquidity.   This will have an impact on markets.  It is argued whether this will cause bond prices to fall (rates to rise) or it will have an impact on equity markets.   I believe it is likely this will impact both areas and the likelihood of falling bond and stock prices at the same time is significant.

US Dollar liquidity is another topic just starting to show up in the press.   The rise in 2018 of the US Dollar after a long decline has taken many market participants by surprise.  The “short US Dollar” and “short Treasury” trades were the most popular at the beginning of the year and have been upended.  It is often that once ‘everyone’ knows something, like that the US Dollar will continue to weaken, its about the time that area reverses and goes against how most are positioned.   The mystery really was given rising interest rates in the US and a stronger economy, why was the US Dollar weak to begin with?  Now the causes of a stronger Dollar are the weakness in Eurozone and Emerging market growth.    But which came first, the stronger Dollar or the weaker economies?

Below we can see the relationship of the US Dollar (UUP) and the TED Spread which is the difference in short term rates in the US and Europe.  The recent spike in funding costs (rates) parallels the rise in the Dollar index.  The rapid Dollar rise in 2014 was partly responsible for the Earnings Recession we saw in 2015.  There’s about 6 months to a year lag from when the Dollar strengthens to its impact on earnings.

ted spread july 2018

Ironically, part of the Tax Reform passed is a cause of poor Dollar liquidity (higher short-term rates result) and the strengthening Dollar.  The ability for US firms to repatriate earnings from abroad at a lower tax rate is causing Dollars to move from Eurozone back to the US.  Additionally, the $1 trillion plus budget deficit the US will run in 2018 and on into the future is also soaking up liquidity.  Repatriation, US deficits, and Fed tightening are all pushing the US Dollar up, and will likely see the Dollar stronger in 2019, which may impact US earnings in 2019.

Finally, there is China.   China is the largest consumer of raw materials.  Besides US PMI, the China Credit Impulse impacts base metals and other raw materials that other emerging market economies export.  When China is creating more, new credit we can see a rise in prices and in the growth of raw material exporting countries and a rise in US PMI with about a 12-month lag.  The chart below indicates that beyond the first half of 2018 the impact from the past China impulse will be fading.   This fade is happening at the same time global Central banks will be withdrawing liquidity and the US Dollar likely strengthening.   This scenario doesn’t bode well for risk assets in 2019.

china credit impulse pmi

Adam Waszkowski, CFA

Money for Nothing: from QE to QT

During the crisis, central banks lowered interest rates dramatically during the stock market crash.  The Fed Funds Rate went from 5.25% July 2007 to 3.0% March 2008 (when Bear Stearns failed, most people remember Lehman, which failed in September).   That summer Freddie Mac and Fannie Mae failed and the FFR was lowered to 2% and then 1% in September and finally 0% was the official rate in December 2008.  All the while financial asset prices kept falling and the economy was hemorrhaging.  Soon after hitting 0% as the cost of money to the banking system, the Federal Reserve started Quantitative Easing, where the Federal Reserve would buy mortgage backed securities (as well as other tax-payer insured instruments) to provide ‘liquidity’ to the markets.   The stated goal was to increase the prices of assets (stocks, real estate, bonds) so that the “wealth effect” would spur people to spend money rather than save it.  Given the anemic pace of economic expansion, the primary effect QE has had has been to push up stock prices well beyond normal valuations.

While the US has ceased QE, raised interest rates off the 0% mark, and laid out a plan to shrink its balance sheet (taking liquidity away from the market); the European and Japanese central banks continue to buy assets. The Europeans buy corporate bonds and the Japanese buy everything including equities.  The ECB has expressed a desire to cease its purchases (stopping new liquidity into the market) starting in 2018, but have not committed to a schedule.  The chart above combines all the central bank’s asset purchases and projections into 2019 overlaid with global equities.  On the chart below, notice how the EM (emerging markets withdrew liquidity late 2015 to 2017—emerging market stock indices (EEM) fell 39% from Sept 2014 through Jan 2016).  Additionally we can observe the effect central bank purchases have had on interest rate spreads, giving investors the most meager additional interest for taking on additional risk.

