Similar to 2Q market conditions, global equities were mostly positive in the third quarter.  As has been the trend throughout 2018, U.S. stocks again led the way, although there was broader participation to the upside across varying geographies.  Japan was a notable outperformer, benefiting from stronger corporate profits as well as a weakening Yen.  Europe was mixed in the quarter, as gains in Switzerland and France were offset by pullbacks in Italy and the United Kingdom.  The weakness in these latter markets was more a function of macroeconomic concerns, vs. stock-specific fundamentals.  Uncertainty regarding Brexit and the populist agenda in Italy had investors moving to the sidelines until there is more clarity on both fronts.  Trade friction continues to weigh on investor sentiment, although progress with Mexico and Canada are clear steps in the right direction.

Revisiting the Why International? Question

After outperforming in 2017, international stocks are trailing the U.S. market by a wide margin in 2018, raising the question of why even include international equities in one’s asset allocation.  To be clear, international equity returns have not exactly dogged it – with an annualized return of 8.3% over the trailing seven years.  However, these returns pale in comparison to the S&P 500:

In Cambiar’s opinion, there are three major factors leading to the current divergence between U.S. and international stock performance:

• Better U.S. corporate earnings growth
• An out of sync global interest rate regime leading to capital concentration in dollar-denominated assets
• Financial pressure on Emerging Markets as a consequence of capital concentration into the dollar/capital flight out of EM

As we look ahead over the next year, there are three critical “macro” events that may improve sentiment towards international equities – potentially at the expense of U.S. stocks.

First, the U.S. Federal Reserve may take a pause in raising rates beyond the anticipated increase in December.  Barring a sustained steepening in the yield curve, additional raises could result in a self-induced inversion.  A respite in additional tightening would be cathartic for international money flows, although an inversion may at least challenge the global preference for dollars – given the ominous financial signal it portends.

Second, the European Central Bank (ECB) should begin the process of exiting from QE (slated for December 2018), and normalizing its interest rate regime in 2019.  Success on this front would bolster the value of the Euro as well as business confidence, along with ending (or at least mitigating) the capital concentration in dollar assets.  On a trade-weighted basis, the Euro (about $1.15 currently) is generally viewed as an undervalued currency, with fair value closer to the $1.25-1.30 level.  But given the interest rate differentials and a difficult-to-quash “what-if” question about bond yields and fiscal sustainability in weaker European countries, it probably continues to trade cheap.

Similar to the Federal Reserve’s messaging upon exiting QE, the ECB will need to emphasize ‘gradualism’ and ‘data dependency’ in communicating its new rules of the road as it stops buying sovereign bonds in massive quantities.  ECB President Mario Draghi will step down in late 2019 after a heroic stint, and legacy at this juncture matters.  A stronger Euro as an alternative reserve currency to the dollar matters a great deal, and would partially neutralize the strong dollar tourniquet that afflicts EM financial conditions.  Alongside European monetary normalization, we expect the terms of the U.K.’s Brexit “deal” to be solidified within the next 12 months, providing closure to another key uncertainty for the markets.

Third, China Finds Ways to Grow – World demand depends little on Argentina or Turkey, but depends considerably on China.  To date, China cut individual tax rates and has let its currency slip a little vs. the dollar, while tightening up the exits by which dollars can leak out of the country.  In 2009, China enacted aggressive fiscal and monetary stimulus plans to offset the GFC-induced global recession.  These measures worked in aggregate, although much of the spending was widely acknowledged as having questionable merit.  Cambiar anticipates a more targeted approach to stimulus, with higher value-added industries getting priority.  China’s growth has slowed relative to the early 2010s; however, the country’s move up the value-added curve to greater prosperity is clear on a broad basis.

Beating a drum as to the merits of a true global asset allocation have become difficult, given the spectacular success of U.S. stocks since 2009.  However, the virtues of asset allocation and diversification remain, despite the increased skepticism that is inevitable when returns have polarized in one direction or another.  Contrary arguments suggest a “this time is different” conclusion, often a dangerous one to reach.  The U.S. economy has more than fully recovered from the depths of the Great Recession, while other major Developed Market economies remain well below potential output.  This set of factors has become all the more acute for market returns as the U.S. has normalized its monetary policy amidst full employment conditions.  There are a number of reasons to believe that recoveries in international markets may gain steam in 2019-20 alongside international monetary conditions, while the ongoing success of U.S. equities may comparatively run on a bit less steam in the coming years.