#79 US equity or rest of the world?

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#79 US equity or rest of the world?

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US equity or rest of the world?

BNP PARIBAS ASSET MANAGEMENT

  • While some production constraints will remain well into 2022, they will be resolved eventually, enabling economies to revert to trend growth rates without generating higher inflation.  
  • Substantial accumulated household savings mean consumers have the resources to go on a spending spree that could have inflationary consequences. If, however, the after-effects of living through a global pandemic inhibit consumption, central bank and state support may be needed to encourage demand.
  • We expect the momentum behind rising wages to fade as employers adjust processes and invest capital to reduce their dependence on labour. Today’s relative weakness of organised labour means comparisons with the 1970s are inappropriate.
  • Equities will struggle to generate above-average returns in 2022. European equities look set to make up lost ground with their US peers. One of the critical calls will be whether value stocks can begin to reverse their underperformance of the last several years. The wide valuation gap between value and growth stocks and the prospect of higher interest rates suggest upside is ahead.
  • While intransigent inflation is likely to lead the US Federal Reserve to raise policy rates several times in 2022, we expect only a short cycle of increases in key rates. The upside of longer-term US Treasury bond yields should be limited by capped inflation expectations and the size of the Fed’s balance sheet keeping real yields low.

Equities

This year (2021) is likely to be the fourth consecutive year of US equity outperformance relative to the rest of the world. If history over the last 50 years is any guide, next year could see lagging returns as previous US winning streaks have never exceeded four years.

Patterns aside, there are other reasons to foresee US equity returns falling behind other parts of the world next year. As the US opened up earlier than most of the rest of the world, much of the recovery from lockdowns has taken place and GDP growth has already surpassed pre-pandemic levels. As reopening progresses in Europe and spreads through emerging markets, economic momentum should follow.

Monetary policy, though, will tighten more in the US than in the eurozone, partly because inflationary pressures are higher as a result of the fiscal stimulus. To the degree that higher inflation crimps demand, the US may see household consumption rise at a slower rate than in Europe.

Should investors hedge the currency when investing in international equities?

“We would suggest allocating to international equities without hedging currency for two reasons: maximizing diversification and boosting total returns.”

Over the last 15 years, international equities have underperformed U.S. equities by a cumulative 270%. Currency played a role in this underperformance, subtracting 25%, as foreign currencies steadily weakened against the U.S. dollar. Investors are left wondering: should they hedge currency exposure when investing in international equities? 

The reality is that in the short-term currencies are impossible to predict, as they are prone to sudden swings. As Alan Greenspan once said about currency trading, “to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin.” Longer term, currencies do tend to revert to their fair value over time. As the U.S. dollar looks overvalued versus a basket of currencies, this suggests a depreciating trend over a multi-year horizon. Crucially, for portfolio construction, allocating to international equities on an unhedged basis helps to maximize the diversification benefits of the asset class and may boost long-term returns.

Despite coming into this year already overvalued, the U.S. dollar has appreciated 3.6% year-to-date. The biggest move occurred following Russia’s invasion of Ukraine due to: 1) a flight to safe haven assets (associated with U.S. markets), 2) widening growth differentials between the U.S. and the rest of the world, as growth downgrades have been larger in Europe (and China due to its “COVID zero” policy), and 3) widening interest rate differentials between the U.S. and other developed countries due to a quicker repricing of Fed rate hikes over the next 12 months. Given these risks, it is surprising the U.S. dollar has not strengthened more, suggesting some fatigue for this upward trend may be occurring. 

United Overseas Bank

Moderating growth momentum

The global economy staged a spectacular recovery in 2021, helped by a pandemic-induced low base the year before. However, different countries are at different stages of recovery. As the low-base effect wears off, global economic growth is likely to moderate in 2022 before stabilizing. Despite the slower rate of expansion, the recovery will be more resilient as a result of a broader-based sectoral growth in the global economic reopening.

Differentiated growth

Asia ex-Japan is expected to be the fastest-growing region in 2022, powered by China and India. Given China’s more measured pace of expansion, Beijing could ease up on regulatory tightening to preserve growth. Elsewhere, Europe leads the growth charge amongst advanced economies. However, the risks of policy missteps remain — Political infighting in the United States (US) could affect infrastructure spending while overly-aggressive China reforms could trigger a slowdown and undermine social stability.

Support from twin growth pillars

Heavy fiscal spending and strong consumption will boost global economic growth. The impact from fiscal stimulus roll-outs by the US, Europe, China and Japan will trickle down to the economy from the second half of 2022. Pent-up savings will fuel consumption and swing demand from goods to services as reopening gains momentum. This could buy some time to ease the supply chain backlog for goods.

Reopening is critical

More economies are expected to reopen in 2022 amid rising vaccination rates and a shift towards a “living with COVID” strategy. Forging ahead with reopening is a test of political resolve and countries which are more connected with the global economy will want to seize opportunities as trade recovers. The emergence of the Omicron variant may slow the pace of reopening, but many countries are choosing to curb its effects using vaccinations and booster shots instead of lockdowns. Supply chain bottlenecks should ease towards the second half of 2022 as trade links are restored.

My conclusions and considerations

Reading some papers about it, over the last 15 years’ international equities have underperformed U.S. equities.

What I think, as I wrote in other articles is correct to analyze all the possibilities that we have in each part of the world to look for investing.

Understanding all the risks and rewards we could achieve following a specified way surely will help by the way.

  • Equities will struggle to generate above-average returns in 2022.
  • European equities look set to make up lost ground with their US peers. One of the critical calls will be whether value stocks can begin to reverse their underperformance of the last several years.
  • The wide valuation gap between value and growth stocks and the prospect of higher interest rates suggest upside is ahead.
  • The year (2021) is the fourth consecutive year of US equity outperformance relative to the rest of the world. If history over the last 50 years is any guide, next year could see lagging returns as previous US winning streaks have never exceeded four years.
  • As the US opened up earlier than most of the rest of the world, much of the recovery from lockdowns has taken place and GDP growth has already surpassed pre-pandemic levels. As reopening progresses in Europe and spreads through emerging markets, economic momentum should follow.
  • Over the last 15 years, international equities have underperformed U.S. equities by a cumulative 270%. Currency played a role in this underperformance, subtracting 25%, as foreign currencies steadily weakened against the U.S. dollar.
  • Asia ex-Japan is expected to be the fastest-growing region in 2022, powered by China and India. Given China’s more measured pace of expansion, Beijing could ease up on regulatory tightening to preserve growth.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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