The chart shows the Fed’s net reductions in liquidity and the Swiss, Japanese and Europeans declining levels of new liquidity to the marketplace.   Given that adding liquidity boosted asset prices, as additional liquidity slows and possibly reverses, it is not unreasonable to assume markets will become much more volatile as we approach that time.  We will likely see the effects of Quantitative Tightening (QT) beginning in, and throughout 2018.  One way to counteract this, would be for private investors to save/invest rather than spend this difference (approx. $1.2 trillion), but a reduction in consumer spending would bring its own problems.

central bank purchases 2019

 

Oberservations and Outlook July 2017

Selected Index Returns 2nd Quarter/ Year to Date
Dow Jones Industrials    3.95%/ 9.35%          S&P 500   3.09%/9.34%         MSCI Europe   7.37%/15.36%

Small Cap (Russell 2000)   2.46%/4.99%     Emerging Mkts  6.27%/18.43%     High Yld Bonds   1.37%/15.3%

US Aggregate Bond 1.45%/2.27%   US Treasury 20+Yr   4.18%/5.66%    DJ/UBS Commodity -3%/-5.26%

2017 and its second quarter continue to be kind to financial assets, with both stocks, bonds and gold all climbing year to date.    European and Emerging Market equities have been the strongest this year, rising smartly after falling by 10% during the second half of 2016.  Emerging Market equity funds are back to a price area that stretches back to 2009!

Bonds continue to vacillate in an upward trend since mid-December. The commodity index is down primarily due to oil, as agriculture and base metals are essentially flat on the year after a recent climb.

Correlations between stocks and bonds have increased recently, with equities being flat over the past 6 weeks as bond prices have declined over the last two weeks.   While this phenomenon is negative for investors, equities appear to remain well inside their uptrend while bonds (and gold) appear to be near medium-term support levels.  We may see both stocks, bonds, and gold again climb concurrently reflecting a continuation of the year to date behavior.

What has been driving stock prices?  Growing earnings, low interest rates, lack of inflation, and ‘moderate’ GDP growth are the most common reasons to explain how prices have gotten to these levels.  Earnings have been on the rise since the end of the ‘earnings recession’ that lasted from June 2014 through March 2016.   After a decline of some 14% we’re now growing again, even robustly, given the low base from the previous year.  Earnings are still one or two quarters away from hitting new all-time highs, yet the S&P500 is roughly 20% higher than in early 2015.  The chart below gives us a visual of what prices rising faster than earnings looks like. Anytime the ratio is moving up indicates prices climbing faster than earnings.

shiller cape 6 30 2017Source: www.multpl.com

By this metric (and there are many others) stocks are valued at a level only exceeded by the roaring ‘20s and the dot-com era.  Can earnings continue to grow to support valuations?  The continued lack of wage growth and continued generationally low labor participation rate are headwinds to growth in consumer spending.  Consumer credit growth has slowed dramatically over the past six months and without wage or credit growth it’s difficult to see how the consumer will spend more to support ‘moderate’ GDP growth.  Low interest rates, or the comparison of low rates to dividend and earnings yield have provided much support over the past several years to the reasoning behind bidding up stocks faster than their earnings growth.

Interest rates bottomed one year ago at 1.3% (10-year treasury) and then ran up to 2.6%, mid-range since 2010 and the upper range of rates since late 2013.  The jury is out still on whether this marks the end of the bond bull market that has lasted since 1981.  The problem is that if consumers and businesses must increase their interest expense, there is that much less left to expand their consumption and investment.   Low rates had been a key enabler of more borrowing, leading to more consumption, and higher profits.  Now, in some areas, analysts are saying that higher rates are ALSO good for stocks because it represents growth expectations.  Frankly we’ve been ‘expecting’ growth now for several years, and the only positive representation of growth (GDP) we have seen is due to a willful under-reporting of inflation.   Gains in expenses in housing, healthcare, and education have far outstripped the general inflation rate.  At the same time, official statisticians tell us our TVs, cell phones, and other tech devices are far cheaper, because we ‘get more’ for our money.  This is called hedonic adjustments.  Look this up and you will understand why one’s personal experience with the cost of living doesn’t mesh with the official inflation statistics.

It seems the main reasons we are given for buoyant stock prices appear tapped out or stretched.  The thing is, it’s been like this for a few years now.  So then, what really is driving prices?  Some of it has to do with FOMO, Fear Of Missing Out.  No one wants to get left behind as prices rise, even if said prices already appear expensive.   As fundamentals have deteriorated over the past few years what is causing or who could be that marginal buyer who always seems to have more money to put towards financial assets? Perhaps this chart has something to do with it.

Central-Bank-Balance-Sheets-Versus-MSCI-World-Index

As central banks have purchased outstanding bonds (and equities in the cases of Japan, Switzerland and Israel among others) the cash or liquidity provided has found its way back into the equity markets.  Additional effects have been to put a bid under bonds, increasing prices and lowering rates.  What many investors in the U.S. don’t realize is that the European and Japanese central banks continue to this day putting approximately $400 billion per month into the financial markets.  If this is the true reason behind stock and bond price levels today, any cessation, slowing or even anticipation of slowing will likely have negative effects on asset prices.  The chart below shows where the U.S. Fed ended its QE efforts while Japan and Europe picked up all the slack and then some.  The astute observer can see where the Fed tapered, while the ECB was not adding liquidity, from 2014 to 2015.  From mid-2014 to early 2016, the Vanguard FTSE Europe ETF dropped by 29%.

central bank buying 4 2017

Beyond central bank liquidity creation there is also the concept of growth in the private sector.  Here too we see that a phenomenal amount of debt must be created to sustain growth.   New debt creation in China dwarfs the rest of the world.  China has put up high growth numbers the past several years, more than 7% annually.

private sector debt creation qe

Going forward it will be crucial to watch for central banks’ behavior as to ending current ‘QE’ policies.  Japan is still committed to a 0% 10yr bond rate, yet the ECB has begun to state that its bond buying won’t last forever, and is likely to slow by mid-2018.  The U.S. Fed has indicated continued tightening via rate hikes (likely one more this year) and to begin to let ‘roll off’ maturing bonds.  The roll-off will take liquidity from the markets.  It will start small and gradually increase in 2019 and thereafter.  These cessation tactics are done under the current understanding that financial conditions are ‘easy’.  Put another way, the banks will start to slow new liquidity and then drain liquidity as long as financial conditions, which include stock market levels, don’t get to difficult.   What exactly is the Fed’s downside tolerance is unknown.  What is knowable, is that the decision-making process takes months to be put into effect and by that time, markets could move down and growth could halt.

Near Term vs Long Term

The concepts of credit creation and central bank balance sheets and their respective monetary policies are will have impacts on asset prices over the longer term.   Year over year earnings growth forecasts, specific companies’ ‘beats’ or ‘misses’ and monthly data on inflation, job growth, and wages all have short term impacts on the stock market.  Currently, earnings are expected to grow robustly, official inflation is subdued and official unemployment are all in the “very good” range.  Combine that with the Fear Of Missing Out concept and that should help keep the markets up and even higher for a while longer.  The problem is that simply because we want markets to move higher doesn’t mean they will.  At some point paying 30x earnings will seem too expensive and the markets will lose some marginal buyers and some will become sellers, for whatever reason.   Based on current valuation metrics and the business cycle, we know that equity returns over the next several years will be very low.  If rates go up, and/or credit (the ability to pay) worsens for individuals and businesses bond funds will likely suffer as well.  Over the long term, avoiding large losses or drawdowns, even while lagging the market on the upside, can have a dramatic positive impact over a full market cycle.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around two classes, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

International Investing – Looking Abroad for Better Returns

With the upcoming Memorial Day kicking off the start of summertime, and 1st quarter earnings season wrapping up, it appears all is well and good, at least outside of the political kabuki theater in Washington. There’s a chorus of animal spirits driving optimism by corporate leaders and consumers alike, which is in turn driving business investment and household consumption and savings.

And it’s not only happening in the U.S. as we’ve seen strong earnings growth and positive surprises across industries and geography – evidence that we are experiencing a bout of synchronized global expansion.

To me, a more broad-based recovery is welcomed as it eases worries of a maturing U.S. business cycle that may not be able to do as much heavy lifting for the global economy as it has recently. And, given such a constructive global backdrop, stock markets around the world may have further to run.

For a U.S. investor, there are 47 individual country-specific exchange traded products (ETFs and ETNs — https://seekingalpha.com/etfs-and-funds/etf-tables/countries) that one could purchase to garner exposure to a basket of stocks in each of these countries.

Post the global recession of 2008 to early 2009, you could have easily ignored 46 of those specific countries and focused on one – the U.S.

You could use the S&P 500 as a gauge or a broader stock market benchmark that includes broader exposure to mid- and small-capitalization companies like the Vanguard Total Stock Market ETF (ticker symbol “VTI”), providing a more complete view of the U.S market than the S&P 500.

It is remarkable how the U.S. stock market has outperformed the rest of the world over the past decade. Among these 47 individual country stock markets at the close of 2016, VTI ranked # 1 over 10 years, # 2 over 5 years (behind Ireland) and # 1 over 3 years. Until last year, investing outside the United States had been a fool’s errand for an entire decade!

But 2017 may mark a turning point. So far this year, the U.S. stock market sits at a lowly 39 out of 47 with a gain of ~ 7.0% year to date (through May 23rd) for the Vanguard Total Stock Market ETF. Of the other investable markets, 29 of the 47 country-specific funds are up double-digit percentages nearly 5 months into the year.

Home Country Bias

If you are a U.S. investor sticking with the U.S. stock market over the past decade has been easy to do; it also has been a winning bet. But the real reason it has been easy is that most investors suffer from a home country bias – the preference to invest in one’s own country’s stocks.

So what? Today, the U.S. stock market currently accounts for 36% of the world’s stock market capitalization; that’s down from 45% in 2003. So, if you truly want a balanced stock portfolio, you should have 64% (nearly 2/3) of your stock investments outside of the U.S. markets.

Does the idea of investing most of your hard-earned wealth in global stocks make you feel queasy? Of course it does. However, you should invest abroad for the same reason John Dillinger gave when the police asked him why he robs banks: “Because that’s where the money is.”

Global Investing Back in Fashion?

Timing the market is more for the lucky than the smart, but still reversion to the mean is the one rule of investing that, given time, always rings true.

Here’s really simple reasons why I think global stock markets have started just such a reversion.

#1 – U.S. investors despise global stock markets. Chances are you have no interest in investing outside the U.S. in either developed or emerging market stocks. After all, international stock markets have gone essentially nowhere in the past decade. If negative sentiment is a necessary contrarian indicator, you could hardly ask for a better setup.

#2 – International stock markets are very cheap. It is no secret that the U.S. stock market is expensive, valuation-wise, compared to the rest of the world. According to Star Capital Research, the U.S stock market is the 3rd most expensive in the world. Only Denmark and Ireland have richer valuations based on future earnings expectations.

As I mentioned earlier, reversion to the mean. Few things are predictable in investing, but given enough time, cheap stocks will get more expensive and expensive stocks will get cheaper.

#3 – International stock markets have turned up and you probably didn’t notice. Chances are you’ve been focused on U.S. stocks more than ever or the political scene in Washington. After all, the Trump Bump gave many U.S. investors a renewed appetite for risk taking, one that harkens back to the 1990s.

However, solid returns in the U.S. stock market year-to-date tell you nothing about how much money you could have made investing outside our country’s borders.

Is 2017 the year that international stocks begin to make their long-awaited comeback? The signs are as good as they have been for a long time. And, who knows, after a few years of leaving the U.S. stock market in the dust, international investing could cease to be a pariah for U.S. investors.

I suspect more U.S. investors will turn to looking outside the U.S. for superior market returns be it in emerging markets or in developed markets like European bourses where a combination of diminished political risks, cheap valuations, years of underperformance, and a European Central Bank (ECB) that is in no rush to hike rates make the region attractive.

The graphic below from Jonathan Krinsky of MKM Partners LLC and Bloomberg points out that a simple comparison of the Vanguard FTSE All-World ex-U.S. ETF (ticker symbol, “VEU”) versus the S&P 500 ETF (ticker symbol “SPY”) showing massive turnaround potential for the rest of the world to catch up.

After several years of underperformance, economic growth in the euro zone has matched that of the U.S. for the past year or so, and appear to be neck-in-neck (as shown in the graphic below).

U.S. vs. Euro Zone, Change in Gross Domestic Product (GDP), Year-over-Year

More than halfway into Europe’s earning season, 69% of companies had beaten earnings per share estimates vs. 75% of S&P 500 companies in the U.S. Overall, this is a fantastic showing.  According to Morgan Stanley, that’s the best showing in over a decade in Europe.

This marked improvement in economic growth is starting to feed through into corporate earnings and revenue. With 1st quarter results in from more than 250 companies, or about a 1/3 of European stocks by market value, the net number beating earnings expectations is on course to be the highest in more than a decade, according to Morgan Stanley. Those companies beating analysts’ estimates for revenue are set for the best performance in at least 14 years, Morgan Stanley added.

Total Returns, including Reinvested Dividends (in euros) of U.S. vs. European Stocks over Past 1 Year

The graphic above shows that over the past year, a recent run by European stocks (as measured by the Euro Stoxx 600 index) has caught up with the S&P 500 over the past month or so.

Total Returns, including Reinvested Dividends (in euros) of U.S. vs. European Stocks over Past 2 Years

On a longer-term basis of 2 years, however, there’s still quite a way to go before European stocks’ previous underperformance relative to their U.S. counterparts is erased.

The Case for Going Global

The combination of an improved outlook for euro zone growth, a benign inflationary environment and a central bank that’s unlikely to echo the Federal Reserve in raising interest rates anytime soon gives European stocks the opportunity to outpace U.S. returns.

Also supporting the case for European equities is the sheer scale of prior underperformance vs. U.S. stocks. However, the same factors also prevail in other major equity regions, especially emerging markets and, to some degree, Japan. However, political risk also remains a negative reality for Europe on a medium- to long-term horizon, even if the most immediate worries seem to have passed.

In many of my multi-asset portfolios, I have followed a geographically diversified approach to my equity positions this year, elevating exposure outside of the U.S. I view my position within the context of diversifying equity exposure across major regions, reflecting a broadening out of economic growth – a synchronization of global growth, if you will – rather than an outsized bet on European outperformance.

While there is a good chance that European earnings growth will come in as the strongest of any region this year, emerging market equities could well give Europe a run for its money in this regard. Japan, too, should see solid earnings growth this year, particularly if the yen remains weak, as I expect it will.

Valuations look significantly cheap for emerging markets as they do for Europe, particularly in comparison to the U.S. stock valuations. Given valuation metrics, the region that looks more challenged than the rest is the U.S. It is clearly the most expensive of any major equity market, and the upside to earnings growth looks somewhat limited unless we can get fiscal stimulus such as tax cuts, infrastructure spending, and regulatory relief passed by Congress.

But for now confidence remains historically high for businesses and households alike, which probably has more to do with expectations for no new anti-business regulations and taxes than actual legislation getting passed that would make it wildly better. With that said, here at home corporate growth (as measured by the S&P 500) is set to accelerate throughout 2017 to a solid 12.3% and 10.8% in 2018, according to Bloomberg Intelligence data. If that comes to fruition, that would be the biggest 2-year advance since 2012 and would help justify rich U.S. market valuations.

In an environment of strong and broadening global economic and earnings growth, I have assigned greater importance this year to being overweight equities relative to bonds, and I am looking to international markets for attractive returns. And while U.S. equities don’t look as compelling as other regions, I’m maintaining exposure a bit of home bias as there are offensive and defensive qualities as well as comfort that U.S. exposure brings to investors’ portfolios.

I wish you and yours an enjoyable summertime ahead and a reflective Memorial Day for those men and women that served and sacrificed to win or preserve our freedom.

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Disclaimer: The opinions expressed herein are those of the author and/or the sources cited. The article is for general education and information about investing and economic matters. Nothing should be construed as advice, nor any of it considered an offer or solicitation of any kind to buy or sell any investment products. We are not responsible for the accuracy or content on third party websites or sources cited; any and all links are offered only for use at your own discretion; and our privacy policies do not apply to linked websites. Eric Linser, CFA is an investment advisory representative of Green Valley Wealth, a dba of Naples Asset Management Company, LLC, a federally registered investment advisor.